What is a 403(b) Plan?
A 403(b) plan is a retirement plan, similar to a 401(k) plan, for employees of public schools, nonprofits, and religious institutions. 403(b) plans resemble 401(k) plans because they have comparable structure, contribution limits, and eligibility criteria. But they also differ from their 401(k) counterparts in some respects. For example, they allow higher contribution limits and have a different menu of investing products as compared to 401(k) plans.
Basics of 403(b) Plans
403(b) plans are meant for employees of public service institutions and nonprofits. They are salary deferral plans that may or may not have matching contributions from employers. Employees in public school systems and nonprofits, including religious institutions, are eligible for 403(b) plans and they can contribute up to a maximum of $19,500 in 2021and 2020 towards such plans.
Employer contribution to 403(b) plans is elective, meaning they can choose to not contribute towards the plan. The maximum combined amount of contributions from employers and employees for a 403(b) plan is $58,000 in 2021 and $57,000 in 2020.
403(b) plans are subject to the 15-year rule. According to this rule, employees who have worked at an institution for 15 years or more can make contributions of $3,000 per year for up to 5 years to their 403(b) plans. Employees above the age of 50 can make catch-up contributions of $6,500 in 2021 and $6,000 in 2020.
Just like 401(k) plans, 403(b) plans also offer account holders the opportunity to make withdrawals after 59.5 years of age. Early withdrawal before the eligible age results in a 10 percent penalty plus taxation of income at prevailing rates. Account holders can take loans against the assets in their account or hardship distributions from it.
Differences between 401(k) and 403(b) Plans
While they seem similar, 401(k) plans and 403(b) plans have important distinctions. Perhaps the biggest difference lies in the institutions that use them. 401(k) plans are used at private, for-profit companies while 403(b) plans are offered to employees of school districts and government employees. Other important differences between the two types of plans are outlined below.
- 403(b) plans are not subject to non-discrimination testing, if the employer does not make matching contributions to the plan. The non-discrimination test is conducted annually by the IRS for 401(k) plans to ensure that highly-compensated employees do not end up benefitting from retirement plan through greater tax benefits. If an employer makes a matching contribution, then 403(b) plans are subject to the same tests as regular 401(k) plans.
- 403(b) plans have fewer investment options as compared to 401(k) plans. 403(b) plans are also known as tax-sheltered annuity plans (TSAs) because of the preponderance of annuity plans, which offer annual payments, offered by insurance companies in such plans. 401(k) plans are generally offered by mutual and index fund administrators, which leads to a larger variety of investing products, across multiple geographies, on offer for investors.
- 403(b) plans are also available in Roth-flavored options, allowing investors to make after-tax contributions to their plan and ensure a tax-free retirement income. 401(k) plans do not have similar options.
- Some 403(b) plans are cheaper as compared to 401(k) plans because they have fewer products on offer and, therefore, require less management.
- As detailed earlier, 403(b) plans have higher contribution limits in comparison to 401(k) plans allowing individuals to save more of their income for retirement.
Advantages and Disadvantages of 403(b) Plans
Many of the advantages and disadvantages of 403(b) plans are the same as those for 401(k) plans. For example, both offer tax benefits and the convenience of investing in financial products to grow your retirement income.
The advantages of 403(b) plans over 401(k) plans are outlined below.
- The vesting period for 403(b) plans is shorter as compared to 401(k) plans. This means that it takes less time to take ownership of your funds in the plan as compared to 401(k) plans. Some 403(b) plans also offer immediate vesting.
- The availability of Roth options in 403(b) plans also ensures tax-free retirement income. Distributions from 401(k) plans are subject to regular taxes.
- Higher contribution limits of up to $58,000 in 2021 in 403(b) plans means that employees can sock away more for retirement as compared to 401(k) plans.
- Fewer investing products in a 403(b) plan can lead to lower fees and simplicity in administration as compared to 401(k) products.
The main disadvantage of 403(b) plans is that they have less investment choices for account holders who might be interested in trading through their retirement accounts in order to avoid capital gains taxes. In the main, 403(b) plans are populated with annuity products from insurance companies. While such products offer predictable and guaranteed income, they lack the returns available from trading products, such as mutual funds and stocks.