The 403(b) Basics
What is a 403(b)?
The 403(b) is an important retirement plan available to employees of educational institutions and certain non-profit organizations as determined by section 501(c)(3) of the Internal Revenue Code. Contributions can be made on a pre-tax or Roth basis. Pre-tax investment earnings grow tax deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income. After tax Roth contributions also grow tax free but are not taxed upon withdrawal (assumed to be retirement). See "Pre Tax vs. Roth Contribution" below for information on tax treatment of 403(b) contributions and withdrawals. The 403(b) is named after the section of the IRS code governing it. IRS Publication 571 provides details on the plan.
The 403(b) can be an excellent way to save money for retirement. It can serve as a supplement to a traditional pension plan or other retirement plan(s), or as a stand-alone plan.
Note: Tax-Sheltered Annuities (TSA) + 403(b)(7) Custodial Account
The 403(b) is also known as a tax-sheltered annuity, but this is an outdated expression. It can give the impression that participants can only invest in annuity products, which was the case when section 403(b) was first added to the IRS code. However, since 1974, participants have also been able to invest in mutual funds through a 403(b)(7) custodial account. Throughout this site "the 403(b)" will refer to a 403(b) plan allowing investment in both annuity products and mutual funds.
Employees of tax-exempt organizations established under section 501(c)(3) of the Internal Revenue Code are eligible to participate. Participants include teachers, school administrators, school personnel, nurses, doctors, professors, researchers, librarians, and ministers. However, employers can restrict access based on such factors as hours worked. Check with your employer for details.
Participants may contribute up to $19,500 for year 2021. For those with employer matches or other employer contributions, the limit is $57,000 or 100% of compensation (whichever is less). This limit rises to $63,500 if age 50 or over. The participant is still limited to the employee elective deferral limit ($19,500 for 2021). An employer can add up to another $37,500.
Age 50 Catch Up
Participants age 50 and older at any time during the calendar year are permitted to contribute an additional $6,500 in 2021.
Employees with 15 years of service with their current employer and an annual average contribution of less than $5,000 per year are eligible for an additional $3,000 contribution per year up to a lifetime maximum catch up of $15,000. This is known as the 15-year rule. For participants eligible for both the age 50 catch up and the 15-year rule, the IRS will apply contributions above the regular limit first to the 15-year rule. Employers are not required to make this provision available.
Employees enroll and participate through their employer. Contributions to a 403(b) are made through a Salary Reduction Agreement. This is an arrangement where the participating employee agrees to take a reduction in salary. The amount by which the salary is reduced is directed to investments offered through the employer and selected by the employee. These contributions are called elective deferrals and are excluded from the employee's taxable income.
- Research available vendors and product costs to find a vendor that provides the investment options and services that meet your needs at a cost you understand.
- To do this, read contracts of fixed annuity products and prospectuses of variable annuity and mutual fund products.
- Open an account with your chosen vendor. Select investments and name a beneficiary or beneficiaries.
- Complete a Salary Reduction Agreement with your employer in which you determine the amount you wish to contribute to your 403(b) each pay period.
Note: Pre-tax vs. Roth contribution
Contributions can be made on a pre-tax basis. This will reduce taxable income. Pre-tax contributions grow tax-free until the time of retirement when withdrawals are taxed as ordinary income. Contributions can also be made on an after-tax "Roth" basis. Roth contributions will not reduce taxable income but will grow tax-free. At retirement withdrawals from Roth designated contributions will not be taxed.
Participants have the option of making pre-tax 403(b) contributions, Roth 403(b) contributions, or as a combination of the two. Total contributions cannot exceed the year's contribution limit. Not all employers offer a Roth 403(b), nor are they required to do so. Check with your employer for details.
This is permitted, but individual employers may not make this option available. Check with your employer for details. Another option is to move money from a former employer into a rollover IRA with a vendor of your choice.
Fees, operating rules, and investment objectives can vary greatly among vendors and across investments. Therefore, it is important to understand all of these before you begin contributing to any 403(b) investment. Additionally, some investments impose surrender charges or restrictions on withdrawals. It is important to know if there are surrender charges or restrictions on withdrawals before investing.
All mutual funds and variable annuities are required to produce a document called a prospectus, which details specific information about investment cost, objective, risk, performance, and operating rules. Ask to see the prospectus before contributing to a variable annuity or a mutual fund. Fixed-annuity products do not have a prospectus. Instead, they have a contract that details operation of the annuity. Ask to see the contract before investing in a fixed annuity.
On average, variable annuities charge 3% annually; mutual funds charge 1.74% annually; and no-load index funds charge 0.07% annually.
How Fees Affect Return
Investment fees matter. A lot. Sometimes numbers alone don't convey how damaging high fees are to savings. Meet the Fee Monster.
By the Numbers
Total value of investment after 35 years, assuming $250 contributed monthly with an 6% average annual return:
Monthly income totals if these balances were converted to an immediate annuity. Source: immediateannuities.com
Note: The charts above are presented for illustrative purposes only and do not reflect actual performance, or predict future results, of any investment account.
Additionally, the state of California makes available a resource called 403bCompare which allows visitors from any state to learn fee and withdrawal information for many individual 403(b) products.
Employers make available one or more vendors or financial firms. A big criticism of K-12 403(b) vendor lists is that most of the firms available offer high fee products sold by sales agents who are not fiduciaries (see Working with a Financial Advisor). 403(b)wise encourages employees to advocate for better, lower cost investments. See our "Advocacy" section to learn how to advocate for better investment choices.
There are two categories of investment products available: annuity products and a 403(b)(7) custodial account made up of mutual funds.
A mutual fund is an investment that pools money from many participants and invests in stocks, bonds, short-term money-market instruments or some combination of the three. The combined holdings of stocks, bonds, or other assets that the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings. There are two kinds of mutual funds: loaded mutual funds and no-load mutual funds. A load is a commission the investor must pay in order to purchase and/or to sell that fund. All mutual funds have operating costs. Mutual funds are securities regulated by the Securities and Exchange Commission (SEC) but are not guaranteed or insured by the Federal Deposit Insurance Company (FDIC).
A fixed annuity works much like a certificate of deposit but is not insured by the Federal Deposit Insurance Company (FDIC). Generally, investors are given two interest rates: the current rate and the guaranteed rate. The current rate is the return that the insurance company promises to pay for a set period of time, typically between one and five years. The guaranteed rate, usually lower, is the minimum rate that investors will likely receive after the current rate expires, regardless of market conditions.
Equity Indexed Annuities
Also know as a Fixed Indexed Annuity or an Indexed Linked Annuity, this product is a sub-class of the fixed annuity. Interest in an Equity Indexed Annuity is linked to a market index such as the S & P 500, the Dow Jones Industrial Average, or the NASDAQ. A participant's money is not actually invested in the index. Instead, the interest rate paid is determined by a formula created by the insurance company that is tied to a market index. This product is not insured by the Federal Deposit Insurance Company (FDIC). There have been numerous warnings about the cost and suitability of these products. Must read: Equity Indexed Annuities: 'Magical' or 'Unsuitable'?
A variable annuity offers a range of investment options, such as mutual funds that invest in stocks, bonds, short-term money-market instruments or some combination of the three. These investments options are referred to as the sub account. The value of the investment will vary depending on the performance of the investments in the sub account. There is usually a death benefit that will pay a beneficiary the greater of the account value or a guaranteed minimum amount, such as total purchase payments. Variable annuities are securities regulated by the Securities and Exchange Commission (SEC) but are not guaranteed or insured by the Federal Deposit Insurance Company (FDIC).