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What is a 403(b) and Why Is It Important?

What is a 403(b)

Posted: Nov 11, 2015 | Author: | Comments: 0

What is a 403(b)?

A 403(b) is a special type of retirement plan that is available to some employees of public schools, tax-exempt organizations and ministers. The 403(b) gets its name from the section of the IRS tax code that oversees it. If you are looking for an excellent way to save money for your retirement, the 403(b) is a great choice. This type of plan can serve as a supplement to a defined benefit plan like a pension. The 403(b) can also stand on its own as a single retirement plan.

How Does a 403(b) Work?

If you are interested in a 403(b), you will need to enroll and participate through your employer. Contributions to your 403(b) are made on a pre-tax basis. This is done through a Salary Reduction Agreement where you agree to take a reduction in salary before taxes to save for retirement. This contribution, also known as “elective deferrals,” is directed to investments that are offered through the employer and that are selected by the employee. These investment options include annuities (Fixed Annuity, Equity Indexed Annuity, or Variable Annuity) and mutual funds.  One of the many benefits of a 403(b) is that the contributions are excluded from your taxable income. Over time, these contributions grow tax-deferred until retirement. During retirement, any withdrawals will be taxed as ordinary income.

How is a 403(b) Different from Other Retirement Options?

Pension plans, including CalPERS and CalSTRS in California, are formula-based defined benefit retirement plans that pay a guaranteed lifetime income at retirement. Eligible employees upon employment are automatically enrolled and must make mandatory contributions in this type of plan.  The amount an employee receives in retirement is based on factors like years of service, age factor percent, and salary. Investment decisions for pension plans are made by plan official and are not self-directed. In contrast a 403(b) is voluntary and self-directed.

The 401(k) is another common type of retirement plan and is known as a defined contribution plan. However, it is used by private sector workers. The 403(b), in contrast, is a retirement plan that is available to certain employees of public schools, employees of certain tax-exempt organizations and certain ministers. The 403(b) is available to help employees supplement lost income gaps at retirement.

Am I Eligible for a 403(b)?

If you are a public school employee or an employee of a not-for-profit organization, you are eligible to participate in a 403(b). However, it is important to note that employers can restrict access to this type of plan based on factors including how many hours you work. Be sure to speak with your employer for more eligibility details.

What is a Roth 403(b)?

A Roth 403(b) is a provision that permits employees to designate all or a portion of their 403(b) savings as an after-tax Roth contribution. The Roth 403(b) is different from a Roth IRA because it is an employer-based plan as opposed to an individual-based plan. This means that the distribution and contribution rules are different. For example, the Roth 403(b) normal contribution limit for 2015 is $18,000 per year. Phase out rules based on annual household income do not apply. Contributions to a Roth 403(b) do not lower your taxable income. In return, the distributions of Roth 403(b) funds during retirement are not subject to taxation.

What Should I Know Before Opening a 403(b)?

One of the most important things to know before opening a 403(b) plan is that it is an investment. You must assess your degree of risk when it comes to investments. If you have a low risk tolerance, you may be more comfortable with a conservative investing strategy of mostly fixed investments. However, if you have a high risk tolerance you may prefer more aggressive investments which can yield larger rewards. You should also understand that fees, operating rules and investment objectives will vary among vendors and across investments.

To make the most out of your 403(b), know yourself as an investor as well as learn as much about investing and the workings of the 403(b) plan as you can. This will better prepare you to be a wise investor and get the most return on your investment.

The team at Ed4Ed.org is here to help you learn about your retirement and supplemental retirement options. Our site is filled with current information about pension plans, 403(b) plans, and more so you can make the best informed decisions about your retirement as possible.