What is a 403(b)?
A 403(b) is an investment account with special tax benefits to encourage saving for retirement.
403(b) accounts are similar to 401(k) accounts but are only available to employees or leaders of nonprofit organizations, schools, and certain public service institutions.
Nonprofit organizations are welcome to offer 401(k) plans as well, but most choose to offer 403(b) accounts because they are less costly to administer and have higher contribution limits. This enables account holders to stash more money in their account if they so choose.
How the 403(b) Works
Like other types of retirement accounts, 403(b) accounts are tax-advantaged. You can contribute pre-tax income to fund a 403(b) account. Pre-tax income is income that has not yet been reduced for income taxes.
For example, if you have taxable income of $50,000 and you contribute $5,000 of pre-tax income to your 403(b) account, your taxable income is reduced to $45,000 for that year. However, incomes taxes are due when funds are withdrawn.
The other key tax benefit is that taxes on capital gains are also deferred until withdrawals are made.
In a standard brokerage account, taxes are due on net realized capital gains every year.
Combining the tax benefits from contributing pre-tax income and deferred capital gains really adds up over time!
There are some limitations to the contributions you can make to a 403(b) account.
Account holders can contribute only a limited amount of money. In 2019, the contribution limit was $19,000, but the IRS adjusts the limit on an annual basis.
If you are at least 50 years old, you can contribute an additional $6,000 per year.
Also, your employer can contribute up to 6 percent of your salary in a contribution match. Employers are not required to provide a contribution match, and matching policies vary on a case-by-case basis.
If you have worked for the same employer offering the 403(b) plan for at least 15 years, you can contribute up to an additional $3,000.
The exact amount you can contribute under this program is based on a formula that uses your years of service multiplied by $5,000, less any elective deferrals made.
Therefore, if you are over 50 years old and have more than 15 years of service at your nonprofit, you can contribute up to $28,000 of pre-tax income per year to your 403(b) plan. This is calculated as $19,000 standard contribution limit + $6,000 age-50-and-older contribution limit + $3,000 years-of-service contribution limit = $28,000.
And this does not take into account any employer contribution match.
There are also some rules for how funds can be withdrawn from a 403(b) account.
Taxes on income and capital gains are incurred when you withdraw money from the account. If you withdraw before the age of 59½, an additional 10 percent tax penalty is applied. This is to encourage people to save money for their retirement.
Comparing the 403(b) to the 401(k) Account
The table below summarizes the differences between the 403(b) account and the 401(k) account.
A 403(b) account has all the benefits of a 401(k) but with some additional perks. The biggest difference for the 403(b) account holder is the ability to contribute up to an additional $3,000 if they have worked at their organization for at least 15 years.
From the employer’s standpoint, 403(b) plans are less costly to set up and administer.
It’s no wonder most nonprofits and government organizations choose 403(b) accounts over 401(k) accounts if they have the option.