Is a 403(b) Plan Right for You?

Key Takeaway

• 403(b) Plans, aka tax-sheltered annuities, are defined contribution retirement plans available for tax exempt organizations, schools, non-profits, government employees, hospitals, and religious groups.
• Unlike 401(k) Plans, 403(b) Plans are exempt from nondiscrimination testing unless employers make contributions to the account.

A 403(b) Plan, AKA tax-sheltered annuities, is a defined contribution retirement plan for employees at public schools and certain tax-exempt organizations such as churches. Similar to its more common counterpart, the 401(k) plan, this plan allows employees to contribute a portion of their pay to the plan on a tax-favored basis and their employer may also contribute to the plan. 

What are the benefits of a 403(b) plan?

Again, much like its 401(k) counterpart, a 403(b) Plan allows an employee to contribute to the plan. These contributions may be on a pre-tax basis (reduces current income but is taxable when withdrawn) or on a Roth basis (made with after-tax dollars but any investment income will be tax-free at withdrawal). Additionally, the investment earnings on those pre-tax contributions will grow tax-deferred as no taxes are due until the funds are withdrawn. 

From the employer and highly compensated employee standpoint, additional benefits include the exemption from certain nondiscrimination testing – unlike a 401(k) Plan, a highly compensated 403(b) Plan participant is able to contribute to the plan regardless of the level of participation of non-highly compensated employees. This is due to the fact that these are considered “individual” contracts so long as the employer does not make contributions to the Plan (this individual contract often has a downside in higher expenses as noted below). 

What are the disadvantages of a 403(b) Plan?

Similar to the 401(k) Plan, 403(b) Plans share the same penalties for early withdrawal – you will pay an early withdrawal penalty of 10% of the distribution amount for any withdrawals before age 59.5 unless it meets one of the few exceptions under the Internal Revenue Code. Also, under current law (there are proposals to change it), participants must begin Required Minimum Distributions (“RMDs”) from the 403(b) Plan at the later of the date they terminate employment or age 72. 

Does ERISA apply to these plans?

In general, most 403(b) Plans are not subject to the Employee Retirement Income Security Act (“ERISA”) unless the employer provides contributions to the plan such as an employer match. 

Can I contribute to both a 403(b) and a 401(k) Plan?

An employee can contribute to multiple plans during a year, but those total contributions across all qualified plans (other than 457 plans) must not exceed the annual deferral limit of $19,500 for 2021 (indexed). 

Now let’s compare some key features

1. Expenses – the expense ratios of the underlying funds or investments tend to be substantially higher in 403(b) Plans vs 401(K) Plans or IRAs. For those employers that choose to utilize a group vs individual 403(b) structure, these expense ratios become more comparable.
2. Administration – traditionally 403(b) Plans were administered or issued by insurance companies. In recent years as employers have adopted a group 403(b) structure, we have seen large mutual fund companies enter the 403(b) administration and recordkeeper space which has served to improve administration and reduce costs.
3. Employee Contributions – for both 403(b) and 401(k) Plans, employees may contribute up to $19,500 for 2021 (indexed) under IRC Section 402(g).
4. Catch-up contributions – a 403(b) Plan participant who is age 50 or above may have the same catch-up contribution under IRS 402(g) of $6,500 for 2021 (indexed) that is found in 401(k) Plans. However, 403(b) Plans, if adopted, may also have a unique 15-year catch-up provision which is best applied prior to the age of 50 due to the interaction with the catch-up provision.
5. Employer Contributions – As noted above, many 403(b) Plans do not have any employer contribution as that enables them to be considered an “individual” contract and not subject to ERISA or the associated nondiscrimination testing. As such, employer contributions are much more common in 401(K) Plans. These employer contributions are subject to nondiscrimination testing to ensure that they do not disproportionately favor highly compensated employees.
6. Portability – both 403(b) Plan and 401(k) Plan balances may be rolled over to an IRA or transferred to a new employer’s retirement plan without any tax consequence to continue tax deferral until retirement or withdrawal.
7. Investment Options – with the passage of the SECURE Act in 2019, 401(k) Plans are more likely to have annuity options within their plan similar to a 403(b) Plan. 401(k) Plans are usually invested in mutual funds although exchange-traded funds (“ETF’s”) are becoming more common. A 403(b) Plan administered by insurance companies is more likely to be invested in insurance company separate accounts which often track mutual funds.
8. Eligibility – as noted above, 403(b) Plans are only available for employees at public schools and certain tax-exempt organizations such as churches.

Check out our 2020 Comparison Guide: 401(K) vs. 403(b).

So, 403(b) Plans are very similar to 401(k) Plans in that they have the same contribution limits (except that 15-year catch-up), have Roth features, are subject to minimum required distributions, and are subject to early withdrawal penalties for distributions before age 59.5. The main differences are the groups that may offer such plans, the incidence of employer contributions,  and the normally higher expenses associated with 403(b) Plans.

If you have questions about these plans and what’s best for your organization, let us know in the comments below or you can reach an Odyssey Consultant.