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

You may be familiar with 401(k) plans, pensions and IRAs, but what about 403(b) plans? A 403(b) plan is a retirement plan for employees who work for public schools and other nonprofits. It’s similar to a 401(k) plan, with a few key differences. 

Use this guide to learn more about what a 403(b) plan is, how it works and how it differs from other types of retirement plans. 

Key takeaways

• A 403(b) plan is a type of retirement plan offered to employees at public schools and other types of nonprofits. 
• As with a 401(k), employees can automatically contribute on a tax-deferred basis to their 403(b) account through payroll deductions. 
• Employees can grow their 403(b) by taking advantage of a potential employer contribution match or investing the savings in mutual funds or an annuity. 
• Employees contributing to a 403(b) in 2022 are subject to an annual maximum contribution limit of $20,500 by the Internal Revenue Service (IRS). However, the amount can increase if employees meet certain criteria.

A 403(b) plan is a type of retirement account for employees at public schools and nonprofit organizations. It’s also referred to as a tax-sheltered annuity plan or TSA plan, meaning employees can make pretax contributions to their accounts.

By contributing to a 403(b), employees are able to save for retirement by setting aside a portion of their paycheck to their account. Employers can also match some of the employee’s contributions to further increase the employee’s retirement savings potential.

With a 403(b) plan, an employee must be 59 1/2 years old to withdraw from the account. Otherwise, they may be subject to a 10% early withdrawal penalty.

An employee contributes funds from their gross salary to their individual 403(b) account through payroll deductions—also known as elective deferrals. The funds are contributed on a tax-deferred basis. This can cut down on the marginal tax rate—or the tax rate paid on each additional dollar earned as income—the employee pays. 

With a traditional 403(b) plan, employees don’t pay income taxes on the money contributed until they withdraw the funds, usually at retirement. 

Employees can typically invest their 403(b) plan savings in mutual funds or an annuity. The rate of return in the employee’s 403(b) account may vary depending on how the mutual funds or annuities perform.

Roth 403(b) plans

Employees might also choose a Roth account instead of a traditional 403(b) plan. With a Roth account, the employee’s contributions are taxed as they’re made, so the funds aren’t generally taxed when they’re withdrawn. 

403(b) employer matching

An employer could match a portion or all of the employee’s contributions to a traditional or Roth 403(b) to further build the employee’s retirement savings. The details can vary depending on the company or organization. 

According to the IRS, there are specific types of employers and organizations that can offer a 403(b) plan to their employees. Here are some examples:

• Public school systems
• Public colleges and universities
• Cooperative hospital service organizations
• 501(c)(3) tax-exempt organizations
• Churches

Employees who may not be eligible to participate in a 403(b) plan

Employers or organizations must follow the universal availability rule, according to the IRS. That means that if an employer allows one employee to defer funds to a 403(b) plan, all employees must have the opportunity to do the same. However, employees who don’t meet certain criteria may be excluded from participating in a 403(b) plan. Here are a few examples:

• Employees who contribute less than $200 annually to an individual 403(b) account
• Employees who participate in another retirement plan—like a 401(k) or 457(b)—offered by their employer
• Employees who work less than 20 hours per week

For 2022, the maximum amount an employee can contribute to their 403(b) account is $20,500. Individuals over 50 can contribute an additional $6,500 to make catch-up contributions at the end of the calendar year. According to the IRS, some plans allow individuals with 15 years of service to increase how much they contribute by whichever of these options is the least amount:

• $3,000
• $15,000 minus the employee’s additional contributions in previous years
• $5,000 times the number of years of service, minus the total elective deferrals made in previous years

There are advantages and disadvantages to participating in a 403(b) plan. Keep in mind that the benefits of participating in an employer or organization’s 403(b) can depend on the plan’s specific features.

Pros of 403(b) plans

• Contributing to a traditional 403(b) plan allows employees to save for retirement on a tax-deferred basis. 
• Employees who contribute to a 403(b) plan can become fully vested—or take ownership of the account—quicker than with other types of retirement plans. And some 403(b) plans allow for immediate vesting, which is not commonly offered with other types of retirement plans.  
• Maximum contributions are typically the same as for other types of retirement plans. However, if an employee has 15 years of service at an organization, they may be able to contribute up to $3,000 more per year, with a lifetime maximum of $15,000. 

Cons of 403(b) plans

• 403(b) plans may have higher fees than other types of retirement plans.
• 403(b) plans tend to have fewer investment options than other types of retirement plans. Most of the time an employee can invest their 403(b) funds in an annuity or mutual funds. 
• Some 403(b) plans—typically those that don’t offer matching contributions—are not subject to the Employee Retirement Income Security Act (ERISA). That means they don’t have to adhere to standards set to protect employees contributing to a retirement account.

There are different types of retirement plans that employers might offer. And in some cases, an employer may offer two types of plans that employees can contribute to. That’s why it may be helpful to understand the differences between some of the most common retirement plan options.

403(b) vs. 401(k)

The main difference between a 403(b) and a 401(k) is that a 403(b) is only offered by public organizations and nonprofits, whereas 401(k)s are typically sponsored by employers in the private and for-profit sectors. Both plans typically allow employees to contribute on an automatic and tax-deferred basis. And both 403(b) and 401(k) plans might offer a Roth alternative. 

Like employers or organizations offering a 403(b), private-sector employers can offer a 401(k) match for their employees. Both retirement plan options share the same annual contribution limits of $20,500 in 2022, and employees must wait until they’re 59 1/2 years old to withdraw from the account—or pay a 10% tax penalty.

The type of investments offered by 401(k) plans can be different from those offered by 403(b) plans, though. Most 401(k) plans offer the ability to invest in stocks, bonds, mutual funds and other types of securities. A 403(b) plan, however, is usually restricted to annuities and mutual funds. 

403(b) vs. 457(b)

A 457(b) is a type of tax-deferred retirement plan for organizations such as local and state governments or other types of nonprofits. Like 403(b) plans, an employee can contribute automatically from their paycheck and may have the option to contribute to a Roth alternative. 

Unlike 403(b) plans and 401(k) plans, it’s rare to have an employer match with a 457(b) plan. The fees can be higher for this type of retirement plan, and it may also be more difficult to take an emergency withdrawal from a 457(b). However, there’s not a 10% penalty for withdrawing before the age of 59 1/2.

Public school employees or individuals who work for certain nonprofits could benefit from contributing to a 403(b) plan. It can be a way to build a retirement fund on a tax-deferred basis. 

Contributing to a 403(b) plan and taking advantage of an employer match might be options as you’re starting to save for retirement.