What You Need to Know about a 403(b) Retirement Account

What You Need to Know about a 403(b) Retirement Account

For most people, a 401(k) serves as the primary tax-advantaged retirement account. However, individuals may have access to other types of accounts based on their work background.

Another option that you may hear about is a 403(b), an account that is open to people who work at nonprofit organizations and some government entities. While a 403(b) resembles a 401(k) in many ways, it has a few unique benefits that make it a great option for people able to open the account.

Here’s what you need to know:

The Basics of a 403(b) Retirement Account

A 403(b) is an employee-sponsored retirement plan that is offered to qualified workers. Some of the categories of workers eligible for these accounts are employees of hospitals and churches, as well as some public-sector workers like teachers and librarians.

The account offers tax-advantaged growth for retirement. Any investments in the account are free from capital gains taxes and contributions are deducted directly from their paychecks.

With a traditional 403(b) account, contributions are deducted from pay prior to paying taxes, which lowers tax liability. However, individuals will pay taxes when they withdraw the money, much like with a 401(k). A Roth option is also offered for 403(b) accounts, which involves contributing taxed income but then avoiding taxes upon withdrawal.

Like other tax-advantaged retirement accounts, a 403(b) comes with contribution limits. In 2021, the limit is set at $19,500. However, employees who are 50 or older can make a catchup contribution of up to $6,500 for a total limit of $26,000. In addition, of the key advantages of the 403(b) is the possibility of making bonus catchup contributions. Those who have worked at the same eligible organization for at least 15 years, can contribute an additional $3,000 per year up to a lifetime total of $15,000.

In combination with the federal catchup contribution, eligible individuals could contribute a maximum of $29,000 per year ($19,500 standard contribution + $6,500 catchup contribution + $3,000 bonus catchup contribution), at least for five years until they would have hit the limit. Thereafter, they would be restricted to the standard limit plus the ordinary catchup contribution limit.

Also, it is worth noting that employers do not generally provide matching or nonmatching contributions to a 403(b), although it is possible. In 2021, the combined contributions cannot exceed $58,000 (or 100 percent of the prior year’s salary if that is less than $58,000).

The Investment Options for a 403(b) Retirement Account

One of the downsides of a 403(b) is that the investment options are generally more limited than with a 401(k) and other tax-advantaged retirement accounts. Typically, you will have access to mutual funds and annuities but would not be able to invest in exchange-traded funds, real estate investment trusts, or individual stocks.

At the same time, the investment options for a 403(b) are chosen carefully and often align with the low-cost bond and stock index funds that experts would recommend for retirement investment. Most people will invest in more stock funds when they are young and then change the ratio to favor bond funds as they get closer to retirement to control risk.

Some 403(b) plans offer target-date funds. These options are mutual funds that adjust holdings automatically as you approach your target retirement date.

You should be cautious if you choose to invest in annuities as they are complex products that often have high fees and low returns. At the same time, they can provide guaranteed income during retirement, so they are attractive. The decision to invest in an annuity should be done with a trusted financial advisor.

The Rules about Making Withdrawals from a 403(b)

In some ways, withdrawing from a 403(b) is similar to a 401(k). You can make withdrawals once you turn 59.5 and they are taxed as regular income unless you have a Roth 403(b), in which case they are not taxed at all.

However, you can also qualify for a standard withdrawal if you become disabled or you experience certain financial hardships. In addition, in the event of your death, your beneficiaries would be able to make withdrawals from the account. As with a 401(k), you must take required minimum distributions once you turn 72 or face a significant tax penalty.

If you withdraw from a 403(b) prior to age 59.5, you will need to pay a 10-percent penalty on top of any taxes that you would normally face. However, a few exceptions exist for this type of account.

The first is the rule of 55, which says that if you leave your place of employment at age 55 or later, you can start taking money from the 403(b) without paying a penalty. Also, if you have medical expense that was not reimbursed and it exceeds 7.5 percent of your adjusted gross income, you can take money from the 403(b) to pay the costs without a penalty.

The other exception is substantially equal periodic payments, which allows you to avoid the 10-percent penalty by sticking to a payment schedule. Distributions must be taken for at least five years or until you turn 59.5. A financial adviser can help you calculate what these withdrawals would look like.