What Is a 403b Retirement Plan and How Does It Work?

Last Updated on February 1, 2022 by pf team

If your employer is a school, university, hospital, or another type of public sector employer, chances are good that one of your retirement plan options is a 403b.

Many public sector employers are replacing or supplementing traditional pension plans with 403b plans that allow workers to build a retirement nest egg in a tax-advantaged way. Here’s what you’ll need to know about 403b plans.

403b plan
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What is a 403b plan (TSA)?

A 403b plan is a tax-deferred retirement plan commonly available to public sector employees.

Similar to other defined contribution plans, like a 401k, a 403b is funded primarily by employee contributions, although it is possible for the employer to contribute to your account as well.

A 403b plan is often also referred to as a TSA plan, which stands for tax-sheltered annuity.

However, this term isn’t always accurate because many 403b plans offer additional investment options and annuities are often only one of several investment choices, which can also include mutual funds.

How does a 403b retirement plan work?

A 403b allows you to contribute up to a fixed amount annually, limited to $19,000 for 2019, with your contributions to the plan being tax deferred. At withdrawal, taxes are paid on the amount withdrawn at your tax rate for that year.

In effect, a 403b plan allows you to reduce your taxable income as you are saving for retirement and allow your contributions to grow without a tax burden.

Earnings from capital gains, dividends, or other growth in your account balance aren’t taxed until you withdraw from your account.

Because a 403b has tax advantages aimed at growing retirement savings, some important restrictions apply.

For example, withdrawals prior to age 59 ½ may be subject to a 10% early withdrawal penalty. However, if you retire — or are fired or laid off — after age 55, you may be able to access your 403b savings without penalty.

Much like a 401k, a 403b can leverage compound interest and time to multiply your contributions and grow your retirement savings.

Employers may also contribute to your account to help build your savings. Money invested in a 403b plan might be invested in mutual funds, money market funds, or annuities.

Federal rules prohibit direct investment in individual stocks through a 403b, limiting options to funds or annuities offered through the plan.

An individual retirement account (IRA) is a better option if you want more freedom when investing for retirement purposes.

Similar to a 401k or an IRA, consistent contributions to a 403b plan throughout your working years can lead to a significant amount of money saved for retirement.

As you begin to withdraw, the remaining balance can continue to grow tax-deferred, helping to stretch your retirement savings.

At age 70 ½, IRS rules require that you begin withdrawing from your 403b, in most cases, subject to the guidelines provided for required minimum distributions (RMD).

403b advantages and disadvantages

A 403b plan can be a great way to save for retirement but depending on your plan and individual circumstances, a 403b may not always be the most efficient way to build your retirement nest egg.

When compared to a 401k, a 403b provides similar tax benefits and the two account types even share the same contribution limits. You’ll find a bigger difference when comparing a 403b to a traditional IRA.

Advantages

  • Tax-deductible contributions: Contributions to your 403b are tax deductible, which means you can put more money to work than with a taxable investment account. Tax-deferral benefits apply to state and federal taxes. However, FICA taxes, which include Social Security and Medicare taxes are still due based on your total earnings.
  • Employer-matching contributions: Some employers provide matching contributions as an employment benefit. A common structure is employer matching contributions of 50% up to 6% of w-2 earnings.
  • Tax-free growth: Any gains earned in your 403b account are not taxed until distribution. This allows your account to continue growing without a tax burden.
  • Loan options: A 403b may have loan privileges which allow you to borrow up to 50% of your balance with a maximum of $50,000. Loans are repaid through a payroll deduction.
  • High contribution limits: Standard contribution limits for a 403b account, currently at $19,000 per year, are over 3 times the annual contribution limit for a traditional IRA.

Disadvantages

  • Limited investment options: Many 403b plans now closely mirror the options you’ll find available with a 401k plan. However, when compared to an IRA, which can hold several types of investments, a 403b offers far fewer options.
  • Beware of fees: Some 403b accounts or investment options can have high fees. In particular, be aware of the costs associated with annuity investments.
  • Penalty for early withdrawal: Like a 401k, there is a 10% tax penalty for early withdrawal, which applies to most distributions before age 59 ½.
  • Tax-deferral might not save much: If you are new to the industry or have lower earnings, tax-deferrals may not be much of an advantage. In some cases, there may be little or no tax liability based on income in a given year, which reduces one of the key benefits of a 403b.
  • Annuities can be tricky to navigate: Most plans now offer both mutual funds and annuities, but for money invested in annuities, it can be costly to reallocate these funds into another investment option.
  • Gains taxed as regular income: Taxes on gains and dividends in a 403b can be higher than on capital gains and dividends in a taxable investment account. 403b distributions are taxed as regular income based on your tax bracket at the time of withdrawal.

403b retirement plan types

There are two types of 403b in regard to tax treatment and each has its advantages.

Traditional 403b plans are more common, but if your plan offers a Roth 403b option, it may be worth a closer look.

Traditional 403b

In a traditional 403b, your contributions are made with pre-tax money.

When your funds are available for withdrawal without penalty, usually at age 59 ½, you pay income tax on the withdrawal amount as regular income.

While this is the most common type of plan, you may also have the option of using after-tax dollars to invest with a Roth 403b, which brings a different tax benefit: tax-free withdrawals.

Roth 403b

Like the better-known Roth IRA, the Roth 403b allows you to invest after-tax money.

There is no tax deduction for contributions and taxes are paid on contributions as they are earned.

However, the unique feature of a Roth 403b is that you can take tax-free withdrawals of your contributions at any time and the entire balance is available tax-free when you reach age 59 ½.

This structure provides more flexibility if access to some of your savings is a concern and removes the tax burden on growth in your account.

Both your contributions and earnings can be withdrawn tax-free when you reach eligible age and have had your account for at least 5 years.

Who can participate in a 403b plan?

403b plans are available for schools and qualified tax-exempt organizations.

While not all organizations that qualify to sponsor a 403b choose to offer a 403b to employees, 403b plans are common for tax-exempt organizations and public-sector employers due to their lower administrative costs.

Most employees can participate if the employer offers a 403b plan.

Under the 403b universal availability requirement, nearly all full-time employees of an organization that offers a 403b can participate.

The IRS allows exclusions for certain workers, such as part-time workers or those participating in an alternative retirement program offered by the same employer.

What are the 403b contribution limits?

403b contribution limits mirror those set by the IRS for 401k contribution limits. For 2019, the maximum individual contribution is $19,000 annually, with this limit applying to both pre-tax 403b accounts and Roth 403b accounts.

By comparison, a Roth IRA is limited to a $6,000 annual contribution in most cases.

For 403b account holders age 50 and older, a $6,000 per year catch-up contribution is allowed, making the total allowable elective deferral $25,000.

Elective deferrals refer to the amounts you contribute to your own account. A separate overall limit applies if your employer contributes matching funds.

For 2019, the total overall limit for 403b contributions is $56,000 or 100% of the employee’s earnings, whichever is lower.

If you qualify for catch-up contributions, the overall limit is $62,000 including employer contributions.

Participation in other types of retirement plans can affect your contribution limit. The limits are usually shared across all retirement account types, so if you contribute to an IRA, the amount you can contribute to a 401k or 403b may be lower.

A notable exception are 457 plans, which have similar contribution limits to a 403b plan but which allow tandem contributions.

In effect, you can double the allowable contribution limit for tax-deferred retirement savings if you participate in both a 457 plan and a 403b plan. 457 plans are also commonly offered by public-sector employers.

What investments can you have in a 403b?

There are 3 distinct types of 403b plans, each of which can serve a different purpose and can have different investment options.

However, most plans now function as a hybrid and bring the features of more than one plan type to retirement investors.

403b(1)

The 403b moniker has become the catch-all name for all types of 403b accounts. The name comes from the more specific 403b(1) account type, which refers to an account that invests in annuities.

An annuity pays out a fixed amount of money each year after reaching maturity.

Historically, this is how 403b accounts were structured — as annuity investment vehicles with tax-deferred contributions and earnings.

Modern 403b accounts typically offer mutual funds as well — but many hold onto their annuity heritage and still offer an annuity option.

403b(7)

A 403b(7) refers to a 403b account that offers mutual funds. You’ll also see a 403b(7) referred to as a custodial account.

While the distinction between a 403b(1) and 403b(7) was more apparent in the past, today most 403b plans offer both options: mutual funds and annuities.

With many 403b(7) plans, you can expect to find funds ranging from index funds and stock funds to bond funds and money market funds.

403b(9)

Sometimes called a church plan, a 403b(9) is a type of 403b plan which allows ministers and church employees to save for retirement with pre-tax dollars. 403b(9) provisions allow for both annuity and mutual fund investments.

A significant benefit of a 403b(9) for clergy is that IRS rules allow for an additional tax benefit based on a housing allowance that can cover several types of housing expense and provides the opportunity for some 403b(9) account holders to stretch their retirement savings further.

What are the 403b withdrawal rules?

403b plans have specific rules regarding withdrawals that are important to consider. Because the 403b is a retirement plan, withdrawals are restricted by age.

This allows you to continue saving in a tax-advantaged way until retirement — but you may sacrifice some financial flexibility.

Prior to age 59 ½, withdrawals from a standard 403b account may be subject to a 10% early withdrawal penalty.

However, if you retire after age 55 — or if you are let go — you may be able to begin withdrawals without paying the 10% penalty. If applicable, the penalty applies only to the amount withdrawn.

At age 70 ½, you’ll be required to begin withdrawing from your 403b account, even if you don’t need the money yet.

Your plan usually notifies you of the amount you’ll need to withdraw, but the IRS expects account owners to be aware of the required minimum distribution amounts.

Penalties may apply if you don’t withdraw enough each year after you reach age 70 ½.

Some 403b plans also have a loan provision, under which you can borrow up to 50% of your vested balance with a maximum loan amount capped at $50,000.

The loan, if available through your plan, is paid back to your account with interest through a payroll deduction as required by IRS rules.

Roth 403b plans, which are funded with after-tax contributions, have different rules for withdrawal and generally offer more financial flexibility.

How is a 403b plan taxed?

When you withdraw from a 403b, you’ll have to pay taxes on the amount you withdraw based on your tax rate at the time of withdrawal. Taxes are only due on the amount you withdraw.

The remaining balance isn’t taxed until you withdraw those funds.

In some cases, the tax liability from 403b withdrawals may be higher than the taxes that would be due if you made the same investment in an individual investment account.

With a 403b, you won’t get the benefit of a lower long-term capital gains rate or for qualified dividends, which are also taxed at the same rate as long-term capital gains.

Instead, you’ll pay taxes on the amount withdrawn based on your tax bracket at the time, which may result in higher tax liability for some retirees.

However, this potential expense is offset in most cases by the accelerated gains available through investing pre-tax money. As mentioned earlier, early withdrawals may also be subject to a 10% penalty, which is paid to the IRS.

403b FAQs

What is the difference between a 401k and a 403b retirement plan?

A 401k and 403b have similar tax advantages, rules, and plan structures.

401k plans are commonly used by private employers, while 403b plans can be sponsored by several types of tax-exempt organizations.

Traditionally, 401k plans offered more investment choices. However, 403b plans are catching up quickly and many 403b plans offer a wide variety of fund choices.

Modern 403b plans often have more features than the simpler annuity-based plans of yesteryear.

Expect a generous choice of funds in most 403b plans and asset allocation features that allow you to invest according to your long-term goals.

Can you have a 403b and a 401k?

If your employer offers both a 403b and a 401k plan, you can contribute to both — if your employer allows you to participate in both.

IRS universal availability rules for 403b plans allow employers to make an employee ineligible for a 403b if they participate in another 401k, 457, or 403b plan offered by the same employer.

If you are eligible to participate in both a 403b and a 401k, annual contribution limits remain the same and apply to (nearly) all income deferral plans.

This means your annual contribution limit of $19,000 is shared between the 401k and 403b plans.

Can you rollover a 403b into 401k?

If your plan allows rollovers, you can roll a 403b into a 401k — or 457 plan or SEP plan, or even into a traditional IRA.

However, not all plans allow rollovers, which can make an IRA your best option for rollovers.

When rolling over funds from one qualified retirement account to another, you have 60 days to move the money into another plan or retirement account after the funds are withdrawn from the first account.

After 60 days, the amount withdrawn becomes taxable as income and may incur an early withdrawal penalty.

If possible, arrange a direct transfer from one plan to the other plan to avoid penalties and possible tax withholding.

Which is better a 401k or a 403b?

Often the best option between a 401k and a 403b depends on which type of plan is available through your employer.

The tax advantages are largely equivalent between the two plan types, which shifts the focus to individual plan features.

401k plans tend to have a wider variety of investment choices but many 403b plans offer similar investment options and investing tools, like asset allocation models.

If your employer offers both, study the costs of each plan as well as the investment options before choosing.

Can I convert a 403b to a ROTH IRA?

It is possible to convert a 403b to a Roth IRA. Roth IRA accounts are designed to provide tax-free income because the money contributed has already been taxed.

This means a rollover from a 403b or similar tax-deferred account becomes taxable at the time of the rollover.

Depending on the rollover amount, you may even find yourself in a higher tax bracket for that tax year or may be phased out of other tax benefits.

If the move makes sense for you, the rollover can leave you with tax free income during retirement and fewer restrictions on withdrawals and contributions for your new Roth IRA.

Is a 403b better than an IRA?

A 403b isn’t necessarily better or worse than an IRA. Many retirement savers have both types of accounts and each has its benefits.

A traditional IRA gives you more control over investment direction and allows several additional asset types as investments.

A 403b has higher limits for income deferral, which allows you to put more money to work.

Can I use my 403b to buy a house?

You can use your 403b to help fund a home purchase. Withdrawing money from your 403b to buy a home is categorized as a hardship withdrawal.

However, while the name hardship withdrawal implies there is no penalty, the opposite may be true when using retirement funds to buy a home or make a down payment.

Expect to pay a 10% penalty on the amount you withdraw if you are younger than age 59 ½ — or age 55 if you are no longer employed by the plan sponsor.

If you need to access your retirement savings to purchase a home, inquire about a loan against your 403b. The loan, if allowed by your plan, must be paid back with payroll deductions per IRS rules.

What do you do with a 403b when changing jobs?

If your 403b balance meets a minimum level, usually about $5,000, you may have the option to leave your account in place with your previous employer — but you won’t be able to contribute to the plan once you leave.

Alternatively, you may be able to rollover the balance to the new employer’s plan or into a traditional IRA without any tax consequences — as long as the money isn’t held outside of a qualified plan for more than 60 days.

Do I need to report my 403b on my taxes?

Your employer reports your 403b contributions on your W-2, which is sent to the IRS directly and is provided to you as well.

There’s no need to deduct your 403b contributions on your taxes. In effect, your contributions aren’t included in your taxable income.

However, you may want to consult your records of your contributions if you have other retirement accounts, like a traditional IRA, so you’ll know how much you can contribute without affecting your ability to deduct contributions made to other retirement accounts.

When can you withdraw your 403 B without penalty?

In most cases, you have to wait until age 59 ½ to withdraw from your 403b without a penalty. The rule of 55 provides an exception if you leave your job after age 55.

Other exceptions exist for cases of permanent disability, tax levies, excess contributions, or when taking substantially equal periodic payments.

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