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403b plan and how it works: The full breakdown

At a glance:

  • Who may participate in a 403b plan?

  • How 403b plans are taxed

  • The Roth 403b

  • 403b rollovers

  • Summary of 403b Plans

The 403b plan, named for section 403b of the Internal Revenue Code, is a type of retirement plan that is eligible to receive special tax benefits. The money contributed to a 403b comes from before-tax dollars. These dollars are deducted from one's paycheck before they are taxed.

Thus, job earnings you contribute to one of these retirement plans are not taxed while they remain in the fund (although how much may be contributed tax-free is limited).

The official name of the 403b is tax-deferred annuity plan. The name is somewhat misleading, as either annuity contracts or mutual funds may be used to fund it.

Papers with 403(b) Plan and book on a table.
The official name of the 403b is tax-deferred annuity plan. (Photo: Getty)

Who may participate in a 403b plan?

Employees of non-profit organizations, such as hospitals, museums, public foundations, churches, research organizations, and local governments are eligible for participation in 403b plans.

Part-time employees may participate in all qualified plans unless they are expressly prohibited because of individual plan requirements. In addition, employers may establish eligibility guidelines for different classes of employees.

Contributions to 403b plans

Both employers and employees may make contributions into a 403b plan for an employee.

However, in most cases, contributions to a 403b plan are made from an employee's elective deferrals. The employee signs a salary reduction agreement with the employer, authorizing him or her to reduce a certain amount from the employee's wages.

This money is used to purchase an annuity contract or invest in a mutual fund. This annuity or mutual fund is the vehicle in which the 403b plan is invested.

How much can you contribute?

Before proceeding further, you will need to know what a MAC is.

A MAC (formerly called the exclusion allowance) is the "maximum amount contributable" that can be deferred to the plan free of tax.

Thus, if your MAC is $2,000, up to $2,000 worth of deferrals will be tax-free. Amounts exceeding that will be taxed. The IRS issues regulations and formulas to help compute an individual's MAC for the year.

The individual may elect to defer an amount up to the MAC. This is pre-tax, so no deduction can be taken on a tax return. The employee's W2 will reflect the lower taxable income. Generally, an employee can elect to defer up to $19,500 for 2020. Those over 50 are entitled to defer a "catch-up" of $6,500.

However, both elective deferrals and employer contributions may not exceed the lesser of $57,000 in 2020 or the MAC.

If you are also contributing to another retirement plan

It should be noted that participation in a 403b plan qualifies as participation in an employer-sponsored retirement program.

This may have consequences for an individual who is putting money into a second retirement plan. Someone who contributes to a tax-deferred annuity plan may not be eligible (depending upon his or her income) to deduct contributions to an individual retirement account.

IRS Publication 571 provides more detailed information on all aspects of 403b plans.

How 403b plans are taxed

All deferrals to a 403b plan within the maximum amount contributable (MAC) are tax-deferred.

Tax is deferred on the contributions, the net investment income, and realized capital gains that accumulate in the plan until the individual begins making withdrawals from it.

An example of how it works

For example, imagine a teacher who paid $10,000 into a 403b over several years. Suppose that the account is now worth $16,000 due to earnings and appreciation. If the teacher chooses to receive a lump-sum payout, the entire amount ($16,000) will be taxed as ordinary income.

How to withdraw funds

There are several ways to withdraw funds from a 403b plan.

Funds may be taken in a lump sum or in periodic payments. In most cases, taking periodic payments will reduce the tax burden on distributions, since a lump sum payment may put the recipient in a higher income tax bracket.

The Roth 403b

For 2006, a new form of the 403b plan emerged on the scene: the Roth 403b.

This was a child of the Economic Growth and Tax Relief Reconciliation Act that took effect in 2006. Employers who provide 403b plans to their employees now have the option to offer this new version as well.

Essentially, the Roth 403b works the way a Roth IRA works: any contributions made to the plan are not eligible for tax deduction.

However, when the funds are withdrawn (provided that you're at least age 59½ and your account is at least five years old), they are not taxed. An extra bonus is that any growth in the account, whether by appreciation or earnings that you reinvested, is also not taxed.

No yearly income limits

There are no yearly income limits that you must fall into in order to contribute to a Roth 403b. Also, you may contribute to both a standard 403b and a Roth 403b, provided that you do not exceed the yearly maximum.

Employers may contribute matching funds to their employees' Roth 403bs. However, these matching funds are not after-tax, like the contributions made by employees. They are before-tax, meaning that they must be kept separate from Roth account funds.

Upon withdrawal, then, the matched portion of the accounts will be subject to federal income tax.

If you take withdrawals early

As with standard 403bs, you will be penalized for taking withdrawals before age 59½. You will be required to take distributions beginning at the age of 70½.

On your income tax forms, your Roth distributions will not be counted as income. Those matched by your employer will be.

Is the Roth 403b for you?

It can certainly be advantageous if you expect to be in a higher tax bracket after age 59½ than you are today. Thus, it may help for you to determine whether tax breaks now or tax breaks later in life will be more important.

Even if you are unsure about your future tax rates, a Roth 403b might still be to your benefit. It may be worthwhile to consult a financial planning professional who will work through a variety of hypothetical scenarios with a computer to help you make an informed decision.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

403b rollovers

A 403b rollover is the moving of a 403b plan from its current custodian (the company holding it) to another.

The following requirements must be met so that the 403b may keep its tax-deferral:

  • The new 403b plan must accept rollovers.

  • If you prefer (or if the new 403b does not accept rollovers), your original 403b funds can be rolled over into a traditional IRA. (Rollovers into Roth IRAs will also be allowed in some circumstances.)

  • The full amount from the original account must be placed into the new 403b (or IRA) within 60 days. If a lesser amount is rolled over, penalty taxes will be applied.

Exceptions to the rule

The IRS may allow exceptions to the 60-day rule for provable hardships.

This may be done in cases of casualty, disaster, or other events beyond the reasonable control of the individual, and does not include foreseeable expenditures, such as the purchase of a home or college tuition.

How you can move funds

You can move the funds via a direct rollover (trustee-to-trustee transfer), in which the funds are transferred from the old custodian to a new one without you touching them.

This is usually the smoothest method because it doesn't incur tax penalties or withholding by the IRS.

You can also remove the money from the old account and put it into the new account yourself. However, with this method, the IRS requires that 20% of the funds be withheld for tax purposes, even if you intend to roll the money over to a new 403b. You will then have to deposit the full rollover amount in order to avoid an early withdrawal penalty.

This means you will need to come up with an amount equal to the 20% that was withheld. Once you have done so, however, the withheld 20% will be returned to you.

Other rules

You are allowed to roll over a 403b account into most other qualified retirement plans (if the plan accepts rollovers), including other 403b plans and 401k plans, as well as traditional individual retirement accounts and Roth IRAs.

Keep in mind that if you roll over previously untaxed funds to a Roth IRA, you will be taxed on the rollover. If you have a Roth 403b (i.e., funded with after-tax dollars), the Roth 403b can be rolled over only into another Roth 403b or Roth IRA.

Summary of 403b plans

For employees of non-profit organizations, the 403b plan provides a flexible retirement plan that allows both the employer and employee the opportunity to make contributions. Although the amount of contributions is limited, the 403b is an attractive plan for those who seek to save for retirement.

Plan contributions are excluded from taxable income but are taxed when they are withdrawn. There may also be a penalty for premature distributions from the plan.

Plan assets may be invested in a wide variety of investment vehicles. Also, the employee may direct which investments to use within the plan. 403b plan distribution options are also flexible, allowing the participant to choose a lump sum distribution, periodic payments, or even guaranteed payments for life.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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