How Does a 403(b) Plan Work?
Employees typically sign up for a 403(b) plan directly through their employer. Contributions are generally made through payroll deductions, and most employers provide a matching contribution up to a capped amount. Contributions are pre-tax. When a person reaches retirement age, his withdrawals from his 403(b) account will be taxed at that time.
Unlike 401(k) plans or IRAs, only employees of participating non-profit organizations may open 403(b) accounts. More specifically, public schools and universities are eligible to offer 403(b) plans. Additionally, any organization classified as a 501(c)(3) organization per U.S. tax code is also eligible for 403(b) plans. Typically, the 501(c)(3) status is reserved for charitable organizations, such as Habitat for Humanity, though some non-profits outside the charity arena also maintain the 501(c)(3) status.
Employees and employers both reap benefits from 403(b) plans. Employees get to save for retirement with tax-deferred contributions. Furthermore, since most people make less income during retirement and, therefore, are in a lower tax bracket, the eventual tax paid on the contributions will likely be lower. Employers benefit from 403(b) plans because they are attractive to high-quality employees who want an employer-sponsored way to save for retirement. Also, 403(b) plans cost employers less than older pension plans since the costs of funding 403(b) plans are shared between the employer and the employee.
Types of 403(b) Plans
There are three types of 403(b) plans: an annuity contract, a custodial account and a retirement income account. An annuity contract plan is made with an insurance company and is the most common kind of 403(b) plan. A custodial account is typically established for a beneficiary rather than the owner of the account. A retirement income account is reserved for churches or other specially designated nonprofits. A financial advisor can discuss the specific differences between the three types to determine which is best for a particular investor.
403(b) vs. 401(k) Plans
The primary difference between 403(b) plans and the more common 401(k) plans is the employer who is sponsoring the plan. For-profit employers can offer 401(k) plans while non-profit employers can offer 403(b) plans. Otherwise, the two plans function quite similarly--both allow employees to make tax-deferred contributions for their retirement. In certain circumstances, 403(b) plans are not subject to the same legal requirements as 401(k) plans, but these requirements do not change the overall function of the accounts. By and large, the two plans operate the same way but are offered by different types of employers.