A 403(b) plan has some similarities to a 401(k), but is distinct enough to merit separate discussion.
Unlike other retirement plans, only certain types of organizations are able to set up a 403(b). Generally, this plan option can be used by:
- Public schools
- 501(c)(3) tax-exempt organizations
Another quirk is that, with limited exceptions, all employees must be eligible to participate in a 403(b). This is known as universal availability. The only employees who can be excluded are:
- Employees who normally work less than 20 hours per week
- Employees who will contribute $200 or less annually
- Employees who participate in a 401(k) or 457 plan, or another 403(b) of the employer
- Non-resident aliens
- Students performing services described in Section 3121(b)(10)
A 403(b) has the same annual contribution limits as a 401(k). In 2019, an employee can contribute up to the lesser of $19,000 or 100% of their compensation. The total contributions made by the employee and employer are limited to $56,000. Both the $19,000 and $56,000 limits may increase each year based on cost of living adjustments. Employees over 50 can contribute an additional $6,000 as catch up contributions. Something specific to a 403(b) is the 15-year rule. Employees who have worked for your organization for at least 15 years, and meet certain criteria, can contribute an additional $3,000 per year for 5 years. See the details under the 15-year rule in IRS Publication 571.
Contributions made by the employer can fall into a few different types:
- Matching contributions: The employer will make contributions based on what an employee contributions. It may be a 100% match, or a partial match, and typically has an upper cap, e.g. 6% of an employee’s compensation.
- Discretionary matching contributions: The employer decides how much to contribute towards the match. Plan documents will specific how it will be allocated among employees, e.g. the match won’t exceed 6% of an employee’s compensation, but the percentage match will depend on how much the employer decides to contribute.
- Discretionary contribution: The employer decides how much to contribute to the 403(b) each year, and plan documents will specify how it will be allocated to employees, e.g. in proportion to compensation.
- Mandatory contributions: The employer contributes a certain amount to the 403(b) each year, e.g. 5% of compensation.
- Former employers: An employer can continue to make contributions for former employees for up to 5 years after employment ends. There are limits to this under 26F.R. § 1.403(b)-4(d).
By default, employees will have the option to make traditional contributions, which reduce their taxable income in the year the contribution is made. The employees would not pay taxes on the growth of their investments, but when they take distributions during retirement, the distributions would be taxable income. When the employer is setting up the 401(K), they can choose to allow employees to make Roth contributions. Roth contributions don’t reduce your taxable income when you make them, but when you take distributions in retirement, nothing is taxed. If you’re making contributions throughout your career, most of what’s in your 401(K) will be growth, not the contributions you made, so you can save a significant amount of taxes by making Roth contributions. Note that any contributions made by the employer are non-Roth, so they’ll be taxable when you take distributions, unless you roll them over into a Roth 401(K) or IRA account. You would pay taxes on the amount you rollover.
403(b)s are subject to nondiscrimination rules. Employee contributions are not subject to testing, but employer contributions are. The intent is to show that the plan doesn’t discriminate in favor of highly compensated employees. CPA firm Windes covers the details here.
Finally, you have to file a Form 5500 each year for a 403(b) plan. This reports information about the plan to the IRS, Department of Labor, and employees who participate in the plan. It covers some details about how the plan is operated, as well as some financial data.
Other types of retirement plans to consider: