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What is a 403(b)?
A 403(b) is a retirement savings plan that’s only available to employees at schools or those employed by other tax-exempt or government organizations. It works similarly to a 401(k), which is a retirement savings plan often made available to the employees of private companies.
The yearly contribution cap on a 403(b) in 2022 is $20,500. Plan holders also have the ability to make catch-up contributions of $6,500 a year if they are over 50 years of age. Plan participants can make special catch-up contributions after 15 years of employment up to a lifetime maximum of $15,000. Employers can also make contributions to the plan but the combined contributions from all sources cannot be more than 100% of the employee’s annual income or $61,000 in 2022, whichever is lower.
How Do 403(b) Plans Work?
Like a 401(k), employee contributions to 403(b) retirement plans are generally made from pre-tax dollars. They are taken off employees’ paychecks and deposited directed into the account.
Once in the account, funds are invested and grow tax deferred, which means that there are no taxes owed on investment earnings, capital gains, or dividend income. When it comes time to withdraw the funds, distributions are then taxed but often at a lower rate than during one’s working years since many people have lower incomes in retirement so their ordinary tax rate is lower.
Employers can make contributions to a 403(b) retirement plan and generally offer matching or non-elective contributions. These contributions are not taxed as income and generally vest immediately. However, some employers offer non-ERISA 403(b) accounts. These are plans that aren't protected under The Employee Retirement Income Security Act of 1974 (ERISA), a federal law that governs retirement plans but which public and non-profit employers are exempted from. Non-ERISA plans do not offer employer contributions.
Tip: Like 401(k) plans, 403(b) retirement accounts are connected to employers and if plan participants change organizations, they will have to decide whether to leave their accounts as is, take a disbursement, or rollover their accounts into an IRA.
Who Is Eligible for a 403(b)?
Employees who work for specific employers are eligible for a 403(b) account, including:
- Public school teachers
- Professors
- School employees
- Librarians
- University employees
- Church employees
- Minister or clergy
- Employees of other 501(c)(3) organizations
Advantages of 403(b) Plans
- Pre-tax investment vehicles
- Tax deferred
- Often allow for employee and employer contributions to a limit of $20,500, as of 2022
- The total contribution limit is 100% of salary or $61,000 in 2022
- They allow top up contributions of $6,500 a year after age 50
- Funds can be used to purchase a first home
- Funds can be accessed in the event of disability
- Funds usually vest immediately
403(b) Withdrawal Rules
Early Withdrawal
In order to begin withdrawing funds, a plan participant must be older than 59.5 years. If one tries to withdraw funds earlier, they will have to pay an early withdrawal penalty of 10% as well as any federal or state taxes deferred on the funds.
There are, however, some circumstances where the withdrawal penalty is waived:
- If the funds are used to purchase or build a first home, the plan participant can make a one-time withdrawal of $10,000.
- If the account holder retires or severs employment after age 55
- If the account holder experiences financial hardship
- If the account holder becomes disabled before they reach the age of 59.5 years.
- If they are used for post-secondary expenses
- If the funds are used for medical expenses that are not reimbursed or to purchase medical insurance should the plan participant lose their employer’s plan and which make up more than 7.5% of your adjusted gross income
- If an account holder dies
- If the funds are used to pay an IRS levy
- If the funds are eligible for the Substantial Equal Periodic Payment or SEPP program.
Standard 403(b) Withdrawal
When account holders withdraw funds after age 59.5 or if they qualify for any of the early withdrawal exceptions, they will pay taxes on the amount that they take out at their current tax rate.
Required Minimum Distributions (RMDs)
Plan participants are legally required to begin taking distributions from before tax or tax deferred accounts once they reach the age of 72 or during the year they retire. These are called required minimum distributions (RMDs). How much an account holder has to take out depends on the account balance and the IRS’ life expectancy estimates. Usually this amount is calculated by the plan's administrator.
If a plan holder does not take out their required distribution on time, the money will be taxed at 50% before it is given out.
403(b) Rollovers
Those who leave an employer can rollover their 403(b) into another retirement vehicle such as an IRA, SEP IRA, 457(b), 401(Kk), SIMPLE IRA, or another 403(b). When the funds are taken out, they must be deposited in a qualified retirement savings account in a minimum of 60 days.
Tip: The funds can also be rolled over into a Roth IRA account but the account holder will have to pay taxes on the amounts rolled over into a Roth account unless they come from a Roth 403(b) account.
403(b) Loans
Like 401(k)s, some 403(b) plans will offer the option of taking out funds as a loan. Plan participants can typically take out up to $50,000 or 50% of their balance, whichever is smaller although some plans will allow account holders to take out more than 50% if they have small accounts.
Once a loan is made, the account holder has five years to pay back the full amount and must make at least one payment every quarter. Payments come from an employee’s paycheck and include interest. This is calculated by using the prime rate and adding 1%.
Tip: If an employee leaves their employer before they pay back the loan, they will have to pay back the entire balance or it will be treated as a distribution and taxes will be owed as well as a 10% penalty.
Bottom Line
403(b)s are a tax-advantaged way to save for retirement offered to employees of qualified organizations. They offer plan participants the ability to grow money tax-deferred for retirement but there are a number of withdrawal rules and potential penalties around accessing the funds before retirement age.
