Q: What Is a 403(b) Plan and How Can I Set One Up?

When it comes to retirement plans, most people immediately think of 401(k) plans and individual retirement accounts (IRAs) but these two options are far from the only ones available. Certain employers may also offer 403(b) retirement plans to their employees, and doing so may offer advantages that other plans can’t quite provide. Below, we’ll introduce you to 403(b) retirement plans and walk you through everything you should know about them.

What is a 403(b) retirement plan?

A 403(b) is a retirement savings plan that can only be offered to employees at certain organizations. A 403(b) retirement plan is similar to a 401(k) plan, but employers need to be a public school, qualified nonprofit, or religious organization such as a ministry to offer one. Eligible participants include teachers, professors, school administrators, librarians, doctors, nurses, and government employees. Ministers may also participate, but they need to enroll in a special plan called a 403(b)(9), which is only for churches. 

What is the difference between a 401(k) and a 403(b) retirement plan?

Only churches, tax-exempt 501(c)(3) nonprofits, and public schools can offer 403(b) plans. Additionally, a 403(b) plan has only two funding options (mutual funds and annuities) whereas a 401(k) has many more. 

In some cases, 403(b) plans are not subject to the same Employee Retirement and Income Security Act (ERISA) regulations as are 401(k) plans. We’ll explore these differences in depth later on in the piece. Keep reading!

How does a 403(b) retirement plan work?

A 403(b) plan allows eligible employees to invest pre-tax dollars into mutual funds and annuities to help fund their retirement.

Like offering any retirement plan, 403(b)s enable small business owners to provide a more competitive benefits package which can help with hiring and retention.

Payroll companies typically deduct the fixed amount an employee would like to contribute from each paycheck. These contributions aren’t taxed until the employee begins making withdrawals after the age of 59.5 or experience a qualifying event, which we’ll get into below.

As an employer, you can contribute to your employees’ 403(b) plans, but you aren’t required to do so. Generally, the two types of employer contribution strategies are as follows:

  • Nonelective: The employer makes contributions whether or not an employee also makes them. 
  • Matching contributions: The employer’s contributions are based on the dollar amount the employee has withheld from each paycheck.

What are the 403(b) contribution limits for 2020 and 2021?

Before we get to contribution limits, let’s cover some more of the 403(b) basics.

A 403(b) plan can be a good retirement option for employees because contributions come out of their salaries tax-free. That means employees won’t need to pay taxes on the money in a 403(b) until they withdraw the funds, typically in retirement.

Since most people are in a lower tax bracket once they retire, they will likely pay lower taxes on their 403(b) contributions in the long run. However, employees who expect to remain in a higher tax bracket may not benefit as much from a 403(b). They may find other types of retirement funds to be more beneficial.

403(b) contribution limit in 2020 and 2021

Now that you know a little more about the retirement and tax benefits of 403(b) plans, here are the rules around contributions.

Contributions to an employee’s 403(b) retirement plan are typically limited to the smallest limit below:

  • Elective salary deferral limit (the amount an employee has withheld from paychecks), or
  • Limit on annual additions (the combination of employer and employee contributions).

Employee elective salary deferral limits

An employee can contribute up to $19,500 out of their salary to their 403(b) plan in 2020 (up from $19,000 in 2019) and this contribution limit will remain the same in 2021.

Employees who are 50 or older at the end of the calendar year can make catch-up contributions of $6,500 to their 403(b) plan in 2020 ($6,000 in 2019) for a total limit of $26,000. In 2021, catch up contribution limits will remain at $6,500.

Annual addition limits

The limit on combined contributions to 403(b) from employer’s and employee’s elective deferrals (the amount an employee has withheld from each paycheck) is typically the smaller amount of:

  • $57,000 for 2020 and 2021 ($56,000 for 2019), or
  • 100% of includible compensation (taxable wages and benefits) from an employee’s most recent year of employment.

Withdrawal age

Employees can withdraw funds from a 403(b) without facing a tax penalty once they turn 55 ½ years old. 

If employees withdraw funds before this age, they will need to pay a federal penalty of 10% along with any state penalties, which typically add a few more percentage points.  

How does a 403(b) compare to other retirement plans?

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While a 403(b) has many of the same features as 401(k) and 457(b) retirement plans, there are some key differences between the three. 

403(b) vs. 401(k)

The primary difference between a 401(k) and 403(b) is the type of employer who can offer the plan. Private, for-profit companies (most small businesses) typically offer 401(k) plans, while only public schools, tax-exempt 501(c)(3) nonprofits, and churches can offer 403(b) plans. 

Investment options are another major difference between the two. A 403(b) typically offers two options for funding: mutual funds and annuities (fixed and variable). On the other hand, a 401(k) plan may offer a broader range of investment options, including mutual funds, exchange-traded funds (ETFs), bonds, and annuities.

Finally, an employer offering a 401(k) needs to comply with the Employee Retirement and Income Security Act (ERISA) regulations. Employers that offer a 403(b) aren’t required to comply with ERISA unless they contribute to their employees’ plans or match funds.

This lack of regulation makes a 403(b) more affordable to administer for many small businesses. However, some employers prefer to offer 403(b) plans with ERISA protection because it holds the plan to specific standards.

403(b) vs. 457(b)

A 457(b) is similar to a 403(b) retirement plan, but the types of employers that can offer each differ slightly.

A 457(b) is for state and local government organizations (which can include public schools) and tax-exempt 501(c) nonprofits. On the other hand, a 403(b) is primarily for employees of educational institutions and 501(c)(3) nonprofits.

However, state and local government organizations (including public schools) and tax-exempt 501(c) nonprofits can offer 457(b) plans. 

There are two types of 457(b) plans: tax-exempt and governmental.

Tax-exempt plans are for organizations that aren’t state or local governments (or a political subdivision, instrumentality such as a police department or department of taxation, or agency). Tax-exempt plans don’t allow catch-up contributions for people age 50 and older, and funds can’t be rolled over into a different retirement plan.

The nuances of each retirement plan type can be confusing. This table breaks down the main differences 403(b), 457(b), and 401(k) plans:

403(b)457(b)401(k)
Eligible EmployerPublic schools and 501(c)(3) nonprofits, including religious organizationsState and local governments (including public schools) and 501(c) nonprofitsAny employer
Eligible employeesAll employees, but can exclude:
  • Employees who work fewer than 20 hours per week
  • Professors on sabbaticals
  • Certain students
  • Union employees covered under collective bargaining agreements
  • Nonresident aliens with no US income
 Tax-exempt: typically limited to select management or highly compensated employees 

Governmental: all employees and contractors
Can’t exclude employees who exceed:
  • Age 21
  • One year of service
  • 1,000 hours of service per year
May exclude:
  • Union employees covered under collective bargaining agreements
  • Nonresident aliens with no US income
Investment optionsMutual funds and fixed or variable annuitiesMutual funds and fixed or variable annuitiesMutual funds, fixed and variable annuities, ETFs, and bonds
Tax-advantaged?Yes, contributions are pre-tax and can reduce the amount of taxable incomeYes, contributions are pre-tax and can reduce the amount of taxable incomeYes, contributions can be pre-tax and can reduce the amount of taxable income
IRS annual employee contribution limit in 2020 and 2021$19,500 for people under age 50; $26,000 for people age 50 or older Tax-exempt: $19,500; Special catch-up contribution of $39,000 for final three years before normal retirement age

Governmental: $19,500; $26,000 if using age 50 catch-up contribution; special catch-up contribution of $39,000 for final three years before normal retirement age (can’t combine with age 50 catch-up contribution)  
$19,500 for people under age 50; $26,000 for people age 50 or older  
Employer contributions permitted?YesYesYes
Rollover to other eligible plans (401(k), 403(b), 457(b), IRAsYesTax-exempt: No

Governmental: Yes
Yes
Distributable events
  • Reach age 70 ½
  • Severance from employment
  • Unforeseeable emergency
  • Plan termination
  • Qualified domestic relations order
  • Small account distribution (not to exceed $5,000)
  • Permissible EACA withdrawals 
  • Reach age 59 ½
  • Severance from employment
  • Hardship (see above)
  • Death or disability
  • Plan termination 
Must comply with ERISA regulations?No, unless the employer contributesTax-exempt: No, unless it is offered to employees other than select management or other highly compensated employees

Government: No
Yes

How much does it cost to set up a 403(b) plan for my employees?

According to a survey released in 2016, the annual cost for an employer to set up and maintain a 403(b) plan is the cash equivalent of between 0.49 percent and 1.48 percent of the organization’s assets. The survey notes that the average cost of 403(b) plans for an employer was 0.73 percent of assets in 2013, which fell from 0.82 percent in 2009.

Pros and cons of 403(b) retirement plans

The pros of 403(b) retirement plans include:

  • Employee tax advantages. If you offer your employees non-Roth 403(b) plans, their earnings and returns can be tax-deferred, so your employees won’t pay taxes on them until they begin withdrawals. The same holds true for Roth 403(b) plans if the withdrawals are tax- and penalty-free qualified distributions. Additionally, traditional 403(b) plan contributions are deductible from employees’ income taxes, and tax credits may also apply.
  • Potentially lower administrative fees. If you opt for a 403(b) with no employer matches for employee contributions, you may pay lower administrative fees than for other kinds of retirement plans. That’s because when an employer offers a plan with no employer matches, the plan is not subject to ERISA regulations, so the plan provider will charge less to administer it.
  • Immediate vesting. While it’s all but unheard of to encounter 401(k) plans that allow for immediate employee vesting of funds, this is more common among 403(b) retirement plans.
  • Potential additional catch-up contributions. Some 403(b) plans stipulate that employees who have spent 15 or more years working for certain organizations can make catch-up contributions to their 403(b) plans. 

The cons of 403(b) retirement plans include:

  • Fewer investment options. With a 403(b) plan, your employees can only invest in mutual funds and annuities. If you want to allow your employees to contribute to a more diverse set of investment options such as stocks and bonds, other options may better offer this capability.
  • No nondiscrimination testing. Unlike many other retirement plan options, non-ERISA 403(b) plans do not require providers to partake in nondiscrimination testing. These annual tests help employers ensure that higher-level or higher-paid employees aren’t receiving more benefits from a plan than are other employees. In other words, non-ERISA 403(b) plans may be less fair for your team.

Choose your 403(b) plan wisely

If you’ve decided 403(b) plans are right for your organization, make sure to opt for ERISA-protected plans. This helps protect your employees’ savings from creditors. Just as many companies become LLCs to protect their assets, it’s smart to put in protections for your employees’ assets. When an employer offers 403(b) plans without employer matching and thus without ERISA compliance, the employees’ contributions may be at risk of seizure from creditors looking to collect on debts.

Also choose plans that are user-friendly, easy to set up and maintain, and replete with low-cost passive funds.

How can I set up a 403(b) plan for my employees?

Insurance companies typically administer 403(b) plans, but some other types of financial services companies offer them as well.

As you evaluate 403(b) providers, you’ll want to consider the following:

  • How easy it is to set up and administer the plan
  • Investment options
  • Administrative costs
  • Amount of assets a provider will manage
  • Any additional services you may want
  • How aggressively a sales representative is selling the plan (a hard sell may signal that it’s a low-quality plan)

A good 403(b) plan should:

  • Offer low-cost passive funds like Exchange Traded Funds (ETFs)
  • Offer a broad range of assets and classes
  • Typically charge no more than 0.50% per year in expense ratios for different funds (the lower the percentage the better)
  • Have ERISA protection to ensure the plan’s quality

With a little research and planning, you should be able to find the right 403(b) plan administrator that meets your employees’ needs without exceeding your budget. Once you choose a 403(b) plan, you can add it as a benefit to your payroll company account, and your provider will take care of the rest.   

Originally published: February 2, 2020

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