403(b) Plan

What Is a 403(b) Plan?

The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians. The plan, which is closely related to the better-known 401(k) plan, allows participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There's also an option for the employer to match part of the employee's contribution.

Key Takeaways

  • 403(b)s are retirement savings plans that serve employees of public schools and tax-exempt organizations.
  • Contributions to 403(b) plans are made through payroll deductions.
  • The IRS limits the amount that employees can contribute to their 403(b) plans.
  • The advantages of a 403(b) include faster vesting of funds and the ability to make additional catch-up contributions.
  • Investment choices may be more limited with a 403(b) and some accounts offer less protection from creditors than 401(k)s.

How 403(b) Plans Work

As noted above, individuals employed by schools and other tax-exempt organizations can save for retirement by contributing to a 403(b) plan through payroll deductions. The plan is akin to the 401(k) plan used by private-sector employees. Participants can include:

  • Employees of public schools, state colleges, and universities
  • Public school employees of Indian tribal governments
  • Church employees
  • Employees of tax-exempt 501(c)(3) organizations
  • Ministers and clergy members

The 403(b) plan has the same caps on yearly contributions that come with 401(k) plans. The maximum contributions allowed are $19,500 and $20,500 for the 2021 and 2022 tax years. The plan also offers $6,500 catch-up contributions for those age 50 and older. Combined employee and employer contributions are limited to the lesser of $58,000 in 2021 and $61,000 in 2022 or 100% of the employee's most recent yearly salary.

Participants must reach age 59½ before withdrawing funds or get slapped with an early withdrawal penalty. 

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 annual limit ($19,500 in 2021 and $20,500 in 2022)—not counting any catch-up contributions.

Special Considerations

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. Each offers employees a tax-advantaged way to save for retirement, but investment choices are often more limited in a 403(b) plan than a 401(k). And remember, 401(k)s serve private-sector employees.

But unlike a 401(k), the 403(b) plan also offers a special plan for those with 15 or more years of service with the same employer (see below).

Types of 403(b) Plans

There are generally two broad types of 403(b) plan—the traditional and the Roth. Not all employers allow employees access to the Roth version.

A traditional 403(b) plan allows the employee to have pretax money automatically deducted from each paycheck and paid into a personal retirement account. The employee has put away some money for the future and at the same time reduced his or her gross income (and income taxes owed for the year). The taxes will be due on that money only when the employee withdraws it.

A Roth 403(b) requires that after-tax money be paid into the retirement account. There's no immediate tax advantage. But the employee will not owe any more taxes on that money or the profit it accrues when it is withdrawn.

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.

Advantages and Disadvantages of 403(b) Plans

There are distinct benefits and drawbacks of holding a 403(b) plan. We've highlighted some of the most common ones below.

Advantages

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.

Certain 403(b) plans are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act (ERISA). As such, these plans tend to come with lower administrative costs, which puts more money back into the employee's pocket.

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.

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. 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 as long as you worked for the same eligible employer for the whole 15 years.

Employers aren't allowed to contribute to the non-ERISA 403(b) plans of their employees.

Disadvantages

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 other plans. Although these plans now offer mutual fund options inside variable annuity contracts. you can only choose between fixed and variable contracts, and mutual funds 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.

Financial advisors often recommend against investing in annuities within a 403(b) and other tax-deferred investment plans. Accounts may lack the same level of protection from creditors as plans that require ERISA compliance. If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state as the laws can be complex.

Another disadvantage of non-ERISA 403(b)s is 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.

Pros
  • Earnings and returns in regular 403(b) plans are tax-deferred until they are withdrawn

  • Plans that aren't subject to ERISA requirements come with lower administrative costs

  • Many 403(b) plans vest funds over a shorter period and some allow immediate vesting

  • Employees with 15 or more years of service may be eligible for increased catch-up contributions

Cons
  • Withdrawals before age 59½ are subject to a 10% tax penalty

  • Plans may offer a narrower choice of investments than other retirement options

  • Accounts within a 403(b) may lack the same protection from creditors as plans with ERISA compliance

  • Non-ERISA 403(b)s is exempt from nondiscrimination testing

What Are the Similarities Between 401(k) and 403(b)?

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. Both have the same basic contribution limits: $19,500 in 2021 and $20,500 in 2022.

The combination of employee and employer contributions is limited to the lesser of $58,000 in 2021 ($61,000 in 2022) or 100% of the employee's most recent yearly salary.

Both 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 2021 and 2022.

What Are the Advantages of a 403(b) Plan?

Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn and tax-deferred if the Roth 403(b) withdrawals are qualified distributions. Employees with a 403(b) may also be eligible for matching contributions, the amount of which varies by employer.

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. Certain nonprofits or government agencies also allow employees with 15 or more years of service to make additional catch-up contributions. 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.

Finally, 403(b) plans are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act.

What Are the Disadvantages of a 403(b) Plan?

Funds that are generally withdrawn from a 403(b) plan before age 59½ are subject to a 10% penalty. One may avoid this 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.

Plans may also offer a narrower choice of investments than the other types of retirement plans.

For 403(b)s without ERISA protection, accounts may lack the same level of protection from creditors as plans that require ERISA compliance.

Another disadvantage of non-ERISA 403(b)s includes an 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.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. "Retirement Plans FAQs regarding 403(b) Tax-Sheltered Annuity Plans." Accessed Dec. 5, 2021.

  2. Internal Revenue Service. "Income ranges for determining IRA eligibility change for 2022." Accessed Dec. 5, 2021.

  3. Internal Revenue Service. "2022 Limitations Adjusted as Provided in Section 415(d), etc.," Page 2. Accessed Dec. 5, 2021.

  4. Internal Revenue Service. "2022 Limitations Adjusted as Provided in Section 415(d), etc.," Page 1. Accessed Dec. 5, 2021.

  5. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed Dec. 5, 2021.

  6. Internal Revenue Service. "Retirement Topics - 403(b) Contribution Limits." Accessed Dec. 5, 2021.

  7. Legal Information Institute. "26 CFR § 1.403(b)-9 - Special rules for church plans." Accessed Dec. 5, 2021.

  8. Internal Revenue Service. "Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers." Accessed Dec. 5, 2021.

  9. Internal Revenue Service. "Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans) For Employees of Public Schools and Certain Tax-Exempt Organizations," Page 3. Accessed Dec. 5, 2021.

  10. Internal Revenue Service. "Retirement Plan Investments FAQs." Accessed Dec. 5, 2021.

  11. Internal Revenue Service. "I. SECTION 403(b) TAX-SHELTERED ANNUITY ARRANGEMENTS." Accessed Dec. 5, 2021.

  12. U.S. Securities and Exchange Commission: Investor. "403(b) and 457(b) Plans." Accessed Dec. 5, 2021.

  13. Internal Revenue Service. "Retirement Plans FAQs regarding 403(b) Tax-Sheltered Annuity Plans: Coverage and Nondiscrimination." Accessed Dec. 5, 2021.