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

403(b)

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

A 403(b) plan’s investing options are decided on by the employer. An employee who invests in a 40(3)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 potentially 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, an employee can contribute $19,000. 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. Comprehensively, employees and employers can contribute a combined total of $56,000 in 2019.

Taxes

Taxes can be an important consideration for all types of investments and specifically retirement account investing.

In a 403(b) plan, scheduled contributions are deducted from a participant's paycheck before taxes are calculated and this is considered a pre-tax contribution. This is also considered a type of tax deduction since it lowers the taxable income.

Example: An individual who earns $3,000 in a pay period and who 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 pre-tax, individuals must pay taxes on the withdrawals they make in retirement. Distributions can begin without penalty at age 59 ½. The tax rate on those withdrawals is based on the tax bracket the participant falls 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.

Roth IRA

A Roth IRA is usually invested in 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 in a 403(b) vs. 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 2019, individuals can contribute a maximum of $6,000 to a Roth IRA. Americans 50 or older can contribute an additional $1,000 in catch-up contributions for a total of $7,000.

Taxes

Some of the other big differences in 403(b) vs. Roth IRA vehicles pertain to 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.

Accumulations 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. These tax rules can make IRAs attractive for investors seeking to avoid taxes all together.

Optimization Considerations

When considering a 403(b) vs. a Roth IRA you are not limited to opening one or the other. In 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 since this is money given to you in addition to your salary. You will have to pay taxes on these funds in retirement so keep in mind your planned tax rate in retirement and subtract accordingly for future projections.

If you are interested in a Roth IRA it is 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 then contribute to your Roth IRA after that.

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 non-profit, tax-exempt employers.
  • Roth IRAs are individual retirement accounts that can be opened by anyone.
  • 403(b) and Roth IRA accounts have differing rules and maximum contribution limits which are important to understand for investors seeking to use them for retirement savings.