What it means
The plan takes its name from the section of the US tax code that lets certain non-profit employers run a salary deferral scheme for their staff. An employee signs a simple election form agreeing to divert a percentage of each pay packet into the plan, and that money never appears as taxable income for the year it was earned.
Tax is deferred rather than cancelled. Contributions and all the investment growth on top of them are taxed only when the money comes out in retirement, which for most people happens at a lower marginal rate than they paid while working.
Many providers now also offer a Roth version, where contributions are taxed up front and qualifying withdrawals later are tax free. For a hospital or university finance team, the plan is simultaneously a payroll liability and a recruitment tool.
Employer matching contributions are a genuine staff cost that has to be budgeted and accrued each month, and the quality of the plan is often what tips a candidate towards a charitable employer that cannot match private sector salaries. In practice an employee chooses a percentage of salary to defer and picks from a fund menu that the employer has negotiated.
That menu historically leaned heavily on annuity contracts sold by insurance companies, which is why annual charges vary so much between providers and why comparing the total yearly cost of each fund is worth an hour of anyone's time. Two quirks are worth knowing.
Staff with fifteen years of service at the same qualifying employer may be permitted an extra long-service contribution above the standard ceiling, and the ceilings themselves are reset each year by the tax authorities, so any figure printed in a staff handbook needs an annual review.
In practice
Real-world examples.
Example
A community college hires a data analyst at $12,000 below the salary a local software firm offered. The recruiter wins the candidate over by showing that a 7% employer contribution to the 403(b), which the software firm does not offer at all, closes most of the gap in total reward.
Example
A regional hospital reviews its plan and discovers the default fund charges 1.9% a year while a comparable index option charges 0.15%. Switching the default saves the average participant several thousand dollars in fees over a career without the hospital spending a cent.
Example
A charity's finance director budgets for a 4% employer match on a $6,000,000 payroll and accrues $240,000 for the year. When take-up rises after an enrolment campaign, she has to revise the accrual upwards mid-year and explain the variance to the board.
Think of it
“403(b) plan is the nonprofit retirement savings program-tax-advantaged like 401(k).
Formula
Calculation
Annual contribution = (deferral percentage x gross salary) + employer match
Cost to take-home pay = employee deferral - (employee deferral x marginal tax rate)
A university administrator earns $70,000 and elects to defer 10% of salary, which is $7,000 a year. Her employer matches 5% of salary, adding $3,500, so $7,000 + $3,500 = $10,500 goes into the plan each year.
Because the deferral is taken before tax, at a 22% marginal rate she saves $7,000 x 0.22 = $1,540 of income tax, so her take-home pay falls by only $7,000 - $1,540 = $5,460 while $10,500 is invested on her behalf. If that $10,500 a year is paid in for 25 years and earns 6% annually, the fund grows to roughly $576,000, of which $262,500 is contributions and the rest is compounded growth.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Harborline Academy Trust, an invented network of six charter schools, offered a 403(b) plan that almost nobody joined. Only 18% of its 400 staff contributed anything, and exit interviews kept mentioning retirement provision as a reason for leaving.
The trust's fictional finance director made two changes. She replaced the old annuity-based fund menu with a short list of low-cost index funds, and she moved from an opt-in to an automatic enrolment design at a 3% default deferral with an employer match of 4%. Participation rose to 71% within a year.
The employer match cost the trust an extra $310,000 annually, but teacher turnover fell from 22% to 14%, and the recruitment and supply-cover savings more than paid for it. The illustrative lesson is that the design of a plan, not merely its existence, drives whether staff value it.
Watch out
Common mistakes.
- Assuming a 403(b) is automatically identical to a 401(k) and ignoring the fee differences that come from the old insurance-contract fund menus.
- Contributing only enough to miss part of the employer match, which is the closest thing to free money most employees will ever be offered.
- Treating the annual contribution ceiling as fixed, when the tax authorities reset it most years and payroll settings need updating with it.
Questions
People also ask.
Can someone pay into both a 403(b) and an individual retirement account in the same year?
Yes, though the tax deductibility of the individual account may be reduced once income passes certain thresholds.
What happens to the money if an employee leaves the organisation?
Vested balances belong to the employee and can usually be left in place, rolled into a new employer's plan or moved into an individual retirement account.
Is the employer match immediately the employee's money?
Not always, because many plans apply a vesting schedule under which the match is only fully owned after a set number of years of service.
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