What it means
The plan is named after the section of the US tax code that created it, and it exists because the 401(k) rules were written for commercial employers rather than for schools, charities and non-profit hospitals. Functionally the two plans are close cousins, and an employee moving from a hospital to a corporate employer will find the mechanics familiar.
The financial logic is identical. Deferring salary into the plan reduces this year's taxable income, the account compounds without annual tax on income or gains, and many employers add a contribution of their own, either as a match or as a flat percentage of salary regardless of what the employee puts in.
The historical difference is the investment menu. These plans grew out of tax-sheltered annuity arrangements, so the choices were traditionally dominated by insurance-company annuity contracts with high charges, and although low-cost fund options are now common, older plans can still carry fees well above what a comparable corporate plan charges.
There is also a distinctive long-service catch-up provision. Employees with 15 or more years at the same qualifying employer may be able to contribute above the normal annual cap, which sits alongside the age-based catch-up available to older savers in most retirement plans.
The same constraints apply on the way out. Withdrawals before the qualifying age generally attract income tax plus a penalty, and required minimum distributions eventually force the balance out of the shelter, so like any tax-deferred plan it postpones tax rather than cancelling it.
In practice
Real-world examples.
Example
A university lecturer defers 10% of a $60,000 salary and receives a 5% employer contribution, so $9,000 a year goes into her account at a cost of $4,680 in reduced take-home pay after tax relief.
Example
A hospital administrator with 18 years of service uses the long-service catch-up provision to contribute above the normal annual limit in the final years before retirement, having under-saved while paying for two children's education.
Example
A school district reviews its plan and finds most teachers are signed up to an annuity product charging 1.75% a year. It adds a low-cost index fund option, and staff who switch retain substantially more of their long-run returns.
Think of it
“403(b) is like a 401(k) for nonprofits and schools-similar retirement plan.
Formula
Calculation
Annual employee contribution = Salary x Deferral rate
Annual employer contribution = Salary x Employer contribution rate
Effective cost of contributing = Employee contribution x (1 - Marginal tax rate)
A teacher earns $60,000 and defers 10% of salary into the school district's plan. The employer contributes a flat 5% of salary whether or not the employee participates.
Employee contribution = $60,000 x 0.10 = $6,000 a year. Employer contribution = $60,000 x 0.05 = $3,000 a year. Total going into the account = $6,000 + $3,000 = $9,000 a year.
Because the deferral comes out before income tax, at a 22% marginal rate the teacher's tax bill falls by $6,000 x 0.22 = $1,320. Take-home pay therefore drops by only $6,000 - $1,320 = $4,680, while $9,000 is added to the retirement account.
Put another way, every $1 of reduced take-home pay produces $9,000 / $4,680 = $1.92 in the account before any investment growth. Now compare two plans running for 25 years on $9,000 a year at a 7% gross return: a plan charging 0.25% in annual fees returns about 6.75% net, while a legacy annuity contract charging 1.75% returns about 5.25% net. That 1.5 percentage point difference in annual charges is why checking the fee schedule matters as much as choosing the deferral rate.Case study
Seen in the real world.
Larkspur Valley School District is an illustrative, fictional employer whose retirement plan had been sold to staff by the same insurance representative for two decades. Teachers were saving diligently, but almost every balance sat in an annuity contract charging around 1.75% a year in combined fees.
A new business manager modelled a typical case: a teacher on $60,000 contributing 10% with a 5% employer contribution, so $9,000 a year going in over 25 years. At a 7% gross return, the difference between a 0.25% fee and a 1.75% fee amounted to a materially smaller balance at retirement, entirely because of charges rather than investment skill.
The district added three low-cost index options and wrote to every participant explaining the fee difference in dollars rather than percentages. In this fictional example roughly two-thirds of staff switched within a year, and new joiners were defaulted into the low-cost option.
Watch out
Common mistakes.
- Assuming a 403(b) is a worse plan than a 401(k). The tax treatment is essentially the same, and the real difference is the investment menu and fees in the specific plan on offer.
- Ignoring the annual charges inside the product. A legacy annuity contract charging 1.75% a year can consume a large share of long-run returns compared with a low-cost fund charging a fraction of that.
- Contributing nothing because the employer contributes anyway. A flat employer contribution is welcome, but a 5% employer figure alone rarely funds a comfortable retirement without employee saving on top.
Questions
People also ask.
Who is eligible for a 403(b)?
Employees of public schools, colleges and universities, non-profit hospitals, churches and certain other tax-exempt organisations, rather than employees of ordinary commercial companies.
Can I have both a 403(b) and an individual retirement account?
Yes, they are separate arrangements with separate annual limits, although the tax deductibility of the individual account can be restricted once you are covered by a workplace plan.
What happens to a 403(b) if I move to a private-sector job?
The balance stays yours and can generally be transferred into the new employer's plan or rolled into an individual retirement account, keeping the tax deferral in place.
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