What Is a 403(b) and How Does It Work?

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Smiling female school teacher sitting on a chair facing students in a classroom holding up and explaining a worksheet
Image Credit: Dreamstime

A 403(b) plan is the public school employee’s equivalent of the private sector 401(k). It’s a retirement account designed to let teachers, administrators, professors and others save for retirement.

But 403(b)s have dangers that you need to watch out for.

Here’s What You Need to Know About 403(b)s

In this article, we’re going to tell you how much is too much to be paying to have your investment money in a 403(b). We’ll also take a look at what your options are if your current plan has you paying too much.

Finally, we’ll lay out a few questions you should ask before doing a 403(b) with any provider.

Table of Contents

What Is a 403(b)?

A 403(b) is a retirement plan for those who are employed by a public school, college, university, church or charitable entity tax-exempt under Section 501(c)(3) of the Internal Revenue Code. 403(b) plans are also called tax-sheltered annuity plans or TSAs, according to the Internal Revenue Service.

Like a 401(k), the 403(b) takes its name from the section of our tax code that makes this program possible.

But unlike a 401(k), which is typically sponsored by a private for-profit company, a 403(b) is usually sponsored by a government organization or non-profit.

How Does a 403(b) Work?

If you’re familiar with 401(k)s, then you already have a good idea of how 403(b) plans work: Employees select a portion of each paycheck to contribute to individual accounts. Employers may make matching contributions to those accounts, though it’s not required.

The money you put into a 403(b) is pre-tax and not subject to federal or state income tax until it’s distributed.

In another similarity to a 401(k), your employer may offer a designated Roth account version of a 403(b). You contribute to a Roth 403(b) with after-tax money that’s never taxed again even when distributed.

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Both 403(b)s and 401(k)s have the same contribution limits and both require you to hit age 59.5 before taking distributions.

Early distributions before age 59.5 are possible, but you’ll likely pay a 10% penalty if you don’t meet stringent requirements from the IRS.

And, just like with a 401(k), you can take out a loan against your 403(b) if your plan permits it.

But here’s a big difference: 403(b) plans are typically administered by insurance companies, not the mutual fund companies or low-cost discount brokerage houses that tend to administer 401(k) plans.

Unfortunately, that means high fees are often coded into the DNA of 403(b) plans. More on that in a moment.

What Are the 403(b) Contribution Limits for 2020?

The 403(b) contribution limit for 2020 is $19,500 (it was $19,000 for 2019).

In addition, catch-up contributions of an additional $6,500 — for a total of $26,000 — can be made by those who have 15 years on the job or are 50+.

However, limits do vary based on circumstance. You can see IRS.gov for complete details.

403(b) accounts also have limits on what are called annual additions. These are defined as the total of all employer contributions plus whatever the employee has elected to save during the year. The limits on annual additions are:

  • $57,000 for 2020 ($56,000 for 2019), or
  • 100% of includible compensation for the employee’s most recent year of service

What Kind of Fees Should You Expect to Pay in a 403(b)?

Unfortunately, fees can be very high with a lot of 403(b) plans. Money expert Clark Howard says a reasonable fee to pay is 0.6%.

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We also reached out to 403(b) expert Dan Otter of 403bWise.org who concurred. “We are in 100% agreement with Clark on what a reasonable fee is,” Otter says.

But too often, it can be difficult to understand your plan’s 403(b) fees.

“Here’s our recommendation: Ask [your plan administrator] for a total breakdown of all fees — including surrender charges. The surrender charges are particularly nefarious as they can last about seven years [on average] and often start anew with each contribution,” Otter explains.

If you can’t get a straight answer about fees from your plan administrator, Otter told us that 403bCompare.com — a vendor registration site run by the state of California — keeps thorough fee information for all vendors selling 403(b) products in the state. Fortunately, Otter says it can also be used by out-of-state residents as a way to get clear disclosure on their plan’s 403(b) fees.

Note: To get total cost when using 403bCompare, you often have to look at the “Fees and Charges” section and at the “Investment Options” section. We’ve highlighted those in green below on a sample screenshot:

403bCompare website

Once you have your plan information and figure out what kind of fees you’re paying, Otter encourages people to post that information on his own organization’s 403bWise Facebook Group. That way, the community can weigh in and others can benefit from your research.
Remember, we’re all in this together!

Should You Pay a Surrender Charge to Move Your Money?

Surrender charges are a nasty surprise you may find in your 403(b) when you go to move the money out of a high-cost plan. Some vendors charge rolling surrender charges, according to 403bWise.org. So each new contribution out of your paycheck starts a new surrender time frame.

What should you do if you’re paying too much in fees in your current plan and want to move your money?

“If you have a better vendor option, [then] stop contributions to the expensive vendor and direct all new contributions to the better vendor. That way your money is going to work right away in a lower cost product,” Otter says.

Next, figure out how much of your old account is subject to a surrender charge. Most plans typically allow you to roll over 10% of assets without penalty each contract year. That way, you can slowly transfer money out instead of paying a surrender charge.

“[But] some people are so mad when they learn the true cost of their 403(b) that they transfer the entire amount,” Otter notes. “It is really a personal decision.”

To help you decide about the best path for you, Otter offers the following formula:

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Divide the surrender charge by the difference between the current product’s total expenses and the new product’s total expenses. This tells you how long it will take to break even.

For example, if you currently have a 5% surrender charge, but will save 2.5% annually in fees by moving your money, you have a two-year break even mark. That means you would be better off moving that money if the surrender period exceeds two years.

4 Questions to Ask About Your 403(b) Plan

Before making contributions to any 403(b) plan, it’s important to do your due diligence. Here are the questions you should be thinking about:

1. Who Is Managing Your Money? The Teachers Insurance and Annuity Association of America (TIAA) is one of the best places to have your 403(b) money. It’s also worth taking a look at low-cost provider Vanguard.

2. How Much Are You Paying? As we mentioned earlier, experts say that paying 0.6% inclusive of all fees is reasonable.

3. Is There a Match Being Offered by Your Employer? Be sure you’re at least picking up the match — regardless of fees. After all, that’s free money you’re being offered!

4. What Should I Do After Picking Up the Match? If you’re with a low cost provider, continue investing with them. If you’re with a high-cost provider, just contribute up to the match. Then, every penny after that you save for retirement should go into your own Roth IRA.

Final Thought

403(b) plans make it easy for employees of public schools and tax-exempt organizations to save for retirement through payroll deductions. In that respect, they’re very similar to a 401(k) for private sector workers.

However, the big difference is often in the fees. Most 401(k) plans tend to be administered by mutual fund companies and the fees have been driven down over time thanks to industry competition. 403(b) plans, on the other hand, tend to be administered by insurance companies — so they generally have high fees that hurt your bottom line.

If you have additional investing questions about your 403(b), consider calling our Consumer Action Center.

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Contact Clark’s Consumer Action Center — a FREE helpline open Monday-Thursday from 10 a.m. – 7 p.m and Friday from 10 a.m. – 4 p.m. EST. We have volunteers available to answer YOUR concerns! Call Team Clark @ 404-892-8227.

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