What is a 403b
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
The 403(b) is a tax deferred 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 and investment earnings in a 403(b) grow tax deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income. The 403(b) is named after the section of the IRS code governing it.
ERISA 403(b) vs. Non-ERISA 403(b)
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans (Department of Labor).
In general, ERISA does not cover retirement plans established or maintained by governmental entities, and churches (Department of Labor). This means that K-12 403(b) plans, public university and public hospital 403(b) plans, and church plans are generally considered to be Non-ERISA plans.
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.
403(b)(7) Custodial Accounts
This is the name of the 1974 addition to the IRS code allowing participants to invest directly in mutual funds through a custodial account. Throughout this site “the 403(b)” will refer to a 403(b) plan allowing investment in both annuity products and mutual funds.
Tax-Sheltered Annuities (TSA)
The 403(b) is also known as a tax-sheltered annuity, but this is an outdated expression.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.
How a 403(b) is Different From a Pension
Pensions, like CalSTRS in California, are formula-based retirement plans in which payout at retirement is based upon such factors as years of service and salary. Eligible employees are automatically enrolled in one of these plans upon employment. All investment decisions for these pensions are made by plan officials. In contrast, the 403(b) is a voluntary, self-directed plan in which payout at retirement is based upon how much money an individual accumulates in the 403(b).
How a 403(b) is Different From a 401(k)
The 403(b) is a retirement plan available to certain employees of public schools, employees of certain tax-exempt organizations and certain ministers. The 401(k) is a retirement plan for private sector workers.
How a 403(b) Works
Employees enroll and participate through their employer. Contributions to a 403(b) are made on a pre-tax basis 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. Contributions grow tax-deferred until the time of retirement, when withdrawals are taxed as ordinary income. See Accessing 403(b) Savings and Making Other Changes to Your 403(b) for information on withdrawing 403(b) money.
Third Party Administrators (TPA)
A third party administrator (TPA) provides plan administration and compliance services to employers.
This is a provision that permits employees to irrevocably designate all or a portion of their 403(b) as an after-tax Roth contribution. This type of contribution will not lower the employee’s taxable income. However, distribution of Roth designated funds in retirement will not be subject to taxation.
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.
How a Roth 403(b) Is Different From a Roth IRA
The tax treatment of a Roth 403(b) and a Roth IRA is similar (after-tax contribution, tax-free withdrawal in retirement). However, the Roth 403(b) is an employer-based plan, while the Roth IRA is an individual-based plan. Distribution rules are different. Roth IRA contributions can be accessed at any time (earnings after five years or until age 59½, whichever is later). The Roth 403(b) can be accessed only with the occurrence of a distributable event (age 59½, separation from service, disability, or death).
What You Should Know Before Opening a 403(b)
All investments carry with them a degree of risk. It is important to understand your tolerance for risk before investing. Those with low risk tolerance may be better suited to a conservative investing strategy that relies, for the most part, on fixed investments. Conversely, those with high risk tolerance may be better suited for more aggressive investments. It cannot be emphasized enough that risk tolerance is highly individualized: An investment strategy that is acceptable by one person may not be suited to another.
It is also important to know that fees, operating rules, and investment objectives may vary greatly among product vendors and across investments offered by a particular vendor. Some investments impose surrender charges or restrictions on withdrawals. The state of California makes available a resource called 403bCompare which allows visitors from any state to learn fee and withdrawal information for individual 403(b) products.
One thing is certain: the more you know about yourself as an investor, and the more you know about investing and the workings of the 403(b) plan, the better prepared you will be as an investor.