Understanding Your 403(b) Plan
An Introduction to the 403(b) Account and How It Works
While not as famous as the 401(k) plan, the 403(b) plan is a type of retirement savings account used by tax-exempt organizations, most employees of public schools, and self-employed religious ministers. Employers that want to establish 403(b) plans typically have a few options in terms of the type of assets in which their employees can invest through their individual accounts. These are:
- Tax Deferred Annuities or Tax-Sheltered Annuities. These are simply a type of annuity contract provided by insurance companies as a type of 403(b) investment to provide income later in life.
- A custodial account at an appropriate financial institution such as a brokerage firm that holds the securities of registered investment companies such as mutual funds. This is probably the most commonly understood type of 403(b) retirement plan.
- A retirement income account that lists either type of investment option as a choice for the owners of the 403(b) accounts; that is, they can invest either in securities, such as mutual funds, or eligible annuities.
The Benefits of a 403(b) Plan
The benefits of a 403(b) plan are often similar to those of a 401(k) plan. They include:
- The ability to attract and retain employees by offering matching benefits. For instance, a company may offer to match employee contributions to their 403(b) plan dollar-for-dollar on the first 5% of payroll.
- Both the company that makes matching contributions and the employee that contributes money through regular payroll deductions can often write these 403(b) contributions off their taxes.
- Money in a 403(b) can grow tax-deferred for decades, resulting in far more wealth for the owner of the account. Only when he or she begins to take withdrawals from their 403(b) account will they pay taxes on the funds.
- Account holders can take loans against their 403(b) when they are in emergency need of cash. These 403(b) loans must be paid back, just like their 401(k) counterparts, or there will be significant tax consequences.
403(b) Contribution Limits
The government provides fairly high 403(b) contribution limits for those who want to plan for retirement. The maximum potential 403(b) contribution is $54,000 per year for fiscal year 2017 if you meet certain conditions. The following is a breakdown of the potential 403(b) contributions that can be made:
- Basic salary deferral (the maximum payroll amount an employee can contribute to their 403(b) plan by having money taken out of their check) is $18,000 for fiscal year 2017.
- Employees 50 years and older can add an additional $6,000 per year in special 403(b) contributions that are often referred to as “catch-up” 403(b) contributions. This is in addition to the $18,000 they can put aside as a regular employee.
- Some people are eligible for an additional 403(b) contribution known as a 403(b) Lifetime Catch-up. This special type of 403(b) contribution is only available to employees who have worked for a qualified organization for 15 years or longer. Often, this special 403(b) contribution is referred to as the “15-year rule” from IRS Publication 571.
- These 403(b) contributions, combined with any matching funds provided by the employer, cannot exceed 100% of compensation or $54,000 for fiscal year 2017. Thus, the only people who will be able to take advantage of the total maximum 403(b) contribution are those who work for a company that has extraordinarily rich benefits.
The government allows these 403(b) contribution limits to increase for inflation by releasing cost of living adjustment figures each year.
When you reach the age of 59.5 years old, you can begin taking regular 403(b) withdrawals without penalties - you will simply pay regular income taxes on the money you take out of the account. If you are younger than that age, however, you will be subject to a special 10% tax penalty on top of the income tax unless you meet one of a handful of special situations (for more information on this, read 8 Ways to Avoid the 10% Early Withdrawal Penalty).
403(b) Required Minimum Distributions
As part of your participation in a 403(b) plan, the IRS will require you to make to begin taking required minimum distributions by April 1st of the year following the calendar year in which you turn 70.5 years old.
The only exception is if the 403(b) plan permits, and the employee is still employed, they can defer the required minimum distributions until the year after they have retired. This option is not available to those employees who own more than 5% of the company.
The reason is simple - the purpose of a 403(b) account is for you to save for retirement. The Government doesn’t want the wealthy to be able to stock away large amounts of capital without ever paying taxes on the gains. This is one of the reasons that it is often advisable to have a Roth IRA in addition to a 403(b) account. The Roth IRA will never be subject to taxes meaning that if you find the next Microsoft or Berkshire Hathaway, every penny stays in your family.
You will be required to begin taking required minimum distribution 403(b) withdrawals in an amount specifically calculated so that the entire balance of your assets within the retirement plan will be distributed to you by the end of your life expectancy. It may sound morbid, but an accountant will actually help you break out the actuarial tables and calculate when you are likely to pass away, using the number of years of life left as a guide to coming up with a precise figure the IRS is likely to support. In some cases, you can use the life expectancy of the designated beneficiary of the 403(b) plan, as well, which could be longer in the case of a married couple where one spouse is substantially younger than the other.
If you do not take your required minimum distribution 403(b) withdrawals, the IRS will penalize you with a 50% excess accumulation tax.