A 403(b) plan is similar to a 401(k) plan with a few exceptions. The most notable difference between 401(k)s and 403(b)s is that 403(b) plans are restricted to employees who work for non-profit organizations, such as schools and charities. Employees of religious institutions are eligible for special 403(b) plans if their employer offers them.

Just like 401(k) plans, 403(b) individual retirement plans provide a great way to save for the future. This is especially true if you work for an organization that matches all, or a portion of, your contributions each pay period. Continue reading to learn more about how 403(b) plans work, as well as the pros and cons of investing in this type of retirement plan.

How does a 403(b) plan work?

When you enroll in a 403(b) plan, you can determine how much you want to contribute to this plan each pay period. You can either select a flat amount, such as $100, or a percentage of your overall pay. For example, if you want to contribute 3% of your earnings to a 403(b) plan and you make $2,500 a pay period, then the amount you contribute to your 403(b) is $75. Your employer automatically deducts this amount from your paycheck and transfers it into your 403(b) account.

The good news is that when investing in a traditional 403(b) plan, contributions are taken out of your pay before taxes, which can reduce your taxable income. Using the example above, if you contribute $75 to your 403(b), you only pay income tax on $2,425. Additionally, many employers offer matching contributions up to a set amount. This benefit can help you double your contributions and grow your investment faster.

You are, however, limited to the amount you can contribute to your 403(b) throughout the year. For 2023, the most you can contribute to a 403(b) is $22,500. When including employer contributions, the annual contribution limit is $66,000 for 2023 or 100% of your annual salary for the year, whichever is less. In rare cases, you may work for an employer that offers both 403(b) and 401(k) retirement plans. While you can make contributions to both plans, your combined annual contribution limit cannot exceed that $22,500 threshold for 2023.

The two types of 403(b) plans

If you’re considering investing in a 403(b) retirement plan, it’s important to understand that there are two different types of plans available. Not all employers offer both plan options, but if your organization does, make sure you know the difference before you enroll.

Traditional 403(b) plan

A traditional 403(b) plan is the most common option for investors. You make contributions to this type of plan on a pre-tax basis. This factor means that you don’t pay taxes on the money you’re investing now. Instead, you will owe taxes on the disbursements you receive once you retire. This is a good option for those who anticipate being in a lower tax bracket during retirement than their current one.

Roth 403(b) plan

On the other hand, you make contributions to Roth 403(b) plans on a post-tax basis. Since you’re paying taxes on the money you earn before investing it, you don’t have to pay taxes later when you withdraw the funds. Additionally, you don’t pay taxes on any earnings on your contributions (subject to certain withdrawal requirements). This is a good option for those who don’t want to worry about an additional tax burden during retirement or those who expect to be in a higher tax bracket after retirement.

Pros of a 403(b) plan

When determining if a 403(b) retirement plan is the right investment option for you, consider the numerous advantages of this type of plan, such as:

Tax advantages

There are tax advantages to investing in both a traditional and Roth 403(b) retirement plan. With a traditional 403(b) plan, you have the advantage of making pre-tax contributions. Taking advantage of this pre-tax benefit can help to lower your current year's tax liability. For example, let’s say you’re an individual tax filer making an annual salary of $92,000 and you make $10,000 in 403(b) contributions. In this scenario, you only pay income tax on $82,000 ($92,000 - $10,000). Not only does this reduce the amount of your annual taxable income, but it also brings you down to a lower tax bracket and a lower tax rate.

On the other hand, if you invest in a Roth 403(b), you receive tax benefits when it comes time to withdraw your money at retirement. When you retire, you can withdraw the funds you contributed to your 403(b) over the years, as well as any earnings during this timeframe, completely tax-free (subject to withdrawal requirements).

It’s important to evaluate your current financial status as well as your anticipated future financial plans and retirement goals when deciding whether to invest in a traditional or Roth 403(b) plan.

Employer matching

Employer retirement plans, like a 403(b), are some of the few investment options that allow employers to make contributions on behalf of their employees. In most cases, employers choose to match their employee's 403(b) contributions up to a set amount. For instance, if you contribute 2% of your earnings every pay period to your 403(b) account, your employer may contribute that same amount to your account. The exact amount your employer will contribute each pay period depends on the terms of the company’s 403(b) plan.

Shorter vesting periods

Employers in both the private and public sectors may use a grading vesting system regarding 403(b) and 401(k) matching contributions. Employers use this method to promote retention within the organization. Basically, vesting means that you gradually gain full ownership of employer-matched funds in your 403(b) over the length of your employment. So if you leave the company before vesting 100% of these contributions, you’re not able to keep the full amount in your 403(b) account.

High contribution limits

Contribution limits are the same for both 403(b) and 401(k) accounts. The contribution limit for 2023 is $22,500. These maximum limits are substantially higher than the contribution limit for individual retirement accounts (IRAs), which is $6,500 for 2023. Catch-up limits are also higher for 403(b) plans than traditional IRAs. For example, you can make catch-up payments of up to $7,500 per year into a 403(b) compared to only $1,000 per year into a Roth IRA.

Cons of a 403(b)

As with any investment opportunity, there are also several disadvantages of investing in 403(b) plans. Be sure to review these potential disadvantages before investing in one of these retirement-saving plans.

Early withdrawal penalty

If you need to withdraw funds from your 403(b) account before you retire (and are age 55 or over) or reach the age of 59 and a half, you will likely have to pay a 10% penalty on any funds you withdraw. You must also include any amount you withdraw as income for that year, which could put you into a higher tax bracket.

Note that you don’t pay income tax on disbursements of your contributions from a Roth 403(b) account, but you will still face a 10% tax penalty on any earnings.

Narrow choice of investments

One of the most significant disadvantages of 403(b) plans is the narrow choice of investment options it offers. As of right now, you can only invest in mutual funds or variable annuities through a 403(b) plan. Unlike 401(k) retirement savings plans, you can’t invest in individual stocks. If you have an option between investing in a 403(b) or a 401(k) plan, assess your retirement plans to determine which option works for your specific situation. It’s recommended to speak with a financial advisor for more specific details.

Higher fees

While administrative fees for managing 403(b) plans vary from company to company, these costs may be higher than other retirement saving options. Be sure to read the plan details carefully to determine exactly what fees you may incur. This step will help you avoid any surprises after you've already enrolled in a plan.

Our take

403(b) plans offer a great way to save for retirement, especially if your employer offers matching contributions. If possible, it’s recommended to contribute at least the same amount as your employer’s matching limit. Otherwise, it would be like throwing money away. However, 403(b) contributions are only one type of retirement investment. To secure your future retirement plans, build a strategic investment portfolio.