What is a 403(b) Plan?
Retirement 401(k) plans are common. However, we’re going to discuss their slightly-less famous cousin, the 403(b) retirement plan here. Named after the IRS tax code, 403(b) plans are offered to employees of certain tax-exempt groups (Code Section 501(c)(3)) and public education institutions. Also, some ministers may be eligible for a 403(b), but churches have a plan of their own.
So what is a 403(b) retirement plan? Let’s go over the specifics…
What is a 403(b) Plan?
A 403(b) retirement plan lets you save money, lower your taxable income and invest your savings. When they were first created, 403(b) plans were tax-sheltered annuities, so they tend to favor annuities. Over the last several years, employers have started increasing their fund options. This gives employees a better way to diversify and pay lower fees. But securities such as stock and real estate investment funds (REITs) aren’t allowed. It’s important to know the investment options your plan offers in order to make the best investing decisions.
Most 403(b) plan contributions are pretax. This means money goes into your 403(b) before the IRS deducts taxes. With pretax contributions, your current taxable income can decrease. Then you pay tax when you withdraw the funds later in life. On the other hand, Roth 403(b) contributions – like a Roth IRA – are post-tax. You pay taxes up front but the distributions in retirement are tax-free. Your investment earnings also grow tax-free which means more money for you.
A 403(b) plan has a set contribution limit determined by the IRS. This means an employee cannot contribute any amount over the limit during a given year. Year-to-year limits can change to take inflation into consideration.
Employee Contributions. For 2020, the employee contribution limit is $19,500, which is an increase from the 2019 limit of $19,000. Once you reach the age of 50, you can contribute an additional amount to “catch up.” In 2019, the addition is $6,000 but will increase in 2020 to $6,500.
With a 403(b) plan, employees usually get another bonus when it comes to their contributions. After 15 years of service with the same employer, workers can contribute an extra $3,000 for up to five years. This means you get to contribute a total of $15,000 more! And you don’t have to be 50 years old to take advantage of this opportunity.
Additionally, most 403(b) plans vest funds over a shorter period of time than 401(k) plans, and sometimes the funds are vested immediately. Vested funds are money you own. You’re entitled to them if you leave.
Employer Contributions. Most 403(b) plans don’t have employer contribution matching because it’s not required. However, if your employer does offer contribution matching, there is a combined contribution limit. It’s the lesser of:
- $57,000 for 2020, an increase from the 2019 limit of $56,000, or
- 100% of the employee’s yearly salary
Fun Fact: If employers offer contribution matching, they can contribute to a former employee’s plan. They can contribute up to five years after the employee’s severance date.
Employee Retirement Income Security Act (ERISA)
Established in 1974, ERISA set standards for most retirement and health plans. The idea is to help protect individuals who take part in these plans. If an employer does not offer contribution matching, they are not required to follow ERISA rules.
This can be a problem because 403(b) plans are exempt from non-discrimination testing (NDT). NDT checks to see if highly compensated or key employees are receiving unfair amounts of benefits compared with other employees. All employees should have equal opportunities and access to benefits.
But that isn’t the only issue with non-ERISA plans. ERISA plans, such as a 401(k), fall under the anti-alienation clause. This states that funds deposited in plans are held by the employer. It also means the employee cannot give the funds away and their rights to the benefits are protected. Without ERISA, a 403(b) isn’t protected from creditors, lawsuits or bankruptcy.
For a 403(b) plan, there are five ways to qualify for a distribution without facing penalties.
- 59½ years of age
- Separated from employer
- Experiencing financial hardship
If you are not 59½ years old when you take a distribution, you will face a 10% penalty. This applies to most retirement plans. The only way to avoid the penalty is if the distribution is one of the other qualified reasons listed above. For more specific information, check the IRS early distribution exceptions.