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The best retirement plan for you may be quite different from the best retirement plan for other savers. Many people get 401(k) retirement plans from their employer, but if you work for a public school or another tax-exempt organization, you most likely have a 403(b) plan.
A 403(b) plan is also known as a tax-sheltered annuity (TSA) — and much like a 401(k), a 403(b) plan is designed to let your employer help you save for retirement. Here’s what you should know about a 403(b) plan and how it differs from other retirement savings vehicles.
What is a 403(b) plan and how does it work?
A 403(b) fund is a voluntary retirement savings option that’s offered by specific employers. According to the IRS, you may be eligible for a 403(b) plan if you’re employed by:
- A tax-exempt 501(c)(3) organization, commonly referred to as charitable organizations
- A public school, including those organized by Indian tribal governments
- Cooperative hospital service organizations
- Uniformed Services University of the Health Sciences (faculty and staff)
- Certain employees of houses of worship
When signing up for a 403(b) plan through your employer, you’ll have the option to choose how your money is invested. The choices available to you are at your employer’s discretion, but typically investment types include annuities from insurance companies and mutual funds from investment firms.
Much like with a 401(k) plan, employees with 403(b) plans agree to let their employers reserve a predetermined amount from each paycheck, before taxes — so-called elective deferral contributions — and place those funds in the account.
Your employer may also provide additional contributions to a 403(b) retirement plan — so-called nonelective contributions — such as matching contributions. These help accelerate retirement savings as plans grows over time. Some employers also let employees make additional after-tax contributions.
There are both pre-tax and post-tax versions of the 403(b): standard 403(b) plans don’t require you to pay taxes on contributions until you start making withdrawals after you retire. Roth 403(b)s contributions are made after tax, and qualified withdrawals in retirement are free of taxes.
Benefits of 403(b) plans
A 403(b) plan gives you control over your retirement savings. A few reasons to take advantage of an employer-sponsored 403(b) retirement plan include:
- Reduced income tax liability: Since contributions are made pre-tax, this plan lowers your taxable income. This benefit, however, doesn’t apply to Roth 403(b) plans which tax your contributions upfront.
- Employer matching contributions: If your employer offers matching contributions up to a certain percentage or amount, it’s more money toward your future retirement. You’re not taxed on these nonelective contributions until you withdraw the funds.
- Flexible contributions: The amount you contribute to your 403(b) is entirely up to you. You can choose to contribute 1% of your income or up to the maximum percentage of your income that your employer matches. As long as your total contribution for the year doesn’t exceed federal contribution limits (more on this below), you control the pace of your retirement savings.
- Hardship distributions and loans: If the terms of your 403(b) allow it, you may have access to hardship distributions or may be able to take out a loan against your retirement fund in the event of a financial emergency.
- Deferred taxes on earnings: Money you contribute to your 403(b) and earnings from the account aren’t taxed until you withdraw them.
- Tax credits: If you make eligible contributions to your 403(b) plan, you may be eligible for the Retirement Savings Contributions Credit, which allows you to claim a credit on your tax return of up to $1,000 (or $2,000 if filing jointly).
The disadvantages of a 403(b) plan are similar to other retirement plans. For example, typically, you’re eligible for penalty-free withdrawals at age 59½. If you withdraw from your 403(b) plan before reaching this age, you might incur a 10% tax on the early disbursement.
Similarly, if you initiate a 403(b) rollover from one employer to another, but fail to deposit the funds into your new 403(b) in a timely manner, it may be considered an early withdrawal and you may face a 10% tax penalty.
Before locking away all of your savings into your 403(b) plan, consider whether you have sufficient funds in an easily accessible deposit account in the event of an emergency or upcoming major purchase.
403(b) plan vs. 401(k) plan: What’s the difference?
The main difference between a 403(b) plan and a 401(k) plan is your employer’s designation. A 401(k), for example, may be sponsored by a private, for-profit company, while only certain non-profit organizations are eligible to set up a 403(b) plan for their employees.
If your employer offers a retirement plan and meets the requirements to set up a 403(b), you’ll be able to open a 403(b) account as long as you also meet employee eligibility requirements for the plan.
Both plans offer tax-advantaged retirement savings in that contributions are not counted as taxable income and are taxed at withdrawal during normal retirement age. At the employer’s discretion, both retirement vehicles also offer a Roth version which taxes your contributions at your current tax rate. Qualified Roth 403(b) and Roth 401(k) disbursements at retirement age are then tax-free.
403(b) plan contribution limits
How much you should save for retirement depends on many factors, including your income, individual financial goals, desired lifestyle while in retirement, and the number of years you have until you reach retirement age. But how much you put in a 403(b) account isn’t limitless.
The IRS sets contribution limits on your elective deferrals, total contributions, regular catch-up contributions, and additional catch-up contributions for workers with 15 years of service.
The maximum that you can contribute pre-tax from your salary in 2020 is $19,500. This is an increase from the 2019 limit of $19,000. If you’re 50 or over by the end of the calendar year, you can make “catch-up” contributions which raises your limit by an additional $6,500 (for a total of $26,000 in elective deferral contributions).
The limit on total contributions through elective deferrals and nonelective contributions is either $57,000 in 2020 or 100% of the amount of “includible compensation” (meaning your taxable income and benefits) during your most recent year of service, whichever is less.
Catch-ups for 15 years of service
If you’ve served with your employer for 15 years or more and your 403(b) offers this additional catch-up provision, you may be eligible for an elective contribution limit increase, based on your years of service. According to the IRS, you can increase your elective deferral limit to the lesser of:
- $15,000, minus the amount of additional elective deferrals made in prior years because of this rule, or
- $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.
If your 403(b) plan exceeds any of these limits, the IRS may charge you penalties.
When deciding how much to contribute to your retirement plan a good rule of thumb is to meet the contribution level of your employer match, if offered. As your income increases, consider raising your contribution each paycheck to help your retirement savings grow further.
403(b) plan withdrawal rules
In addition to the limitations set by the government on how much you can put into your 403(b), it also establishes rules around when you can make withdrawals from your retirement plan. In order to take penalty-free disbursements from your 403(b) plan, one of the following must apply:
- You’re at least 59½ years of age
- You’re no longer employed by your employer
- You’re disabled, or have died
- You’re facing financial hardship
- You’re a qualified reservist requesting a distribution
If none of these scenarios apply to your withdrawal, may be subject to a 10% early disbursement tax. However, you’re required to take your first minimum disbursement by the following April 1 after you turn 72 or retire. Typically, any disbursements from a 403(b), except for Roth accounts and after-tax contributions, are considered taxable income
What happens to your 403(b) plan if you leave your job?
Over your career, you might change employers along the way. Whether you can leave your retirement savings in the 403(b) plan depends on your employer’s rules. Some employers require you to initiate a rollover of your 403(b) funds into another retirement vehicle, like an Individual Retirement Account or another 403(b) with your next employer.
You can roll over your funds into an eligible retirement plan, tax-free, as long as you do so within 60 calendar days. If you pass this time, you may be charged a 10% early disbursement penalty.
If you aren’t fully vested in your company, you may lose some or all of your employer’s contribution to your 403(b) plan. Vesting schedules vary by employer so speak to your human resources department to learn more about your plan’s vesting requirements. All elective deferrals from your 403(b) plan is eligible for rollover, however.