What is a 403(b) plan and how does it work?

A 403(b) is the retirement planning vehicle used by not-for-profit or other tax-exempt employers of nurses, doctors, teachers, professors, school personnel, researchers, clergy, and some governmental organization workers. 403(b) plans are named after the section of the Internal Revenue Service (IRS) code that created them.

It has been estimated that 403(b) plans cover about 20 percent of U.S. employees. But for some reason they get much less press than 401(k) plans, which are sponsored by private, for-profit companies. Like a 401(k) however, a 403(b) is a way for eligible employees to save for retirement through payroll deductions (also called elective deferrals) on either a percentage of salary or set dollar amount basis.

403(b) vs. 401(k) plans

Like a 401(k), 403(b) plans can be funded with pre-tax or after-tax dollars. Pre-tax contributions grow tax-deferred until you withdraw them at retirement, at which point they are taxed as ordinary income. After-tax contributions, also known as Roth contributions, means your money grows tax-free, and since you have already paid taxes on these contributions, you will not pay tax on withdrawals made in retirement.

Both plans include a 10 percent tax penalty for early withdrawals taken before reaching age 59 ½. Military reserve duty, permanent disability or medical expenses exceeding a certain percentage of your adjusted gross income may make you eligible for a qualified distribution that does not trigger the penalty.

Both 401(k) and 403(b) plans may allow for loans, hardship withdrawals and an additional catch-up contribution for employees over age 50. An additional commonality includes allowing an employer match (should an employer choose to offer one). Contributing to your 403(b) at least up to the amount of your employer’s match is a good way to avoid leaving (almost) free money on the table.

403(b) contribution limits

Employees can contribute up to $23,000 in 2024. Those over age 50 can also contribute up to an additional $7,500 in catch-up contributions. Regardless of age, employees with at least 15 years of service with the same employer and an average annual contribution of less than $5,000 per year may be permitted to defer an extra $3,000 per year over and above normal IRS deferral limits (up to a lifetime limit of $15,000 for this type of catch-up contribution). Not all employers offer catch-up contributions based on the 15-year rule.

For plans with employer contributions, you can contribute up to 100 percent of your salary, or $69,000, whichever is less. This limit rises to $76,500 for those age 50 or over. Contributions made over and above the IRS elective deferral limits are made on an after- tax basis.

Advantages of 403(b) plans

• A 403(b) plan allows you to save on a tax-advantaged basis, deferring taxes on your income and any investment earnings or enjoying a tax-free benefit, depending on which plan you select.
• 403(b) employer contributions may vest faster than in 401(k) plans.
• If you are no longer with your employer, 403(b) rules may be more flexible than 401(k) early withdrawal rules.
• You can contribute more to a 403(b) plan each year than you can to an IRA.

Disadvantages of 403(b) plans

• 403(b) plans may contain limited investment options that are not employee-friendly such as annuities with low returns, expensive fees and surrender charges. If you have a 403(b) plan, look to invest in funds that have low fees.
• 403(b) plans without employer matching contributions do not include Employee Retirement Income Security Act protections, which means there are no minimum standards for the retirement plan. Minimum standards include helpful safeguards for savers.
• Like a 401(k), 403(b) plans also include required minimum distributions. These are required starting in April of the year after you turn age 73 unless you are still employed.

How to choose investments in your 403(b)

As mentioned above, eligible investment options in your plan will charge you a fee (taken out of your balance on a monthly or quarterly basis), so it’s very important to be aware of how much you are paying for the “privilege of investing.” Fees matter, so you need to read the plan prospectus (for mutual funds and variable annuities) or the contract (for fixed annuities) which outlines costs of the various investment options as well as investment objectives, risk levels and performance history.

You should be able to locate this information online through your plan administrator. However, speaking to someone in your employer’s Human Resources department may be helpful if you need additional assistance or clarification.

When it comes to selecting funds, a good general rule is to favor stock funds when you have many years before retirement and increase your exposure to fixed-income investments as retirement gets closer. Stock returns have historically been higher than fixed-income returns, but their volatility makes them less suitable for those with short time horizons. 

How much should you contribute to a 403(b)?

Since a 403(b) can be an important component of your retirement income, in addition to Social Security and other investments or savings, experts advise contributing between 10 to 15 percent of your salary and to start as soon as you become eligible. Bankrate’s retirement calculator can help you calculate how much to save for retirement based on your annual salary, contribution rate, age, expected rate of return, employer match (if applicable) and other relevant factors.