In the mysterious world of IRS tax codes, we often see the term 401(k). However, you may be less familiar with what a 403(b) is.

Today, you’ll not only learn what a 403(b) plan is but also how these plans work, the difference between them and 401(k) plans, and how they can benefit nonprofit employees.

Let’s dig in.

A 403(b) is a retirement account created for specific employees of tax-exempt organizations. It is sometimes referred to as a TSA or tax-sheltered annuity plan.

A 403(b) plan allows employees to contribute to a retirement plan using tax-sheltered income, thereby reducing tax liabilities. Under this plan, the contributions made in 403(b) are not taxed by the IRS, only the withdrawals.

Possible candidates for such plans include

• Teachers
• Government workers
• School administrators
• Pastors and church employees
• Nurses, doctors, and other medical professionals
• 501(c)(3) entities, such as a nonprofit, university, or organization that provides social services

Named after the tax code that specifies it, a 403(b) plan enables participants to save money for retirement through payroll deductions while taking advantage of specific tax breaks. Employers offering 403(b) plans can also choose to contribute and match employees' contributions.

You can take a closer look at the maximum amount any individual can contribute to their 403(b) plan per year here.

Under the U.S. Department of Labor, employers are required to meet minimum requirements to guarantee that employee benefit packages are created fairly and financially healthy, more often referred to as ERISA or the Employee Retirement Income Security Act.

However, some 403(b) plans, like schools and governmental plans, may be exempt from ERISA's regulations.

When considering whether to invest in a 403(b) plan, take the following into account:

• Does the plan offer matching funds?
• Does the plan offer other features such as housing for clergy?
• Does the plan allow for catch-up payments for employees? Some 403(b) plans allow employees to contribute an additional $3,000 in catch-up yearly payments.

Finally, it’s important to note that there are also Roth 403(b) plans (though not all employers allow employees access to Roth 403(b) plans.)

In a Roth 403(b), the retirement account must be funded with after-tax dollars. Because Roth contributions are made after-tax, you must pay taxes on them at the time of contribution. However, all eligible withdrawals are tax-free, and the employee won't be responsible for further taxes when money is withdrawn.

What it boils down to with the traditional 403(b) plan vs. the Roth 403(b) is whether you want to pay taxes on your contributions now or after you retire.

Now that you know what a 403(b) is, it is time to discover how they work.

Under a 403(b) plan, pre-taxed funds can automatically be withheld from the employee's paychecks and deposited into a personal retirement account.

Some items to be aware of concerning 403(b) plans:

• All employees must be eligible for the 403(b) plan.
• Deposited money is free of capital gains taxes.
• Participants need to reach the age of 59 ½ before withdrawing money, or they will be hit with a hefty penalty.
• Minimum payouts must be made by age 72.
• Employees are allowed to access their accounts early if predetermined hardship regulations are met, such as becoming permanently disabled.

Regarding regulations, 403(b) plans are generally comparable to 401(k) plans; however, longer-tenured employees may have access to additional latitude regarding withdrawals and catch-up contributions.

As an example, let’s consider two hypothetical investors, Jill and John.

Both Jill and John each contribute $3,600 annually to their 403(b) plans and earn 6% annually on their investments. Jill uses a traditional 403(b) plan, and her contributions are made pre-taxed, while John uses a 403(b) Roth; thus, his contributions are taxed as regular income before being deposited into his 403(b).

Thirty years later, John's withdrawals will be tax-free because he chose a Roth, but Jill will have to pay taxes on hers, as she chose a traditional 403(b) plan.

Both 403(b) and 401(K) plans are great tools that can help you save for your inevitable retirement. The 403(b) and 401(k) plans share similarities as well as some differences, so let's take a closer look at what each has to offer.

A 403(b) plan, like a 401(k), enables you to set aside a portion of each salary for retirement. The cool thing is that by contributing to a 403(b) or 401(k) plan, you show the IRS a reduction in your gross income and, therefore, the amount of income taxes due for the year. You are then only taxed upon withdrawal from your retirement plan. Either plan can be used to generate sizable wealth for your retirement.

While a 403(b) is similar to the more well-known 401(k) in several ways, there are also a few significant distinctions between them. So how do these plans differ? Let’s take a look:

• The biggest difference between the two retirement accounts is which employer can offer them. While 403(b) plans are provided by charitable organizations, 401(k) plans are offered by commercial, for-profit businesses.
• 403(b) plans have more limited investment options than their counterpart 401(k) plans. 401(k) plans offer bonds, mutual funds, annuities, and stocks as investment options, whereas 403(b) plans only provide investment opportunities in annuities and mutual funds.
• Because the possibilities in a 403(b) plan can sometimes be restricted in scope, you may explore rolling over a 403(b) account into a 401(k) to obtain access to more investment opportunities.
• 403(b) plans have fewer administrative costs and are cheaper for employers to offer because the government doesn't want to add additional financial burdens to nonprofit organizations.
• As a self-employed individual, you would not be able to invest in a 403(b) plan, but can open a solo 401(k).

The IRS established a pre-approved program for 403(b) plans that is comparable to the existing IRS program for qualified retirement plans. With the help of this program, prototype and volume submitter plan document suppliers can get the IRS to approve the format of their 403(b) documents.

More simply stated, a pre-approved 403(b) plan can be purchased by an employer from a verified document provider, such as a benefits specialist or financial institution. The provider will oversee and monitor a company's employee compensation packages to ensure they are fair and just to its employees.

Three pre-approved 403(b) plans are available to employers:

1. Plans for standardized prototypes.
2. Plans for a non-standard prototype.
3. Plans for volume submitters.

More in-depth information about these plans can be found at: IRS 403(b) pre-approved plans.

Are you ready for even more good news? You can roll your 403b to a 401k if you are no longer working for the same employer or if you retire.

And if your new place of employment also offers a 403(b) plan, you can merge your former account into the new account being offered. This can be incredibly beneficial if your new employer offers matching donations and it is also a great way to preserve the benefits you have already established with your pre-existing 403(b) plan.

And if you start to work for yourself, you can convert your 403(b) plan into an independent 401(k) plan.

At the core of every nonprofit’s mission is to help others. However, in the midst of doing good work, nonprofits can lose sight of their employees' needs and retirements. A 403(b) retirement plan is a great way for nonprofits to take care of their employees who are so selflessly taking care of others.

In summary, because there are no minimum ERISA rules, 403(b) plans are more of a mixed bag and need to be carefully explored before investing in one. Nevertheless, if contribution matching is provided and the investment options are reasonably priced, a 403(b)plan can be a smart way to save for retirement.

Curious about other topics related to nonprofit management? Check out our posts on how to create nonprofit bylaws and nonprofit board member responsibilities.