403(b) Plan Explained: A Complete Beginner’s Guide

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Infographic: Infographic: A Beginner’s Guide to 403(b) Plan

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403(b) Plan Explained: A Complete Beginner’s Guide

Just $150 a month invested in a 403(b) can grow to over $1 million over time. But one hidden detail inside some 403(b) plans can erase hundreds of thousands of that growth.

I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years. I’ll show you how a 403(b) works, how to make the most of it, and how to avoid the mistake that matters most.

What is a 403(b) Plan and How Does it Work

A 403(b) is a kind of retirement account that’s offered by many public schools, as well as certain nonprofits and churches. It’s like a 401k for these employers.

Money usually goes straight from your paycheck into the account, and your employer can add money too, which we’ll get to.

After contributing money, you choose what to invest it in from the options available, although these can be quite limited.

A 403(b) is retirement money, so you really shouldn’t take money out early. Withdrawals before age 59 1/2 usually face a 10% penalty.

There are two kinds of contributions to a 403(b):

1. Traditional
2. Roth

Some employers offer just one, and the difference is when you pay federal income tax.

Roth vs Traditional 403(b) Contributions

With Roth contributions, you deposit money that’s already been taxed, and it grows completely tax-free. When you retire and pull it out, you don’t owe the IRS anything.

Traditional contributions switch the tax timing.

You get a tax deduction in the year you contribute, which means you don’t pay taxes on that money now. But you will owe tax on every dollar you withdraw in retirement.

While studying for the CFP® exam, I learned that there’s no universal winner between traditional and Roth contributions. 

If you’re early in your career and expect to have a higher income in retirement than you do today, Roth contributions might be better.

But later, when you have a higher income, Traditional contributions might be better.

But keep in mind this one thing. If you’re employed by a US public school district or 501(c)(3) charity and meet other criteria, you could be eligible for Public Service Loan Forgiveness (PSLF).

This can reduce monthly student loan payments based on income and lead to loan forgiveness after 10 years.

The income that’s considered is your Adjusted Gross Income, and traditional 403(b) contributions reduce it – which works in your favor. So it’s worth calculating the effect when choosing how to contribute.

But there’s an employer feature that can make your contributions way more valuable.

How Much to Put in a 403(b) Account

Some employers match 403(b) contributions.

Say your employer matches dollar-for-dollar up to 5% of salary. If you earn $50,000, 5% of your salary is $2,500.

If you contribute $2,500 or more, you will get another $2,500 from your employer – which is the maximum possible match.

But if you contribute just $2,000, your employer would only match that, and you’d miss out on $500 of free money.

This employer match might not seem like a lot now, but it will grow significantly by retirement thanks to compounding.

So try to contribute enough to get the full match if your employer offers one, as long as you can still cover your expenses.

403(b) Plan Fees and Investment Options

Unlike, say 401k plans or IRAs, many 403(b) plans include high-fee annuities or mutual funds that can really hurt your long-term investment returns.

An expense ratio is the percentage of your investment that a fund charges each year in fees.

Say you invest $150 per month in the stock market for 40 years and the investments earn 11% before fees.

At a 0.1% expense ratio, you’ll end up with over $1 million.

But with a 2% expense ratio, you’ll only have around $600,000 – that’s $400,000 less just because of the 2% fee.

So if your plan offers a low-cost index fund, like one that tracks the S&P 500, that’s a great choice – especially if you have decades until retirement. You get to invest in the entire US stock market and pay low fees.

But if your 403(b) doesn’t offer a low-cost index fund, compare the expense ratios of the investments it does offer. Start with the lowest-cost diversified funds available, and check what they actually invest in before choosing.

If your cheapest reasonable option still charges high fees, contribute enough to capture any employer match first.

Then, consider putting additional savings into a different account, like an IRA, where you can choose lower-cost investments. Because as we’ve seen, even a small difference in annual fees can become huge over several decades.

But which kind of IRA should you pick?

Check this out to find out the differences between a Roth IRA and Traditional IRA, so you can pick the right one for your situation and build more wealth over the long run: Roth vs Traditional IRA Explained for Beginners: Which is Better?