Is a 403(b) a Good Way to Save for Retirement? The Pros and Cons

Your HR office may have handed you a sheaf of papers on your first day of a new job at a nonprofit organization. Among this important reading material, you may find details about your company's retirement plan options.

Unlike an employee who works at a for-profit company, you won't get information in your welcome packet about a 401(k). As an employee of a nonprofit organization (a 501(c)(3) tax-exempt organization) or government agency, you may have access to a 403(b) instead. For-profit companies utilize 401(k)s instead of 403(b)s — it's the first of a few differences between a 403(b) vs. 401(k).

In this piece, we'll walk through the definition of a 403(b), how a 403(b) plan works, the pros, cons, and alternatives to a 403(b), and several FAQs that may percolate once you learn that you're eligible to invest in this retirement plan type.

Let's take a look.

What is a 403(b)?

What is a 403(b), exactly? A 403(b) retirement plan, also referred to as a tax-sheltered annuity plan, is a tax-advantaged retirement savings plan. It allows employees in the U.S. to contribute a predetermined portion of their salary to selected investments with the goal of saving for retirement.

How a 403(b) plan works

As a teacher, public school administrator, government employee, a pastor in a religious organization, or if you fulfill another type of role, you can choose from several 403(b) investing options. You typically have the option to invest in annuities and mutual funds.

An annuity, or an insurance product, gives you a regular, scheduled payment in the form of guaranteed income in the future, usually during retirement. You may hear jargon about accessing annuities under your employer’s "tax-sheltered annuity plan," which means the same thing as a 403(b) plan.

A mutual fund refers to bundles of securities, such as stocks and bonds, that gives you immediate diversification in many companies and industries. When you diversify your portfolio, it means that instead of investing in the stock of one company, sector, or asset class, you invest in many to spread out your risk. Diversification ensures you don't put all your eggs in one basket, or in this case, all your money in one company.

It's worth noting that because 403(b)s mainly focus on annuities and mutual funds, your 403(b) options can seem much more limited than what you might find in a 401(k) or individual retirement account (IRA).

How to sign up for your 403(b)

You may receive eligibility to participate in your organization's 403(b) plan as soon as your first day on the job. However, that's not always true with every company. Check with your employer about the exact date when you can start investing in your organization's 403(b) and put it on your calendar.

To sign up for the 403(b) when you become eligible for enrollment, you’ll probably need to fill out paperwork or sign up online to choose your investments, most likely through your company's HR office. You can typically invest either a percentage of your salary or a specific dollar amount through payroll deduction.

Next, you must choose between a traditional 403(b) and Roth 403(b). Both have similarities, but the tax treatment makes up the largest difference between the two. Let's look at both:

• Traditional 403(b): You fund a traditional 403(b) with pre-tax contributions and your money grows on a tax-deferred basis. In other words, you won't pay taxes now; you'll pay taxes when you withdraw the money in retirement.
• Roth 403(b): When you opt to invest in a Roth 403(b), you invest after-tax dollars into your retirement account. As with a traditional 403(b), your money also grows tax-free but you won't pay taxes when you take the money out in retirement.

Quick note: If your employer offers to match the money you put into your fund, that portion of the money you take out in retirement does get taxed. A "match" means that an employer might contribute to your 403(b) plan, but companies are not required to offer employer contribution at all. A common format for an employer match is 50 cents on every dollar you contribute, up to 3% to 6% of your pay.

403(b) max contribution limits

Any employee can contribute up to $23,000 in tax year 2024. If you're 50 or older, you can add an additional {% lp_custom_tag '403b-catch-up-tax-year-2' % in catchup contributions. The employee-employer combined annual 403(b) max contribution (your employee contribution plus the employer match) can go up only to the lesser of $69,000 for 2024 or your salary for your most recent year of service.

In 2025, the employee contribution will be $23,500. If you're 50 or older, you can contribute and additional $7,500. 

How to withdraw money from a 403(b)

By law, the IRS requires you to take retired minimum distributions (RMDs) by age 72. That doesn't mean you have to leave your money in there until the day you turn 72. You can begin making withdrawals from age 59 1/2 onward. If you take money out before age 59 1/2, you must pay a 10% early withdrawal penalty and you'll lose out on tax-deferred growth.

You also won’t necessarily have access to all your money right away. You'll want to check your vesting schedule with your company's benefits or human resources administrator. It could take three to five years before you own all of your company's matching contributions. This means if you leave your job before you become completely vested, you cannot take all the money with you.

Pros to a 403(b)

It's a great idea to take a look at the pros and cons of investing in a particular retirement fund before you get started. Let's walk through the pros first.

• Additional catch-up benefits: In addition to the $6,500 catch-up benefit, some 403(b) plans also offer a 15-year rule perk. Here's how it works: If you've been working for your employer for 15 years or more and you've contributed less than $5,000 per year up until this point, you can contribute up to $3,000 more per year on top of your contribution limit. The catch: You can only contribute up to a $15,000 lifetime maximum.
• Lowered tax bracket: You can lower your tax bracket by putting money into a 403(b), which means you give yourself the opportunity to owe less in taxes for the particular tax year in which you invest.
• Potential for immediate vesting: Some plans allow for immediate vesting, which means that you can keep all the money you invest, including matching contributions, from day one of your new job.
• Opportunity to save money: You can stockpile a lot of cash when you save in a 403(b). Even without the 15-year rule perk, you can save up to $72,500, which includes catch-up contributions. Imagine if you saved that much of your paycheck every year. You have the opportunity to make a large impact on your retirement savings.
• May get to choose your vendor: You may have to choose your 403(b) plan from a group of pre-selected firms, or vendors. This gives you the opportunity to choose investment products that meet your financial goals, time horizon, and risk tolerance.

Cons to a 403(b)

• May have to choose a vendor: Sound familiar? Choosing a vendor can be both a pro and a con, depending on your perspective. Again, you must choose the right investment products for you, which can seem like a daunting task, especially for novice investors. Read through the plan documents available to you, specifically the parts about the vendor's investment products and services, tax information, and more. You may want to consult your benefits administrator before you make a decision, especially if you have questions about what a specific plan offers.
• High fees: Fees can eat away at your balance. You may have to pay high brokerage fees, advisor fees, account closure fees, custodial fees, and administrative fees. Experts often equate annuities with high fees and low returns, according to the U.S. Securities and Exchange Commission. You may even have to pay surrender fees if you choose to leave an annuity, which can take a large chunk of money out of your overall investment.
• Narrow range of investment choices: You may not have access to as many investments through a 403(b) because most plans don't come directly from mutual fund companies. You may sacrifice a wide range of diversity in your 403(b) investment options.
• Possible lack of ERISA oversight: The Employee Retirement Income Security Act of 1974 (ERISA) sets standards of protection for individuals who invest in retirement plans. Non-ERISA 403(b) plans can have long vendor lists, individual contracts, higher fee structures, and a lack of protection from creditors. This doesn't apply to every 403(b), but it's a good idea to find out whether yours has ERISA oversight.

Alternatives to a 403(b)

If you have access to a 403(b) and receive a match from your employer, you may want to seriously consider taking advantage of the match. Why not take advantage of free money from your employer?

If you don't get an employer match at all, you may want to look elsewhere for more robust investment choices, lower fees, and other added benefits. Low-return, high-cost annuities in a 403(b) can damage the impact to your nest egg.

Consider looking into traditional IRAs and Roth IRAs, which offer tax perks similar to 403(b) plans. You may have access to a more comprehensive list of fund choices as well. The only downside: You can't contribute as much money to an IRA or Roth IRA. You can contribute up to $7,000 in tax year 2024. Those age 50 and older can contribute an additional $1,000.

FAQs

Bottom line

A 403(b) can offer a plethora of opportunities if you're an educator or nonprofit worker thinking ahead to your golden years. Consider all your options, including your preference for a traditional 403(b) over a Roth 403(b), and talk to your plan administrator about all investment products.

Your benefits office can also help you understand your 403(b) options. You may also want to talk to a fiduciary financial advisor who can help you learn how to invest money, especially when it comes to your retirement planning. A financial advisor can also help you understand the full scope of investments to fit your goals, including short- and long-term investments.