Most everyone has heard of a 401(k), but few people are familiar with its lesser-known cousin, the 403(b). The two accounts are similar, but there are a few key differences in eligibility requirements and contribution limits that it pays to understand. Here’s a quick look at what a 403(b) is and how to use it most effectively.
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403(b) accounts are available only to ministers and employees of nonprofit organizations, public schools, and certain hospitals. These employers may offer 401(k)s to their employees instead, if they choose, but most prefer the 403(b) because of its lower administrative costs.
A typical employee under age 50 can contribute up to $18,500 to a 403(b) in 2018. This limit is the same for 401(k)s. And just like 401(k)s, 4013(b)s allow employees aged 50 and older to contribute an extra $6,000 per year, bringing their total to $24,500. Note that these are the limits for 2018, and they may be subject to change from year to year.
Some 403(b)s also enable individuals with 15 or more years of service to contribute extra money. This amount is the lesser of:
- $15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule
- $5,000 times the number of the employee’s years of service minus the total elective deferrals made for earlier years
The first option is clear enough, but the second two could use a little clarifying. Let’s start with No. 2. Say you’ve contributed $13,000 to your 403(b) in previous years under this rule. This means you can only contribute $2,000 this year, because the rule limits these contributions to a maximum of $15,000.
The third option requires you to do a little bit of math. If you’ve worked at a company for 15 years, then you would multiply $5,000 by 15 for a total of $75,000. Then, you subtract the total amount you’ve contributed to your 403(b) account (matching contributions from your employer don’t count), and you’re left with your maximum catch-up contribution. So, if you have $73,500 in your 403(b) account already, you could only contribute $1,500 extra under the 15-plus-years-of-service rule.
Catch-up contributions can also be stacked. So if you’re over 50 and you have more than 15 years of service at your job, you could contribute up to $27,500 this year (the $18,500 standard contribution limit, plus $3,000 for 15-plus years of service, plus the $6,000 catch-up contribution).
Employers can choose to match your 403(b) contributions just as they would 401(k) contributions. However, don’t expect a dollar-for-dollar match. It’s common for employers to offer a match of $0.50 on the dollar for contributions of up to 3% to 6% of your pay.
In a traditional 401(k), your employer’s contributions aren’t typically yours to keep right away. They often follow a vesting schedule, so you may have to work for the company for a certain number of years before you actually own any employer-contributed funds in your account. Otherwise it may follow a graded scale, in which you become vested over time. For example, if there’s a four-year vesting schedule, that means after the first year, you own 25% of the employer-contributed funds, after the second year, 50%, and so on.
However, with a 403(b), there is often a much shorter vesting period. The plan may allow immediate vesting, which means that even if you only work for the employer for a year and then quit, all of your matching funds are yours to keep.
The investment options in a 403(b) tend to be similar to those offered by a 401(k). Both are more limited than an IRA, however, so if you want more investment choices, you should consider opening one of these as well.
You can typically choose between annuities, mutual funds (including target date funds), and bonds. It’s important to evaluate your options and look at the fees that each investment product charges and which ones best line up with your risk tolerance.
Like 401(k)s, 403(b)s come in two basic varieties: traditional and Roth. These types are the same except in the way your contributions and withdrawals are taxed (or not taxed). Contributions to traditional 403(b)s are tax-deferred, which means the amount you contribute will come off of your taxable income this year, but then you will be taxed when you withdraw the money from your account in retirement. Contributions to Roth 403(b)s are made with after-tax dollars, so you pay taxes on your contributions, but not on distributions made past age 59 1/2. Speaking of which…
As with other types of retirement accounts, you will be penalized with a 10% early-withdrawal tax if you withdraw the money from your 403(b) before age 59 1/2. This tax is on top of the income tax you would pay on a withdrawal from a traditional 403(b) account (but not a Roth-style account). For this reason, it’s best not to touch the funds until you’re past 59 1/2.
A 403(b) is a viable alternative to a 401(k) as a retirement savings vehicle. It could even prove to be a better option for you if you can take advantage of the extra contributions allowed for those with 15 or more years of service. But whichever retirement account you choose, it’s important to sit down with your employer and talk through your options so you understand exactly what you’re getting.
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