What Is a 403(b) Tax-Sheltered Annuity Plan?

403(b) Plan

Investopedia / Michela Buttignol

What Is a 403(b) Tax-Sheltered Annuity Plan?

A 403(b) is a retirement plan offered by public schools and non-profit organizations and is similar to a 401(k) plan. A 403(b) plan is designed for certain employees of tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.

Key Takeaways

  • The 403(b) Tax-Sheltered Annuity Plan serves employees of public schools and tax-exempt organizations.
  • Contributions to 403(b) plans are made through payroll deductions.
  • The IRS limits how much employees can contribute to their 403(b) plans.
  • Investment choices may be more limited with a 403(b) and some accounts offer less protection from creditors than 401(k)s.

403(b) Contributions

The 403(b) Tax-Sheltered Annuity Plan operates like a 401(k) plan, allowing participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There's also an option for the employer to match part of the employee's contribution, with contribution limits set by the Internal Revenue Service (IRS).

A 403(b) is akin to a 401(k) plan for private-sector employees. Participants must reach 59½ before withdrawing funds or face an early withdrawal penalty. Those who contribute to a 403(b) include:

  • Employees of public schools, state colleges, and universities
  • Public school employees of Indian tribal governments
  • Church employees
  • Employees of tax-exempt 501(c)(3) organizations
  • Ministers and clergy members

If an employer offers a 403(b) and a 401(k), individuals can contribute to both but their aggregate contribution cannot exceed the annual IRS limit of $23,000 in 2024. Individuals aged 50 and over can contribute an additional $7,500 as a catch-up contribution.

Types of 403(b) Tax-Sheltered Annuity Plans

Two 403(b) plans include traditional and Roth. Not all employers allow employees access to the Roth version. A traditional 403(b) plan allows the employee to have pretax money automatically deducted from each paycheck and paid into a personal retirement account. The employee reduces their gross income and income tax for the contribution year. Taxes will be due on the money only when the employee withdraws it.

A Roth 403(b) requires that after-tax money be paid into the retirement account. There's no immediate tax advantage. But, the employee will not owe any more taxes on that money or the profit it accrues when it is withdrawn.

Clergy can also participate in a 403(b) but there's a special plan type that's designed specifically for employees of religious institutions. This plan is called the 403(b)(9).

Advantages of 403(b) Plans

Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions.Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.

An employee with 15 or more years of service with certain nonprofits or government agencies may be able to make additional catch-up contributions to a 403(b) plan, such as $3,000 a year, up to a lifetime limit of $15,000. Unlike the usual retirement plan catch-up provisions, individuals don't have to be 50 or older to take advantage of this as long as they have worked for the same eligible employer for 15 years.

Disadvantages of 403(b) Plans

Funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty. Individuals may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.

When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. A 403(b) may offer a narrower choice of investments than other plans. Although these plans offer mutual fund options inside variable annuity contracts, contributors can only choose between fixed and variable contracts, and mutual funds inside these plans⁠. Securities, such as stocks and real estate investment trusts (REITs), are prohibited.

Pros
  • Earnings and returns in regular 403(b) plans are tax-deferred until they are withdrawn

  • Many 403(b) plans vest funds over shorter periods while some vest immediately

  • Employees with 15 or more years of service may make additional catch-up contributions

Cons
  • Withdrawals before age 59½ are subject to a 10% tax penalty

  • Plans may offer narrower investment choices than other plans

  • Accounts within a 403(b) may lack the creditor protection provided by other plans

What Are the Similarities Between 401(k) and 403(b)?

Some employers offer employees the opportunity to contribute to both a 401(k) and 403(b). Each offers employees a tax-advantaged way to save for retirement, but investment choices are often more limited in a 403(b) plan than a 401(k). 401(k)s serve private-sector employees. Unlike a 401(k), the 403(b) plan offers a special plan for those with 15 or more years of service with the same employer.

When Is Money in a 403(b) Tax-Sheltered Annuity Plan Taxed?

The deferred salary is not subject to federal or state income tax until the money is distributed. A 403(b) plan may offer designated Roth accounts and contributions are taxed in the income year is tax-free when distributed.

What Types of Employers Can Establish a 403(b) Plan?

Public educational institutions or 501(c)(3) tax-exempt organizations are the only types of employers that may establish a 403(b) plan. 

The Bottom Line

The 403(b) is offered by public schools and other tax-exempt organizations to many of their employees. It works just like a 401(k) plan supported by corporations and may include matching contributions. The IRS establishes annual contributions to 403(b) Tax-Sheltered Annuity Plans.

Article Sources
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  1. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

  2. Internal Revenue Service. "IRC 403(b) Tax-Sheltered Annuity Plans."

  3. Internal Revenue Service. "How Much Salary Can You Defer if You’re Eligible for More than One Retirement Plan?"

  4. Internal Revenue Service. "Retirement Topics - Designated Roth Account."

  5. Internal Revenue Service. "Retirement Topics - 403(b) Contribution Limits."

  6. Internal Revenue Service. "Section 403(b) Tax-Sheltered Annuity Arrangements." Page 1.

  7. Internal Revenue Service. "Retirement Plan Investments FAQs."

  8. Financial Industry Regulatory Authority. "401(k) Basics."

  9. Internal Revenue Service. "IRC 403(b) Tax-Sheltered Annuity Plans."

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