403(b) Accounts Explained: What Are They and How They Differ From a 401(k)

People saving for retirement face the often daunting task of not only understanding available options, but finding the ones that suit their needs well. Workers in the for-profit world usually turn to an employer-sponsored 401(k). Certain employees of public schools and specific tax-exempt organizations, however, can participate in a tax-sheltered vehicle called the 403(b) retirement plan.

When comparing 403(b) versus 401(k) plans, you’ll find that these tax-deferred retirement plans offer benefits not available to people working for for-profit entities; however, they also feature certain disadvantages. By understanding what a 403(b) is and how it works, you can better benefit from privileges offered, and hopefully, build more wealth for retirement.

Here’s a look at what this guide to a 403(b) covers:

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How Does a 403(b) Plan Work?

Specific types of workers in nonprofit organizations have the option of deferring a percentage of their salary into a 403(b) retirement account. The contributions are tax-deferred, so contributors make these initial contributions with pretax dollars. Account holders will not pay taxes on contributions or gains within the account until after they make withdrawals.

In 2019, employees can contribute up to $19,000. Employees who are age 50 or older at the end of the calendar year may also contribute an additional $6,000. The IRS refers to these as “catch-up contributions.”

In many cases, an employer will automatically enroll employees in its retirement plan. Automatic enrollment forces employees who are not interested to opt out manually.

Once in the plan, the employer can conduct elective deferrals. In this case, the employer withholds a percentage of wages and places that money in a 403(b) account. An employer can also add a nonelective employer contribution. Plans that have employers match a portion of an employee’s contributions fall into this category.

Still, receiving those funds depends on a schedule for vesting, or ownership, of the plan. All contributions made by an employee become vested instantly. Employer matching contributions, however, usually vest on a schedule determined by the employer. Vesting can happen immediately, or the employer can choose to vest a certain percentage of contributions for each year of service offered. Vesting at 100% becomes automatic when an employee reaches retirement age or upon termination of the plan.

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Related: Not All of the Money in Your 401(k) Is Really Yours

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How Much Should I Contribute to My 403(b)?

As mentioned before, employees can contribute up to $19,000 in 2019. The majority of employees will likely not have the ability to contribute this much. Fidelity estimates people in their 20s save an average of 7%. When people reach their 60s, the average savings rises to 11.2%.

Experts offer a wide variety of recommendations on how much to save. The key to finding the money to contribute, however, may lie in cutting spending and finding additional income sources.

People who are under 35 can also benefit from the gift of time. Workers who wait until age 40 to begin saving will have to contribute more than three times as much as those who begin at age 25 to build the same amount of savings. For workers who are behind, eligibility for catch-up contributions becomes available at age 50, which means these workers can place an additional $6,000 per year in the 403(b).

Whatever your limitations, you should always try to take advantage of any employer match that’s offered. Employers may match 50 cents for every dollar contributed up to 6% of one’s salary. As a result, the match effectively adds 3% to an employee’s salary and offers employees an automatic 50% return on their investment. In other words, it allows an employee to build a 9% savings rate that only costs 6%.

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Read: 27 Best Strategies To Get the Most Out of Your 401(k)

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Choosing Investments for Your 403(b)

Employers usually have choices when it comes to investing 403(b) funds. They work with a variety of brokerages to offer investments. Often the investments are mutual funds, which meet a variety of risk tolerances.

Employees can use numerous strategies to increase the size of their retirement accounts. But numerous options can lead to confusion, prompting some people to seek an advisor.

One option is to work with advisors connected to your specific fund plans. Although they can help, their pay may depend on what funds they sell to you, which means their pay and your interests are not aligned.

You can also hire a certified financial planner, often referred to as a CFP. These advisors typically work for a flat fee, which will involve an out-of-pocket cost on your part. The advantage of working with an outside advisor increases the likelihood that the investments recommended will be in your best interest.

See: 2019-2020 Best Brokers

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Can I Withdraw From a 403(b) Plan?

Ideally, employees should wait until they at least turn 59½ before withdrawing money from their 403(b). Withdrawing money before this time usually results in penalties. The IRS will allow early withdrawals, however, if plan holders face hardships such as a lay off from employment, disability, financial hardship or their passing. Employees can also loan money against the 403(b) account, subject to terms of the plan.

If you have to withdraw from the plan, a plan administrator will take you through the process, but read the agreement carefully. Employees who withdraw money from their 403(b) will have to fill out IRS Form 5329, whereas plan administrators will file IRS Form 1099-R.

Note that if you withdraw money outside of these terms, you may have to pay a 10% early withdrawal penalty. Even worse, removing that money from the account will probably also result in lost gains that would have gone to the employee had they kept the money in the 403(b).

See Next: 11 Ways To Withdraw Money From Your 401(k) Without Penalty

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Differences Between a 403(b) Plan and a 401(k) Plan

The 403(b) and the 401(k) plan have similarities. Both take a portion of your paycheck to invest in retirement funds. They also offer the same tax-exempt growth while funds remain in their respective plans. Annual contribution limits for the 401(k) and the 403(b) are also the same — $19,000 in 2019. Additionally, employees can begin penalty-free withdrawals at age 59 1/2 in both plans.

Both types of plans also feature differences. The most obvious difference when comparing 403(b) versus 401(k) plans is that 403(b) participants must work for a school, government entity or a specific type of nonprofit organization. For one, organizations that offer a 403(b) do not earn profits. Hence, the plans cannot participate in profit sharing when an entity is nonprofit. Also, 403(b) plans may not offer ERISA protections. This means that these plans do not offer protections available in other types of plans.

Even so, 403(b) plans offer some advantages. On average, they come with lower fees. Moreover, 15 or more years of participation allows employees to contribute an additional $3,000 per year to their plans.  Further, a 403(b) can give employees more flexibility with contributions, loans and hardship distributions.

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The following table outlines the basic similarities and differences:

403(b) vs. 401(k) Plans
403(b) Plan 401(k) Plan
Eligibility Work for a nonprofit or government entity Work for any private employer
Contribution Limits $19,000 per year, plus an additional $3,000 per year after 15 years in the plan; additional $6,000 per year if 50 or older $19,000 per year; additional $6,000 per year if 50 or older 
Investment Options Plan-selected mutual funds, variable annuities, retirement income account (church employees) Plan-selected options
Penalty-Free Withdrawals Reach age 59 1/2 or retire at 55; greater options for hardship withdrawals Reach age 59 1/2; limited options for hardship withdrawals
ERISA Protections Optional Required

Read Next: Here’s Your Do-or-Die Retirement Plan If You Have Nothing Saved

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Savings for More Than Just Retirement

Employees at nonprofits have more than one option for savings vehicles. Plus, tax laws allow for other retirement savings vehicles accommodating all types of workers. Moreover, people need to remember that retirement is not the only savings need. People needing to save for a home, car, major purchase or emergencies turn to other types of savings plans. Depending on whether you have short-term or long-term savings needs, you may want to consider one of these options:

Free Savings Account

Many banks offer what amounts to a checking account without checks, also known as a savings account. They will allow people to set aside money in an interest-bearing account, often without requiring minimum balances or charging fees. In many cases, banks will allow multiple savings accounts based on needs. You may also link these accounts to a checking account for easier deposits or withdrawals. 

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High-Yield Savings Accounts

High-yield savings accounts offer higher interest rates than the traditional savings account. Investors need to keep in mind that high-yield typically means 1% interest or more in today’s environment. High-yield savings accounts also offer easy fund transfers.

However, fund transfers must go to a checking account, which means high-yield savings account holders will not have immediate access to funds. Moreover, the definition of high-yield is relative. Many banks have begun to offer yields at 2% or above. Hence, such rates may only hold a limited appeal.

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Money Market Accounts

Money market accounts –which differ from money market funds — work similarly to other savings accounts. They usually receive FDIC insurance protection and have limited withdrawals like other savings accounts. Money market accounts may, however, require a minimum balance. As of the time of this writing, Bank of America required a $2,500 minimum balance, while Citi did not require a minimum. It’s worth noting that money market accounts may pay a higher rate of interest than traditional savings accounts.

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Individual retirement accounts are accounts opened by people for retirement savings. In a traditional IRA, contributions and money earned within the account are tax-free. Individuals pay taxes only after they withdraw funds. With a few exceptions, you may not withdraw the money before you turn 59 1/2 without incurring a penalty.

To contribute to an IRA, you must be under the age of 70 1/2. Contribution limits for 2019 are $6,000 — or $7,000 for people age 50 and older. People who contribute the maximum amount to a traditional IRA may still contribute up to $19,000 to a 403(b) in 2019.

See: What Is an IRA?

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Roth IRA

Roth IRAs work similarly to traditional IRAs except for one key difference. Participants must contribute after-tax dollars to the Roth IRA. However, gains within the account remain tax-free. Moreover, if the participant waits until age 59 1/2, withdrawals are tax-free.

Like with traditional IRAs, maximum contributions for 2019 are $6,000 — or $7,000 for people at or over the age of 50. To contribute, however, single filers must earn less than $122,000 in adjusted gross income to make the maximum contribution to the Roth IRA. They must earn less than $137,000 in AGI to contribute at all. For married filers, those limits rise to $193,000 for a full contribution and $203,000 to add any funding for that year.

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Is a 403(b) Plan Suitable for Me?

403(b) plans offer nonprofit workers additional options for funding retirement. These offer options not available to all types of workers. These plans may also serve as a source of funding when facing certain hardships.

Other types of retirement plans, such as IRAs and non-retirement savings options, are available, however. Once you know your plan options, you also need to find the disciplines and the strategies to place savings in these accounts — especially when employers offer matching funds. Once you have funded the account, consider seeking financial advice to find the investments that will suit your needs and risk tolerances well.

For nonprofit workers, 403(b) plans are merely one of many tools. By understanding these plans, not only can you enjoy a wealthier retirement, but you can also have a nest egg in times of hardship.

Click through to find your best age to retire, so you can plan ahead.

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