Why do I need to contribute to a 403(b)?
403(b)'s build wealth for retirement and contributions may have a significant impact on your annual tax situation - potentially helping you save on taxes!
Your pension is not enough, it is up to you to make up the shortfall by investing in your 403(b), 457, and Roth IRA.
What is a 403(b) Tax-Sheltered Annuity?
The 403(b) is a tax-deferred retirement plan available to employees of educational institutions and certain non-profit organizations. Participants contribute to either annuity contracts with insurance companies or mutual funds with mutual fund companies. Contributions and investment earnings grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income. Withdrawals before age 59 ½ are subject to an additional 10% federal income tax penalty.
The 403(b) was established in 1958 by the federal government to encourage employees in certain tax-exempt organizations to establish retirement savings programs. The name refers to the relevant section in the Internal Revenue Code. For exact Internal Revenue Service wording, refer to IRS Publication 571. You can obtain this document by calling 1-800-829-3676 or by clicking here.
Why Contribute to a 403(b)?
- Supplement Retirement Income – Most educational institutions and other non-profit organizations are provided with a pension upon retirement. Few pension plans, however, provide an amount equal to salary. A 403(b) plan can provide a supplement to help close that gap.
- Lower Taxes – 403(b) contributions are made on a pre-tax basis which can greatly reduce your tax bill. Generally, if you contribute $100 a month to a 403b plan, you’ve reduced your Federal income taxes by roughly $28 (assuming you are in the 28% tax bracket). In effect, your $100 contribution costs you only $72. The tax savings are magnified as your 403b contribution increases.
- More Tax Savings – all dividends, interest, and capital gains accumulate in a 403b account on a tax-deferred basis. This means your earnings will grow without taxes until the time of withdrawal, when they are taxed as ordinary income. Withdrawals before age 59 ½ are subject to a 10% federal income tax penalty.
How does a 403(b) plan work?
The employee can contribute to 403(b) plans, employer, or both depending on the type of plan you have. You can defer all or part of your income to your 403(b) account, or you can choose to receive cash payments from your employer right away. Your elective deferral (the amount you defer to your plan) can be after-tax Roth contributions (plan dependent) or pre-tax.
If your employer makes contributions to your 403(b) plan, the amount can be a fixed percentage of your wages, they can match a percentage of your contribution, or the amount can be entirely up to your employer. 403(b) plans are unique in that employers can contribute to your account for up to 5 years post-employment.
Who can participate?
According to the Universal Availability Rule, if one employee is eligible for elective deferrals, all employees can do so. Certain groups can be excluded from this rule, including part-time employees, eligible under a different type of plan (like a 401(k)), under 21, or employees who haven’t been there very long.
If you have been automatically enrolled in your 403(b) program by your employer, be sure to examine your portfolio. Some plans will automatically calculate your deferral percentage, and you’ll want to make sure that your contributions are appropriate for your situation.
What are the contribution limits?
For more detailed information, refer to IRS Publication 571. You can obtain this document by calling 1-800-829-3676 or download it directly from the IRS website by clicking on “IRS Publications” and scrolling to “Publication 571 Tax Sheltered Annuity Programs.”
A special catch-up election also exists. This provision allows you to increase your elective deferral limit for any calendar year by $3,000 more than the indexed limit. To qualify, you must have completed at least 15 years of service with the same employer (The years of service need not be consecutive). In most cases, contributions made under this catch-up provision cannot exceed $3,000 per year, up to a $ 15,000-lifetime maximum (under current rules). Participants are advised to consult IRS Publication 571 and/or a tax or financial professional when calculating this limit.
Can I also contribute to an IRA?
Yes! Your ability to make deductible contributions to an IRA (traditional or Roth) will be dependent on your income and filing status. You can contribute up to $6,000 annually to a traditional or Roth IRA ($7,000 if you’re age 50 or older).
Income tax considerations
When you make pre-tax 403(b) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay than an after-tax contribution of the same amount). Your contributions and investment earnings are fully taxable when you receive a distribution from the plan.
In contrast, your after-tax Roth 403(b) contributions are subject to income taxes upfront but are tax-free when distributed to you from the plan. And, if your distribution is qualified, then any earnings are also tax-free.
A distribution from your Roth 403(b) account is qualified only if it’s made after the end of a five-year waiting period, and the payment is made after you turn 59½, become disabled, or die.
If your distribution is non-qualified, then you’re deemed to receive a pro-rata portion of your tax-free Roth contributions and your taxable earnings.
Your employer’s contributions are always made on a pre-tax basis, even if they match your Roth contributions. Your employer’s contributions and investment earnings on those contributions are always taxable to you when you receive a distribution from the plan.
If you receive a payment from your 403(b) account before you turn 59½ (55 in certain cases), the taxable portion may also be subject to a 10% early distribution penalty unless an exception applies.
When can I access my money?
403(b) plans require that the money stays in the account until the age of 59.5 years old, become disabled, or no longer work for the employer from which the elective deferrals came from. If you should have an immediate hardship or need, sometimes you can withdraw early. However, this is plan-dependent and should be treated as a last resort. If you withdraw early, this sum will be charged income tax and potentially a 10% penalty tax. Should your plan allow after-tax contributions, your plan can let you access your money at any time.
Contributions made by your employer to custodial accounts fall under similar restrictions but can be more lenient. Your plan representative will be able to inform you of these specific rules.
What happens when I terminate employment?
In short, it depends on your vesting schedule. Your employer makes vested contributions that you officially own. In some cases, your plan could require up to 6 years of employment before your employer contributions are considered vested. However, this is not always the case, and some plans will have schedules. Should you terminate your employment, your options are as follows:
- Leave your money in your 403(b) account
- Transfer your money into a new 403(b) account
- Roll your dollars over into an IRA
- Roll your dollars over into another employers retirement plan
- Take a cash distribution
What else do I need to know?
- If you are not satisfied with your plans vendor and their investment offerings, you can transfer your assets from one contract to another (if you’re still employed with this employer) should your employer offer 403(b) plans from multiple vendors.
- In the event of bankruptcy, your account is protected from creditors under Federal Law. The Employee Retirement Income Security Act (ERISA) may also protect your account from creditors.
- At the age of 72 (or after you terminate employment, if later), you must start to take distributions from your account.
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To be eligible for a 403(b) plan you must be employed by:
- A public school, college or university
- A 501(c)(3) nonprofit organization
403(b) plans provide tax deferred earnings on plan contributions, potentially less tax on assets, the ability to take loans from the account, and reduced taxable income through pre-tax contributions.
Employers benefit from 403(b) plans because these plans keep valuable employees content and the shared cost of funding between employers and employees.
When you retire you are not required to take funds out of your 403(b) account. You can leave the money in your 403(b) and they will continue to accumulate until you withdraw them, annuitize them, or you can even roll them over later.
If you retire at age 55 (or older) you may be able to make withdrawals from your 403(b) account without penalty. Usually, you need to wait until you’re 59.5 years old to withdraw funds without penalty (if you’re still working).
Administrative costs for 403(b) plans are lower than 401(k) plans. This is because 403(b) plans can only be used by school districts, governmental organizations, non-profit companies, and religious groups.
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