Most people have heard of a 401k plan, and it’s often a topic of discussion in the news and around water coolers in many offices, but what is a 403b plan? The IRS created the 403b as a tax-deferred retirement plan for members of public education organizations, some non-profit organizations, cooperative hospital service organizations, and self-employed ministers. Because these plans cover a smaller segment of the population, they often don’t make the news, but they are still a vital component of retirement savings for millions of Americans.
For the average participant, 403b plans are virtually identical to 401k plans in terms of how they operate. Contributions are made by an employee through payroll deduction and these contributions are made on a pre-tax basis. This means every dollar that’s added to the 403b plan each year reduces their taxable income. The money is then invested and can grow tax-deferred. Finally, when money is taken out of the account, usually at retirement, the distribution is taxed as ordinary income, hopefully you have figured out how much money you need to retire.
Another similarity to 401k plans is that 403b plans can also offer 403b loans and hardship withdrawals. For the loan, the rules are similar to the 401k loans and you can borrow up to $50,000 or half of the account value, whichever is lower. The loan is then repaid over a one to five year term through payroll deductions. In addition, there’s the ability to take out a loan for a first time home purchase with a longer repayment period.
How a 403b Differs from a 401k
From an employee’s standpoint, there’s little difference because the tax treatment and advantages are the same. But there are a few differences between the two plans that impact the employer. Most importantly, reporting requirements. Without getting too technical, 403b plans may not face the same discrimination testing, especially if it is not an ERISA plan. This means far less reporting requirements for the employer, which translates to much lower management expenses.
One difference that can affect employees is that some 403b plans don’t offer the same investment opportunities within the plan that many 401k plans do. Instead, they may treat the investments as an annuity instead of being able to invest in individual funds. This was quite common a number of years ago, but as times and market conditions have changed, many plans have opted to mirror those of traditional 401ks.
403b Contribution Limits
Just like the 401k contribution limits, the 403b adopts the same standard annual employee contribution limits. That means in 2013, an employee can contribute up to $17,500, plus an additional $5,500 catch-up contribution if the employee is age 50 or older. In addition, if the plan allows for employer and employee contributions, the total limit in 2013 is the lesser of $51,000 or 100% of the employee’s salary. This limit includes any catch-up contributions.
One unique option for some 403b plans is the 15-year catch-up provision. If permitted by the 403b plan, an employee that has at least 15 years of service with a public school system, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches (or associated organization), their 403b contribution limit is increased by the lesser of:
- $15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule, or
- $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.
If an employee qualifies for the 15-year rule, his or her elective deferrals under this limit can be as high as $20,500 for 2013.
Just like a 401k plan, a 403b plan administrator will determine which company or companies to partner with and which investment options are available. In some cases, this may mean you only have a select number of funds from one fund company, or it could mean many options from various investment companies. While the individual investor doesn’t have a say in which investments are provided, there are typically enough options to at least create a portfolio that matches your investment objective and the do tend to be more conservative investments.
In some cases, the 403b may also allow an individual investment account. Usually for a small quarterly or annual fee, plus trading costs, you can invest in almost anything you want within the offerings of a specific investment company, in addition to the default options. While not terrible common, this is something to at least ask about since it may open the doors to many lower cost investment options.
Finally, there are still some old 403b plans that use the traditional annuity scheme, which doesn’t offer employees much of an option at all. While it may have higher costs and fewer options, if the employer makes a matching contribution it’s still usually a good idea to take advantage, at least to get the free matching funds.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.