403(b) Plan: Introduction
What Is a 403(b) Plan?
A 403(b) plan is a tax-advantaged retirement plan for public school and nonprofit employees and certain ministers. It’s also a type of defined contribution plan, meaning that participants know how much money they are putting in, but not how much they will ultimately receive. That depends on how the investments they choose perform. By contrast, a pension is a defined benefit plan, where participants receive a guaranteed payout based on their years of service and salary history. These plans have fallen out of favor and largely been replaced by defined contribution plans like IRAs, 401(k)s and 403(b)s.
If you understand how 401(k) plans work, 403(b) plans are similar. If not, don’t worry — we’re about to explain all the details. (See also: What is the difference between a 401(k) plan and a 403(b) plan?)
403(b) Plan Types
403(b) plan accounts must be one of three types:
- an annuity contract from an insurance company
- a custodial account invested in mutual funds
- a retirement income account for church employees that invests in annuities or mutual funds
They’re called 403(b) plans because they’re described in section 403(b) of the Internal Revenue Code (the tax code). They’re also called tax-sheltered annuities (TSAs), because when the plans were first invented, participants could only invest in annuities. But since 1974, participants have also had the choice of investing in mutual funds, making the TSA name outdated — not to mention that most of us associate those initials with airports nowadays.
Why Establish a 403(b) Account?
Contributing to a 403(b) plan, if your employer offers one, is a great way to save for retirement. The account’s tax benefits help you save and grow your investments faster.
There are three tax benefits of contributing to a 403(b) account. First, you don’t pay income tax on your contributions to the plan because they are either deducted or excluded from your income. An exception is that if the plan is a Roth 403(b), your contributions are taxed, but your distributions are not taxed.
Another exception is that you still pay Social Security and Medicare taxes on your contributions. It is possible to make both pre-tax (regular) and after-tax contributions to a 403(b) if your employer allows it, as long as you don’t put in more than the IRS allows per year. More on why you might want to make after-tax contributions later, in section 3.
Second, as the money inside your 403(b) account grows through dividends, interest, and investment appreciation, you don’t pay taxes on those earnings or gains until you withdraw them. Your money grows much faster this way because you aren’t losing part of it to taxes every year.
Let’s say you start with nothing, have $125 withheld from each paycheck for 20 years, and earn an average annual return of 6% before inflation. Without taxes eating away at your returns, you’ll end up with more than $125,000! If your money was in a taxable account instead, you’d end up with about $102,000, a difference of $23,000.
Third, if your income is low to moderate, you may be eligible to claim the Retirement Savings Contributions Credit, also called the Saver’s Credit, for money you have taken out of your paycheck to put into your account. This credit will partially offset the first $2,000 you put in your 403(b).
Employers also get benefits when they establish 403(b) plans for their employees. Eligible employers are public schools, 501(c)(3) nonprofits and churches. Employers are not required to contribute to employees’ 403(b) plans. But if they do, the benefits of offering a 403(b) plan are tax savings — employers contribute pretax dollars on an employee’s behalf — and employee attraction and retention.
The downside of offering a 403(b) plan from an employer’s perspective is that it can be time-consuming. Investment companies such as TIAA, Fidelity, TransAmerica and many others provide plan management to ease this burden, but employers must pay for these services.
Next, we’ll explain who may establish and participate in a 403(b) plan and how to establish an account.