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What Is a 403(b) Plan?

A 403(b) plan is a retirement account for certain employees of public schools and tax-exempt organizations. Participants include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.

The 403(b) plan is in many ways similar to its better-known cousin, the 401(k) plan. Each offers employees a tax-advantaged way to save for retirement, but investment choices are often more limited in a 403(b), and 401(k)s serve private-sector employees.

Key Takeaways

  • 403(b)s resemble 401(k)s but they serve employees of public schools and tax-exempt organizations rather than private-sector workers.
  • The advantages of a 403(b) compared to a 401(k) can include faster vesting of your funds and the ability to make additional catch-up contributions.
  • Investment choices may be more limited with a 403(b), however, and some accounts offer less protection from creditors than 401(k)s.

Understanding a 403(b) Plan

The features and advantages of a 403(b) plan are largely similar to those found in a 401(k) plan. Both have the same basic contribution limits: $19,500 in 2020 and 2021. The combination of employee and employer contributions are limited to the lesser of $58,000 in 2021 (up from $57,000 in 2020) or 100% of the employee's most recent yearly salary. 

Both also offer Roth options and require participants to reach age 59½ to withdraw funds without incurring an early withdrawal penalty. Like a 401(k), the 403(b) plan offers $6,500 catch-up contributions for those age 50 and older in 2020 and 2021. Unlike a 401(k), it also offers a special plan for those with 15 or more years of service with the same employer (see below).

If your employer offers a 403(b) and a 401(k) you can contribute to both but your aggregate contribution cannot be more than the $19,500 limit, not counting any catch-up contributions.

Although it is not very common, your job situation could end up giving you access to both a 401(k) and a 403(b) plan.

Advantages of a 403(b) Plan

Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions.

Employees with a 403(b) may also be eligible for matching contributions, the amount of which varies by employer. Plans that do not offer employer matches deprive employees of the essentially free money these provide, but they may lead to lower administrative costs.

403(b) plans that are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act (ERISA) may have lower administrative fees when compared to 401(k)s or other retirement plans subject to greater oversight. One of the rules for non-ERISA 403(b) plans is they cannot have employer contributions.

Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do. Also, if an employee has 15 or more years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan that those who have a 401(k) plan can't make.

Clergy can also participate in a 403(b) but there's a special plan type—a 403(b)(9)—that's designed specifically for employees of religious institutions.

Under this provision, you can contribute an additional $3,000 a year up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don't have to be 50 or older to take advantage of this. But you do have to have worked for the same eligible employer for the whole 15 years.

Disadvantages of a 403(b) Plan

As with a 401(k), funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.

A 403(b) may offer a narrower choice of investments than the other types of retirement plans. The reason is that 401(k)s tend to be administered by mutual fund companies, which can offer a host of these diverse and versatile investment options.

Most 403(b) plans now offer mutual fund choices as well, albeit inside a variable annuity contract in many cases. However, fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans⁠; other securities, such as stocks and real estate investment trusts (REITs) are prohibited.

The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities.

These investments have some advantages but financial advisors often recommend against investing in annuities in a 403(b) and other tax-deferred investment plans for a variety of reasons.

For 403(b)s that don't have ERISA protection, accounts may lack the same level of protection from creditors as plans that require ERISA compliance, including 401(k)s. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state. The laws can be complex.

A lack of ERISA protection means that the plan doesn't have to follow ERISA standards to ensure plan safety.

Another disadvantage of non-ERISA 403(b)s include their exemption from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.