What Is a 403(b) Plan?

Sometimes referred to as a tax-sheltered annuity plan or TSA, a 403(b) is a retirement-savings option that’s generally offered only to employees of colleges and universities, public schools, certain nonprofit organizations, and churches. Like its better-known cousin in the private sector, the 401(k), a 403(b) plan is a convenient way to save for your retirement by having money automatically deducted from your paycheck and placed into your 403(b) account. And as with 401(k)s, most employers who offer 403(b) plans will also match some or all of what you contribute. In fact, a 2015 study found that 96.6% of the employers it surveyed offered a match.

Here are answers to some of the most common questions people have about 403(b) plans.

How Much Can You Contribute?

Top takeaway: The older you are and the longer you’ve worked, the more you’ll be able to put away for retirement.

The maximum amount that you can contribute to your 403(b) plan each year is currently $18,000 (as of 2017), as long as you earned that much. If you made less than that, the limit is equal to your total earnings. The maximum can change from year to year based on the cost of living. As with a 401(k) plan, if you’re over age 50 you can make additional catch-up contributions of $6,000 for a total maximum of $24,000 (as of 2017).

The 403(b) has another, unique feature for employees who have worked at an organization for at least 15 years. They may be able contribute as much as $3,000 extra per year for up to five years. This “15-year rule” is explained in IRS Publication 571.

Employer matching contributions. Your employer may also contribute to your 403(b), often by matching your contributions up to a certain amount through what’s known as an employer match.

Matching formulas vary, but a relatively common one is for an employer to match your contributions dollar for dollar on the first 5% or 6% of salary you defer. So, if you earn $50,000 a year and defer at least 6% of that, or $3,000, your employer might kick in another $3,000. Because that is basically free money, financial advisers often suggest putting at least enough in your 403(b) plan each year to get the maximum match from your employer.

Combined contribution limits. There are limits on how much you and your employer together can contribute to your account. For 2017, for example, the maximum is either the amount of your compensation for the year or $54,000 ($60,000 for those over 50), whichever is less.

So, for example, if you’re under 50 and haven’t worked for your organization for 15 years, you could contribute a maximum of $18,000, and your employer could conceivably add as much as another $36,000, so long as your taxable compensation was at least $54,000.

What Can You Invest in through Your 403(b)?

Top takeaway: 403(b)s have broadened their investment options in recent years, offering more and often better choices.

While 403(b) plans were once fairly restricted in terms of what you could invest in, today they are more like 401(k)s, offering a wide range of investment choices. One recent survey found that 403(b) participants had their pick of 31 investment options, on average.

Your choices might include several stock and bond mutual funds, as well as annuities. Annuities are insurance contracts that promise to pay you a regular income starting at some point in the future and continuing either for the rest of your life or some defined period, such as 10 or 20 years. On the plus side, annuities can ensure that you’ll always have some income, no matter how long you live. On the minus side, they can be very expensive, with high sales commissions and other fees that will eat into your eventual benefit.

You can spread your contributions among multiple investments, such as putting a certain percentage in stock funds and a certain percentage in bond funds or an annuity, to diversify them. As a general rule, bonds are less volatile than stocks, but stocks offer greater potential for gains. The closer you are to retirement, the less risk you will probably want to take with your retirement savings, so you might want to ratchet down the portion of your 403(b) account that is invested in stocks as you get older. However, financial advisers often suggest keeping at least a little money in stocks, no matter how old you are, because stocks provide some protection against inflation.

A simpler approach is to put your money in a target-date fund, which most 403(b) plans now have on their menu of offerings. These funds hold a portfolio of investments tailored to the year you expect to retire. For example, if retirement is likely to be many years in the future, the fund may invest largely in stocks. Target-date funds are also designed to adjust their holdings over the years, becoming more conservative as your retirement date approaches.

The Tax Benefits Of 403(b) Plans

Top takeaway: Your money can grow tax-deferred and maybe even tax-free.

The main tax advantage to a 403(b) plan is that, as with a 401(k), the money your account earns will grow on a tax-deferred basis. The tax treatment for contributions to the plan varies depending on which of the two basic types of 403(b) plans you choose.

Traditional 403(b) plan. With a traditional 403(b) plan, the money that your employer withholds from your paycheck to fund your 403(b) account won’t be taxed until you eventually withdraw it.

Roth 403(b) plan. With a Roth 403(b), which some but not all employers now offer, you won’t receive any tax benefit from your contributions, but you will be able to make tax-free withdrawals later, as long as you meet certain requirements. In general, that means you must have had the Roth account for at least five years and have reached age 59½ or older. You may also qualify for tax-free withdrawals if you have become disabled.

In a traditional 403(b), your earnings won’t be taxed until you withdraw them. In a Roth 403(b), they won’t be taxed at all, as long as you meet the requirements referred to above.

Traditional Or Roth: Which Is Right For You?

Top takeaway: Decide if you’d benefit more from a tax break now or after you retire.

Your decision about the type of 403(b) plan to choose will be driven in large part by your expectations for your future income. If you expect to make less, and pay less tax, in future, a traditional plan is usually the better choice. People who think their income, and therefore their tax rate, will rise in retirement should favor a Roth 403(b).

You might choose a traditional 403(b), then, if you expect your income to be lower after you retire, as is true for most people. The deduction will help reduce your taxes now, and your 403(b) withdrawals years from today are likely to be taxed at a lower rate than you are currently paying.

But if your income is lower now than you expect it to be in retirement, it could be smart to forgo the immediate tax deduction, which might not be worth much anyway, and enjoy tax-free income from a Roth 403(b) after you retire. That could be the case if you’re just starting out in your career and making an entry-level salary that you’re reasonably certain will rise in the years to come.

Note that if your employer allows it, you can hedge your bets and have both types of accounts. However, your combined contributions to them can’t exceed the maximums mentioned above: $18,000 if you’re under 50, or $24,000 if you’re 50 and up.

When Can You Withdraw Money from a 403(b) Plan?

Top takeaway: Flexible “hardship” rules make it possible to get money early, but consider the long-term consequences first.

You can begin taking money from your 403(b) plan, without penalty, after you reach age 59 1/2. Your withdrawals (except in the case of a Roth account) will be taxed as ordinary income. As with 401(k) plans, some employers may allow you to make withdrawals earlier in the case of a financial hardship.

The list of expenses that can qualify as hardships, according to the IRS, includes:

  • Medical expenses for you, your spouse, dependents, or beneficiary.
  • The cost of buying a principal residence, but not mortgage payments.
  • Certain expenses for repairing damage to your principal residence.
  • Payments to prevent eviction from your principal residence or foreclosure on your mortgage.
  • Post-secondary tuition, fees, and room and board for you, your spouse, and your children, dependents, or beneficiary.
  • Funeral expenses for a parent or spouse.

Bear in mind that any money you withdraw from your 403(b) account will be that much less you’ll have to draw on when you retire. And because of the effects of tax-deferred compounding, what seems like a relatively small withdrawal today could result in a significantly smaller account balance 20 or 30 years from now. For example, suppose you withdraw $10,000 at age 30. If you’d left the money in your 403(b) instead, and it earned even a relatively conservative interest rate of 5% a year, it would grow to more than $55,000 by the time you reached age 65.

For some unexpected expenses, like a big medical bill or unexpected home repair, you might have nowhere else to turn. But for less urgent “hardships,” such as buying a home, you could do better to wait a while and try to save up the money outside of your retirement account.

Required Minimum Distributions

Once you reach age 70½, you must generally start making withdrawals from your 403(b) each year, referred to as required minimum distributions, or RMDs. Slightly different rules may apply if your account goes back to 1987 or earlier, which your employer or plan administrator should be able to explain.

You will need to determine your RMD each year, following an IRS formula based on your age, marital status, and beneficiaries. For example, an unmarried 403(b) owner would have to withdraw about 3.6% of the account in the first year, with the percentage rising each year after that. An unmarried account owner who lives to age 115 or older would need to take out about 53% of the remaining balance each year.

The IRS explains these rules on its website and has tables showing how much you’re supposed to withdraw every year. One reason to follow the rules closely: The IRS imposes a whopping 50% penalty on any amount you should have taken out of your account but failed to. That’s known as an excess accumulation.

As an example, if your RMD for the year was $20,000, but you only withdrew $12,000, your excess accumulation would be $8,000, and your penalty tax on that would be $4,000. Had you instead withdrawn the $8,000, you would only have paid regular income tax on it, an amount ranging from 10% to 39.6%, or $800 to $3,168, at current tax rates.

Note that Roth 403(b) accounts are also subject to RMDs, unlike Roth IRAs. You will generally have to start taking withdrawals after you reach age 70½, although you may be eligible for an exception if you are still working for the same employer at that point. In that case, you might not have to start withdrawals until after you actually retire.

Borrowing From Your 403(b) Plan

Top takeaway: Your employer may let you borrow from your account, but you’ll have to repay fairly quickly.

You may also be able to take a loan from your 403(b) account, if your employer’s written rules permit it. In general, you’ll have to pay the loan back within five years. If you use the money to buy a principal residence, however, you may be allowed to pay it back over a longer period. Note that if you leave your employer while you still have an outstanding 403(b) loan, you may be required to repay it immediately.

Maximum loan amount. By law, the maximum you can borrow from a 403(b) plan is 50% of your vested account balance or $50,000, whichever is less. If you have under $10,000 in the account, however, you can borrow up to that amount. Bear in mind that your employer may set different limits or not allow loans at all.

Interest rates. The interest rate you’d pay on a 403(b) loans is determined by your employer. Many employers set it at the prime rate plus one or two percentage points. So if the prime rate is 3.75%, as it was in early 2017, your loan rate might be 4.75% or 5.75%.

In general, if you can get a great personal loan from a source other than your 403(b) plan, that may be a better option because you won’t be putting your retirement funds at risk. However, a 403(b) loan is generally preferable to a 403(b) hardship withdrawal because your account will regain its value as you pay the money back. With a withdrawal, the money is gone forever.

What Happens If You Change Jobs?

Top takeaway: You can preserve your 403(b)’s tax advantages by leaving it at your old employer or rolling it into another qualified retirement plan.

If you leave your job prior to retirement, you’ll generally be able to leave it with your former employer (if your former employer allows) or move it to your new employer’s 403(b) plan (if that employer allows). Another option is to roll it over into an IRA or other eligible retirement plan. (Again, these options track those for most 401(k) plans.)

Of course, cashing in your account could be an option too. But that’s usually a very bad idea unless you absolutely need the money for other critical purposes. Not only will you face taxes and possible early-withdrawal penalties, but you could be putting your future retirement security in jeopardy.

The IRS explains the withdrawal rules, and may others affecting 403(b) plans in Publication 571, “Tax-Sheltered Annuity Plans (403(b) Plans) for Employees of Public Schools and Certain Tax-Exempt Organizations,” which is available on its website, irs.gov.

Sources

IRS Publication 571

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