403(b) Plan: How It Works, Benefits & Drawbacks

Last Updated: June 5, 2019
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There is no doubt that a well-planned retirement is important.  When you began working, you’ve probably heard people tell you to start investing in your 401(k) plan.  But sadly, not all employers offer 401(k) plans to their employees.

Instead, they may offer a pension or a 403(b) plan as an option for the employees.  If you look at its general purpose and intention, you’d hardly notice any difference between a 401(k) and a 403(b) plan.

Just like a 401(k) plan, employees can choose to invest in conservative, middle, or high-risk investments.

What Is a 403(b) Plan?

A 403(b) plan is a retirement plan for a public school, nonprofit employees and selected ministers.

  Its main feature is a tax advantage.  It falls into the category of a defined contribution plan which means that participants know how much they must contribute but not how much they will eventually receive.  That amount will depend on the performance of the investments they will choose.

On the other hand, a pension is a defined benefit plan that already pegs how much a participant will receive based on their years of service and salary history.  These plans are no longer as popular as before because employers prefer defined contribution plans like IRAs, 401(k) and 403(b).

If you are familiar with these plans, you may have noticed the similarities between a 401(k) and a 403(b).  If you’re not, you can read on as we try to explain all the details in this article.

How Do 403(b) Plan Work?

If you are a 403(b) participant, your contributions will come through regular salary deductions (deferrals) which the fund managers place in a participant-directed account.  There is an annual maximum dollar amount that you can contribute as the Internal Revenue Code (IRC) provides.

Once your contribution is in your account, you can decide where you want to invest them from a list that your employer or plan sponsor has selected.

Just remember that investing always involves market risk, including the possible loss of your money.  As you begin your investment journey, we’ll help you understand these market risks and give you strategies to help your deal with them.

Who Can Contribute To a 403(b)?

You can contribute to a 403(b) if you’re an employee of any tax-exempt organization that you find under section 501(c)(3) of the Internal Revenue Code.  Tax people, bankers, and investors often call these organizations as Section 501(c)(3) organizations or simply 501(c)(3) organizations.

Some of the participants to this plan are teachers, school administrators, school personnel, nurses, doctors, professors, researchers, librarians, and specific ministers.

403(b) Contribution Limits

Similar to a 401(k), there is a limit to elective deferrals for a 403(b) plan. For 2019, the most a participant can contribute to a 403(b) plan from out of his salary stands at $19,000 ($18,500 in 2018). Employees who are 50 years old and above at the end of the calendar year can make catch-up contributions of $6,000 up to end of 2019.

There is also a limit on annual additions or the combination of all employer contributions and employee elective deferrals to all 403(b) accounts.  It is $56,000 or 100% of includible compensation for the employee’s most recent year of service, whichever is lesser.  Some plans permit employees with at least 15 years of service to make catch-up contributions.

How Much Should I Contribute To a 403(b)?

On average, most people try to invest fifteen percent of their income to retirement each year.  Your employer will contribute their share to the plan, but that portion will count with the fifteen percent.

You have the choice to divide the contribution between your 403(b) and an IRA account.

For your IRA, you have more freedom to determine how much you invest.  If you have an employer, you should always take full advantage of their share to your plan.  After all, it is free money that adds to your retirement funds.  Remember to invest in your 403(b) up to the full amount of the match and put in the maximum to your IRA contributions.  If you do this, you can invest in your 403(b) all the way to your fifteen percent goal.

You begin by making your contribution as much as the match if you have one. If you get a raise, increase the amount of your contribution accordingly. If you are in the process of paying off debt, increase your contributions as soon as you have paid off the debt.

How to Choose Your 403(b) Investments

Although they are very similar, a 401(k) and a 403(b) plan part ways when it comes to the menu of investment choices available to their participants.

A 401(k) plan participant can choose from a wider range of investments, including mutual funds, exchange-traded funds, and even individual securities.  A 403(b) plan participant can only opt for mutual funds and annuities.

To some, this limited option for a 403(b) may be a bad thing.  But in reality, many untrained investors find too many options can be counter-productive because they tend to become confusing at some point.  With the 403(b), the limited options could actually work in favor of the participants.

These are the two options:

  • Mutual Funds
  • Annuities

When it comes to annuities, there are just two forms to choose from: fixed or variable annuities.

In a fixed annuity, the participant gets a guaranteed payout, just like a pension.  A variable annuity works much like a mutual fund.  The investor’s income at the time of retirement will depend on how well the investments in the annuity performed.

But, whether it’s fixed or variable, one thing remains constant for both of them:  their fees are higher than those of other investment products.  The upside is, the returns tend to be more stable.  A good example is lifetime annuities which guarantee income for life for the participant regardless of how long he or his spouse lives.

As you deliberate on how to invest your money, do not ignore fees, annual charges that come with the investment, investment returns, the types of mutual fund and the types of annuities.  You should also pay attention to their cashing out policies.

Do I Have to Use an Agent or Advisor to Set Up a 403(b)?

There’s no need to hire an agent or advisor to set up a 403(b).  Individuals are capable of managing a 403(b) on their own using financial education, patience and realistic expectations.  Getting an agent or an advisor can give you access to their services which include:

Retirement planning, advice on state retirement plans, and analysis of your other financial needs.

But these agents and advisors do not give their services for free, so you would have to compensate them.  Just make sure that you are clear on what services you are receiving and how much you should be paying for these services.

That’s the only way you can gauge the real value of employing the services of a representative.

Pros And Cons of 403(b) Plan

As you might have noticed, the 403(b) plan is only available to employees of certain organizations.  Since these individuals often do not have the option of a 401(k) plan through their employers, they can set up their own tax-sheltered annuities, which we call 403(b) plans, so they can save for their retirement.  The 403(b) plan, as in all other retirement plans, offers unique benefits and their own challenges to a participant.

Pros

Cons

They help to attract and retain employees due to their matching benefits. For instance, some companies offer to match employee contributions to their 403(b) plan on a 1-to-1 ratio on the first 5% of payroll.The tax benefits on a 403(b) become valid only if you use the money for its stated purpose. Because of this, if you withdraw money before the allowable minimum retirement age will open yourself to a penalty.  This penalty is equivalent to whatever taxes are due at an income tax rate equal to your current income tax bracket plus a 10% penalty on the early withdrawal.  This is like turning your liquid asset, the cash you contribute, into an illiquid asset – the receivable funds that will mature later.
The contributions to the plan enjoy tax benefits. The contributed employee and the employer that matches the contribution can write off their contributions from their taxes. There are restrictions on what kind of investments you can do in a 403(b). One restriction is that you can’t put the funds in a high-risk instrument.
The funds in the plan enjoy a tax-deferred status for decades so they bring a higher value to the owner of the account.They will only begin to pay taxes on the funds when they start to make withdrawals from them.If you over-contribute to a 403(b) account, the IRS may subject you to penalties. You should observe the annual maximum limit as the limit of the amount of personal savings you can make.
In case of emergency, the account holders can take a loan against their 403(b) plan to get cash. Of course, they should pay back these loans, as in the 401(k), or they will have to pay taxes on them. It will be mandatory to make designate deductions from your account when you reach the age of 70 ½.If you don’t follow the minimum distribution schedule, you will subject yourself to the penalties for excess contribution.
You should already specify a beneficiary prior to your death.However, if you have a limited choice on your beneficiary, he or she may also face the same distribution restrictions from the IRS because of the tax status of the account.
Lastly, whenever you put your money in an account that enjoys a specific tax status, you give up some of your rights over the use of the funds.For you to receive the benefits that the IRS gives, you have to follow their guidelines.  You should only set up your 403(b) account if you are willing to abide by the rules – because if you don’t follow them, you run the risk of paying penalties that may contribute to financial losses.