Near-Identical Cousin? 403(b) Plans & Tax Implications Explained

We all hear a lot about the importance of saving for retirement. And for many workers, access to a 401(k) plan is a key component in long-term planning.

But there are some workplaces that don’t offer a 401(k). Instead, they may offer 403(b) plans. If you work for a nonprofit organization, a school, a hospital, or as a minister, you’ll likely be choosing among 403(b) retirement plan options. Here’s what you need to know.

Who Can Contribute to a 403(b) Retirement Plan?

If your organization offers a 403(b) plan, and you’re eligible, you can contribute. Employers that offer 403(b) plans include:

• Tax-exempt organizations or nonprofits that qualify for 501(c)(3) status with the IRS
• Public school systems organized by a state or tribal government
• Religious organizations (for ministers)
• Cooperative hospital service organizations

It’s important to understand that there is no “solo” or “self-employed” option for a 403(b), such as you’d see with a 401(k). If you want to participate in a 403(b), it has to be set up by your employer. Self-employed ministers must be treated as employed by a qualifying tax-exempt organization, then contribute to an account administered through that organization.

For the most part, you’ll find that 403(b) plans are almost identical to 401(k) plans. In fact, employers that meet requirements to offer 403(b) plans can choose to offer 401(k) plans instead.

But there are some administrative process rules that are a little less stringent for some 403(b) providers. These rules can potentially reduce some of the associated costs, making 403(b) plans attractive to smaller organizations. There are also some interesting tweaks related to contribution limits.

403(b) Contribution Limits

On the surface, 403(b) contribution limits and tax treatment are similar to what you’d see with a 401(k) plan. The IRS sets the same contribution limits for 403(b) plans as for 401(k) and 457(b) plans.

For 2019, the contribution limit is $19,000 (with a catch-up option of $6,000 for those aged 50 and older). As with its 401(k) cousin, it’s also possible to make Roth contributions to your 403(b), if the plan allows. Your employer may also match employee Roth contributions, but this match would need to be tracked separately, as withdrawals from the match would be taxable—just like any pretax employee contributions.

Note that your combined contributions to 403(b) and 401(k) accounts are limited to $19,000. The IRS treats them the same, so you can split your contribution among accounts, but you can’t double it.

There are three primary advantages that come with 403(b) contributions over 401(k) plan contributions:

1. If you have served long-term in a qualifying organization—for at least 15 years—you can get an additional $3,000 catch-up contribution.
2. Employees may be able to receive 403(b) plan contributions from former employers for up to five years after leaving employment.
3. 403(b) plans are exempt from required IRS plan testing on 401(k) plans. With 401(k) plans, it’s possible that your employer must limit your contributions based on a salary percentage, potentially reducing what you can stash in your account. In contrast, a 403(b) retirement plan retains what’s called “universal availability.”

403(b) Taxes and Withdrawal Penalties

How do 403(b) taxes work? Employee contributions are usually made pretax with your earnings growing tax deferred. You put your money in pretax, reaping the tax advantage today, and pay the 403(b) taxes when you withdraw from your retirement account down the road. Like a traditional 401(k), 403(b) plans are subject to required minimum distributions (RMDs) once you reach age 70 1/2. 

However, if your employer offers a Roth option, you can use that for tax-free growth. You make contributions with after-tax money and don’t worry about paying taxes on withdrawals in retirement—or taking RMDs.

The 403(b) withdrawal penalty is also the same as the 401(k). You pay taxes on the amount taken, plus a 10% penalty if you take money before age 59 1/2. The Roth implications are also the same. You need to meet the minimum withdrawal age, plus have your account established for at least five years, if you want to withdraw earnings penalty free. As with other Roth accounts, though, you can withdraw contributions at any time without penalty.

403(b) Bottom Line

In many ways, 403(b) plans really are cousins to the 401(k). However, there are some minor differences that can make a 403(b) retirement plan attractive in certain circumstances. Carefully consider your retirement planning needs and the availability of different plan choices as you decide.