403(b) vs. Roth IRA: An Overview

403(b) plans and Roth IRAs are two vehicles designated for use in retirement planning. Roth IRAs are a personal retirement planning vehicle that can be used by anyone. 403(b) plans are similar to 401(k) plans in that they are offered by employers. However, which plan is offered depends on the type of employer.

A 403(b) plan is a retirement account that can only be offered by public school systems, nonprofit organizations, and some churches and hospitals. If you fall into this category of employment, you may be wondering about the differences between the two vehicles and how to optimize their use.

Key Takeaways

  • Both 403(b) and Roth IRA accounts are vehicles used for retirement investing.
  • 403(b) accounts are offered by public employers and certain nonprofit, tax-exempt employers.
  • Roth IRAs are individual retirement accounts that can be opened by anyone.
  • 403(b) and Roth IRA accounts have different rules and maximum contribution limits. 

403(b)

401(k) plans and 403(b) plans are offered through employers. When these plans are available to you, they offer a great opportunity to both save and potentially receive extra pay in the form of matching benefits. Matching benefits match the amount you contribute to the plan dollar for dollar up to a specified limit.

A 403(b) plan’s investment options are decided by your employer. An employee who invests in a 403(b) plan must choose among the investments available within the plan. As such, each individual employer’s 403(b) plan may be different, so it’s important to read the fine print and understand the options. In general, in addition to matching benefits, plans may offer special plan account options, loans, and other provisions that can allow for accessible cash.

403(b) plans have maximum contribution limits, which are important to identify annually, as they increase with annual cost-of-living adjustments. In 2019 you can contribute $19,000 (In 2020, that rises to $19,500). Employees over the age of 50 have the option to contribute an extra $6,000 in catch-up contributions for a total of $25,000 (In 2020, catch-up contributions rise to $6,500, for a total of $26,000). Comprehensively, employees and employers can contribute a combined total of $56,000 in 2019 and $57,000 in 2020.

Taxes

In a 403(b) plan, scheduled contributions are deducted from your paycheck before taxes are calculated. This is called a pretax contribution, and it is considered a type of tax deduction, as it lowers the taxable income.

Example: An individual who earns $3,000 in a pay period and falls into a 15% tax bracket pays $450 in income tax. If that same individual contributes $500 to a 403(b) plan, the tax is calculated on an income of $2,500, bringing the tax bill to $375. Using these calculations, the 403(b) participant makes a significant retirement account contribution and saves $75 in taxes at the time of the contribution.

Because 403(b) contributions are made pretax, you must pay taxes on the withdrawals you make in retirement. Distributions can begin without penalty at age 59-1/2. The tax rate on those withdrawals is based on the tax bracket you fall into when the withdrawals are made.

Another tax advantage for 403(b) plans is that growth in plan assets is tax-deferred. This means all dividends, interest, and capital gains received in the plan are accumulated tax-free until they are withdrawn as income.

Contributions to 403(b) plans are made with pretax dollars, meaning you will pay tax on distributions, while contributions to Roth IRAs come from after-tax dollars, resulting in tax-free distributions.

Roth IRA

A Roth IRA is usually invested through a separate personal account unless it is offered within a 403(b) plan. Regardless, the rules for Roth IRAs are all the same.

Individual Roth IRA accounts can be opened through just about any large brokerage in the U.S. Charles Schwab, Vanguard, E-Trade, and TD Ameritrade all offer Roth IRA accounts. One of the main differences between a 403(b) and a Roth IRA is that a Roth IRA is usually a separate personal account that does not need to be adjusted through employment changes. A 403(b) plan will be held with an employer, while an individual Roth IRA account is held at a brokerage, with no need for management adjustments if you change jobs. If you leave an employer, a 403(b) account typically still remains open, but many investors will often transfer the funds for consolidation purposes.

A Roth IRA does not have the advantage of matching benefits. Therefore, all the money you contribute to the Roth IRA is your own. In both 2019 and 2020, you can contribute a maximum of $6,000 to a Roth IRA. If you are 50 or older, you can contribute an additional $1,000 in catch-up contributions, for a total of $7,000.

There are income limits for being allowed to contribute to a Roth IRA. In 2019 if you are married filing jointly, you can contribute the maximum amount if your modified adjusted gross income (MAGI) is less than $193,000—the number rises to $196,000 in 2020. If it falls between $193,000 and $203,000, you can contribute a reduced amount. (For 2020, the range is $196,000 and $206,000). If it is $203,000 or more, you may not contribute to a Roth IRA for that year. (For 2020, the cutoff is $206,000).

If you file singly, these amounts are $122,000, between $122,000 and $137,000, and $137,000 or more in 2019. For 2020, the amounts are $124,000, between $124,000 and $139,000, and $139,000 or more.

If you are married filing separately and lived with your spouse at any time during the year, you cannot contribute if your MAGI is $10,000 or higher. There are no income limits for a 403(b). These rules apply for both 2019 and 2020.

Taxes

Some of the other big differences between 403(b) and Roth IRA vehicles have to do with taxes. Roth IRA contributions are considered after-tax contributions. Essentially, you are making a contribution from your own pocket, which is believed to already be taxed with standard income tax regulations. There are no tax deductions with a Roth IRA.

Earnings in a Roth IRA are tax-free, and withdrawals of funds from a Roth IRA are tax-free in retirement. Roth IRAs also allow for tax-free withdrawals after the account’s five-year anniversary.

Optimization Considerations

When considering a 403(b) vs. a Roth IRA, you are not limited to opening one or the other. It can be beneficial to have both types of accounts when planning your retirement savings. However, if you have both, you may want to choose which to prioritize when allocating your funds. A 403(b) account is generally the most optimal choice if there is employee matching, as this is money given to you in addition to your salary. You will have to pay taxes on these funds in retirement, though, so keep in mind your expected tax rate then and subtract accordingly for future projections.

If you’re interested in a Roth IRA, it’s good to open an account as soon as possible, to take advantage of the withdrawal benefits after the five-year anniversary. Once your Roth IRA is open, you can contribute as much or as little annually as you would like, in line with the maximum restrictions. Generally, it can be optimal to max out your 403(b) contributions first, then contribute to your Roth IRA after that.