If you’re employed and interested in saving for retirement, you may have heard of a 403(b) or an IRA (Individual Retirement Account). A 403(b) and an IRA are both tax-advantaged accounts to help you make the most of saving for retirement, but each comes with different setups and advantages. For one, you can only gain access to a 403(b) from select employers while there are several IRA types to pick from. Let’s put each one up against the other, see how they differ, and what makes sense for your financial plans.
- A 403(b) is offered by non-profit employers such as hospitals or public schools and closely resembles a 401(k).
- IRAs (Individual Retirement Accounts) come in various types such as traditional, Roth, and Self-Directed.
- 403(b)s have higher contribution limits and a better impact on taxable income and deductions than IRAs.
- IRAs offer superior choice and control over investment options and are more accessible than 403(b)s.
- Using both accounts will leverage their complementary advantages and maximize the size of your investment base.
What’s a 403(b)?
The 403(b) is an employer-sponsored plan for retirement offered by non-profits such as schools, zoos, or churches. It mirrors the structure and benefits of a 401(k) retirement account, so you’re not missing out if you don’t work for a non-profit. Workers can make pre-tax contributions, as a percentage of their total pay to their accounts each pay cycle. An employee can select where to invest their money from a list of mutual funds, index funds, REITs, or other investable assets. Some plans allow employees to select and invest in individual stocks, though this setup is rare. Once the employee invests, the growth on these investments is untaxed until the account holder withdraws from the account.
The real advantage is in the employer match — many companies offer a matching scheme where if an employee contributes a certain amount to their 403(b), the employer will match it. For instance, at my old job if I contributed 5% of my total pay to the 401(k), my employer would contribute 2.5% of my total salary as their contribution. The employer match is rightly considered “free money” and is a key advantage of this type of retirement account, not often seen in other investment vehicles. It is usually advised to contribute at least enough to your 403(b) to earn the employer match, if one is offered.
In 2022 the maximum annual contribution to a 403(b) is $20,500 or $27,000 for those 50 or older. If you are 50 or older, you qualify for catch up contributions of $6,500 a year. The 403(b) also offers a little known type of catch-up contribution called the 15 year-rule. Some plans allow employees who have been with their organizations for at least 15 years and have contributed less than $5,000 per year on average to contribute up to $3,000 extra per year. They can keep adding up to a $15,000 lifetime cap. However, this option is up to the employer’s discretion to offer it so it is best to ask yours to see if your plan offers this.
The earliest age the account owner can withdraw without penalty is 59 1/2. But they must begin taking required minimum distributions or RMDs at 72. The taxes paid at retirement depends on future tax rates and how much in income the account holder has at that time.
If an account holder switches jobs, they can rollover their 403(b) into an IRA which we will cover more below.
What’s an Individual Retirement Account (IRA)?
An Individual Retirement Account or IRA is a self-directed retirement savings account that you set up and manage on your own. You can open one with reputable brokerages such as Fidelity, E*Trade, or Charles Schwab. As it is self-directed, you have the freedom to decide what assets you want to invest in and how much. You can invest in whatever mutual funds, index funds, REITs, futures, bonds, or individual stocks you choose. IRAs come in different types and you can have multiple ones at the same time. You are capped at a $6,000 contribution limit across all your IRAs for 2022 or a $7,000 limit if you are 50 or older. You are able to make withdrawals starting at 59 1/2.
Depending on the type, you can fund your IRA with pre-tax dollars or after-tax dollars. Let’s learn more about each one below.
Types of IRA
To fund one, you make after-tax contributions to your account. Since you’ve already paid tax on the money, the investment growth and its profits are untaxed — meaning tax-free distributions. Unlike other retirement accounts, you can take out any contributions penalty-free as you need to. But it’s not recommended to do so except in cases of extreme financial hardship.
This IRA does not qualify for tax breaks, so you have to save up the cash if you want to fully fund this account each year. In fact, one of my main financial goals is to save up and fund this account as early in the year as I can to give my investments more time in the market.
This is one of the most popular and best retirement savings accounts. When I first started working in college, my parents urged me to open this account to take advantage of long-term investing to create tax-free income in retirement. I consider opening up this account as a milestone in my personal finance journey.
If you’d like to learn more about the Roth IRA, and it’s pros and cons for your retirement planning, read more here.
This is the most common type of IRA, mainly differing from a Roth IRA in its tax treatment. You fund a traditional IRA through pre-tax contributions that count as tax deductions — saving you money on this year’s taxes. Your investments grow tax-free, but you must pay taxes on your withdrawals in retirement, like a 403(b) plan. Unlike a Roth IRA, you must begin taking required minimum distributions (RMDs) at 72.
Making Post-Tax Contributions to a Traditional IRA
You can also fund it with post-tax dollars, but you cannot take a tax deduction. It can be problematic if you mix pre- and post-tax money in the same account. The IRS’s pro-rata rule specifies that if an IRA contains both types of contributions a withdrawal will have a ratio of taxable and tax-free income. You will have to go through the hassle of closely tracking your contributions and filing additional paperwork with the IRS, such as Form 8606.
It is simpler to use a Roth IRA for your post-tax dollars. But if you are over the income limit, it is better to use a separate IRA account for after-tax dollars so you can do a backdoor Roth conversion at a later time. You will still have to file a Form 8606 each year, but it will do away with further accounting headaches in the future.
If you have a leftover 403(b) or 401(k) from a prior employer, you can transfer its holdings to a Rollover IRA to expand your investing options. This IRA type works like traditional IRAs but is meant to hold your transferred assets to help you avoid paying taxes by maintaining their deferred status.
Though you can make regular contributions to this account, it’s recommended to only use it for rollovers to reduce risk of accounting confusion by adding your own tax-deductible contributions. If you do a trustee-to-trustee transfer, then you can transfer your assets from one financial institution to another without tax implications. I made this type of transfer after I quit my job, which I highlight more here.
Self Directed IRA (SDIRA)
This IRA account can be organized as a traditional or a Roth while allowing you to invest in assets such as real estate or businesses that you can’t own in the other accounts. SDIRAs are more complex accounts to form and manage, for some of these reasons:
- They must satisfy specific IRS rules that prohibit owning certain things such as life insurance or collectibles (e.g. old coins, artwork).
- The financial institution holding your SDIRA cannot provide financial advice or verify the investment quality — making the input from your financial advisors more crucial.
- This IRA account comes with several fees not seen with the other IRA types such as an account opening fee and an account renewal fee.
High net-worth folks are the primary users of SDIRAs as they use them to hold specific asset classes or to engage in complex financial planning setups. If you’d like to learn more, feel free to read here.
How Does Each Stack Up? — IRA vs 403b
Let’s compare the various aspects of each account below.
Like a 401(k), 403(b) plans usually offer a limited set of mutual funds, such as small-cap, large-cap or actively-managed funds. Some may offer the ability to invest in individual stocks, but this is a rare setup. Many of these funds come with high expense ratios as they are specific funds meant for employer-based retirement plans. However, many underperform the S&P 500 on a long-term basis.
When I examined the options in my 401(k) I found that many of the default investment options charged high fees and had underperforming results. I converted my funds to an S&P 500 Vanguard Index Fund to minimize my fees and increase my return. As a result, I rode the ~27% growth the S&P 500 experienced in 2021.
In contrast, you can invest in an array of assets with an IRA, bringing you more flexibility and control over your retirement planning. If you like to research and pick individual stocks for long-term holding or set your own strategy, then using an IRA has a lot to offer you.
Access to Each Account
It is easy to open an IRA with any brokerage whenever you want. With 20 minutes of computer work, you can have both Roth and traditional IRAs.
To gain access to a 403(b) plan you must work for a non-profit employer such as a hospital, public school, or house of worship that offers it.
Both accounts can only be funded by earned income, so you can only put in money you make from work.
Contribution Limits & Employer Contributions
The 403(b) plan has an annual contribution limit of $20,500 for 2022 ($27,500 for 50+) with no income limits to prohibit contributions. It has much higher contribution limits and simpler rules than IRAs.
In 2022, you can only contribute $6,000 to all of your IRAs ($7,000 for 50+). There is no income threshold to contribute to a traditional IRA, but the Roth version comes with its limits depending on your income and filing status. But you can bypass this hurdle by doing a backdoor conversion.
The 403(b) plan’s higher limits mean the bulk of a person’s retirement funds will come from this account rather than an IRA. Plus, many 403(b) plans come with employer contributions aka free money. That alone puts this account ahead.
Winner: 403(b) plan
Taxable Income & Impact of Deductions
Both a 403(b) plan and a traditional IRA offer tax deductions to lower your present taxable income. But, the 403(b) has a larger tax deduction than its IRA counterpart lowering your tax bill by a higher margin. As an added bonus, employer contributions are tax-free in the present.
Winner: 403(b) plan
Because these accounts have complementary advantages, I suggest using both in your retirement investing strategies. Using both accounts will give you the best blend of pre-tax deductions and future tax-free income — giving your present and future selves a happier financial life and lower tax bills.
Today’s tax savings from deductions will spend time invested in the markets growing — as shown above. Coupled with an employer match, the long-term compound growth from your invested tax savings is an advantage only found in a pre-tax employer-sponsored plan. In the above graph, a $10,000 starting amount mixed with compound growth over 40 years produces a 22x return making the investment worth $217,000.
Using only a Roth IRA and no pre-tax option causes an opportunity cost due to the lost returns on your tax savings. You can use both a traditional IRA and a 403(b) to maximize your pre-tax deductions, but using a Roth IRA yields a complementary benefit.
A Roth IRA lowers your future taxable income, coming in handy if you expect to be in a higher future tax bracket than where you are today. Then it works out to pay taxes upfront and make Roth contributions.
No one knows what tax brackets will look like in 30-40 years, so the conventional advice is to contribute enough to your 403(b) or 401(k) to get your employer match and to make the maximum contribution to your Roth IRA.
Ultimately, your retirement planning comes down to your expectations of your current and long-term financial needs. It’s best to work with a financial advisor to craft a retirement plan that works for you.