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403(b) plans and how they work

403(b) plans work almost identically to 401(k) plans. But there are a few differences. Read our full 403(b) vs 401(k) comparison here.

A 403(b) is a retirement plan provided by employers in nonprofit organizations. This includes school systems, hospitals and healthcare systems, and religious organizations. 401(k) plans, on the other hand, are provided by employers engaged in for-profit businesses. That’s basically every other employing organization in the country.

Similarities between 403(b) and 401(k) plans

Tax deferral. Both plans allow for tax-deductible contributions, as well as tax deferral of investment income earned within the plans.

Employer match. Both plans provide for employer matching contributions.

Contribution maximums. Both plans enable employees to contribute up to $22,500 per year, or up to $30,000 per year if they are age 50 or older (2023 figures).

Withdrawal restrictions. Ordinary income taxes must be paid on any distributions from either plan. Both plans require that you wait to make withdrawals until you reach age 59½. Otherwise, you will be subject to the 10% early withdrawal penalty tax in addition to ordinary income tax. Both plans also require that you begin taking required minimum distributions (RMDs) beginning at age 70½.

Roth provisions. Both plans allow you to also pay up to $6,500 per year into a Roth provision in your plan, or $7,500 if you are age 50 or older.

Loan provisions. Both plans allow you to borrow up to 50% of the vested balance in your plan, not to exceed $50,000.

Differences between 403(b) and 401(k) plans

Vesting. 403(b) plans often offer shorter vesting of employer matching contributions. Many even offer immediate vesting of those contributions. Depending upon the type of vesting schedule that 401(k) plans choose, vesting of employer matching contributions can take as long as six years.

Maximum allowable contribution (MAC). 403(b) plans have a special provision with regard to maximum contributions. If you have worked for the employer for a minimum of 15 years, you can make an additional contribution of $3,000 per year. This means you can contribute up to $25,500 per year, or up to $33,000 per year if you are age 50 or older. This provision does not exist for 401(k) plans.

However, it’s also worth noting that relatively few 403(b) plans actually offer a MAC provision. While they can legally include it in the plan, they’re not required to do so, and most don’t.

Investment options. 403(b) plans often have restricted investment options. The primary option is usually either fixed or variable annuities. This is the reason why 403(b) plans are often referred to as tax-sheltered annuities or TSAs.

Some may also offer a limited number of mutual funds. According to an analysis prepared by Aon Hewitt, the investment breakdown of 403(b) plans looks like this:

  • 43% is held in fixed annuities;
  • 33% in variable annuities;
  • And 24% in mutual funds.

401(k) plans often restrict investment options as well. Some plans are limited to half-dozen mutual funds or exchange-traded funds (ETFs). But some plans have wider options. And sometimes they’re nearly unlimited.

For example, if a 401(k) plan is held by a major investment brokerage firm, you may be able to invest in stocks, bonds, mutual funds, exchange-traded funds and real estate investment trusts (REITs).

Investment fees. 403(b) plan investment fees are typically higher than what they are in a 401(k) plan. See below.

Typical 403(b) plan fee structure

The reason 403(b) fees are higher than what they are for 401(k) plans is in the available investment selection. The fees charged by the investments available in a 403(b) plan are higher than what is commonly accepted by investors who have a choice in the matter.

Once again, according to the analysis prepared by Aon Hewitt, the fees charged on variable and fixed annuities and mutual funds included in a 403(b) plan look like this:

  • Variable annuities: 2.25%.
  • Fixed annuities: 1.15%.
  • Mutual funds: 0.97%.

By contrast, the average expense ratio of an ETF is just 0.44%. And you can do even better than that by investing in low-cost index funds.

What makes the situation even more complicated for 403(b) plan participants is the fact that those investment fees charged on the annuities and mutual funds are often invisible. This is in part because they are buried in the literature describing the investment vehicles. Most people lack understanding about the significance of these fees.

The other issue is the lack of options. Since 403(b) plan investors don’t have low-cost investment options, they also lack the basis of comparison to make the determination that the investment fees they are paying are excessive.

The long-term damage done by high 403(b) fees

The best way to demonstrate the damage caused by the high fees charged by 403(b) plans is by example. We’ll do one based on two people saving for retirement through their employer plans under identical parameters. The only difference between the two is that one participates in a 403(b) plan and the other in a 401(k) plan.

Sam and Tara each earn $75,000 per year and invest 10% of their respective salaries into their employer’s retirement plans. Sam is a teacher who participates in a 403(b) plan. The plan has average annual fees of 1.50%. Meanwhile, Tara works for an IT firm and participates in a 401(k) plan that has average annual fees of 0.50%.

The big difference in fees is a result of Sam’s investment mix of annuities and mutual funds. Tara’s investment is entirely in low-cost ETFs.

Both plans average 7% annual returns before deducting fees. This means Sam’s net return on investment in his 403(b) averages 5.50% per year after fees. Tara’s gets a net return on investment in her 401(k) that averages 6.50% per year after fees.

How does this look at the end of a 40-year career? To keep it simple, we’ll ignore employer matching contributions as well as annual salary increases.

Sam: He contributes $7,500 per year for 40 years, for a total career contribution of $300,000. He earns an effective net rate of return of 5.50% over that time. At the end of his career, Sam’s 403(b) plan has grown to $1,054,824.

Tara: She also contributes $7,500 per year for 40 years, for a total career contribution of $300,000. She earns an effective net rate of return of 6.50% over that time. At the end of her career, Tara’s 401(k) plan has grown to $1,363,183.

The difference between the two terminal plan values? $308,359.

403(b) vs. 401(k)
ACCOUNT ANNUAL CONTRIBUTION TOTAL CONTRIBUTION EFFECTIVE NET RATE OF RETURN THE AMOUNT AT RETIREMENT
Sam's 403(b) $7,500 $300,000 5.50% $1,054,824
Tara's 401(k) $7,500 $300,000 6.50% $1,363,183

Sam doesn’t contribute any less to his 403(b) than Tara does to her 401(k). And both plans provide identical gross returns on investment. The only difference between the two retirement planning outcomes is fees.

The shocking conclusion: The higher fees in Sam’s 403(b) plan ultimately cost him well over $300,000!

Put another way, the higher fees in Sam’s 403(b) plan cost 22.6% of his retirement savings. That’s $308,359 divided by the $1,363,183 Sam would have ended up with had his 403(b) plan had the same fee structure as Tara’s 401(k) plan.

Making the best of a bad retirement plan

Unfortunately, if your employer offers only a 403(b), that is the best retirement plan you have. You’ll have to participate in it to at least some degree, due to the fact that it offers very generous contributions and tax deferral. But there are at least two ways you can minimize the damage.

Invest your 403(b) in mutual funds

The first is to choose the lowest-cost investment option you have within the plan. That will almost certainly be mutual funds. While they're not as inexpensive as ETFs, they're considerably less expensive than annuities. That’s not hard to imagine, either, since annuities are among the most expensive investment options available. Investing 100% in mutual funds could lower your overall annual expense ratio from 1.50% or more to something less than 1%.

Invest some of your retirement contribution in an IRA

Let’s say you’re currently contributing $15,000 per year to your 403(b) plan. Instead, reduce the plan contribution to $10,000 and contribute the remaining $5,000 to an IRA account.

The benefit is that within the IRA you can invest in low-cost ETFs, instead of mutual funds and annuities. But there’s also a secondary benefit. Since an IRA is completely self-directed, you will have a choice over what to hold in your account.

One flaw in this plan is the possibility that the IRA contribution will be either partially or entirely nondeductible. The IRS limits IRA deductibility if you are covered by another retirement plan and your combined income exceeds certain thresholds. Since you are participating in a 403(b) and may also be covered by an employer pension plan, you may be subject to these limits.

You’ll have to crunch the numbers and determine if the reduction in investment expenses justifies the loss of deductibility of part or all of your IRA contribution. You’ll also have to factor in any loss of the employer match due to making lower employee contributions.

Combine putting some of your retirement money into an IRA with shifting your 403(b) investments completely over to mutual funds. This will lower your effective investment expenses considerably and improve your return on investment.

Other than those two options, you can also lobby your employer benefits department to either switch retirement plans — perhaps over to a 401(k) — or to add more low-cost investment options to the 403(b) plan. But my money would be on the mutual funds plus IRA strategy. It’s always easier to make individual decisions than to change the collective minds of bureaucracies.

About the Author

Kevin Mercadante

Kevin Mercadante

Freelance Contributor

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com.

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