How-to Guides

For employees of educational institutions and certain nonprofit organizations, the 403(b) plan can be a key element in their retirement-saving strategy. Employer-sponsored 403(b) plans allow participants to contribute pretax dollars into a retirement savings account, then withdraw funds when they retire, permitting account earnings to grow on a tax-deferred basis. Similar to their private sector counterparts, 401(k) plans, 403(b) plans have a variety of rules that govern contributions, withdrawals, and other factors that current and potential participants should be aware of.
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403(b) plans are available to employees of educational institutions and certain nonprofit organizations that offer a plan. Plan participants include teachers, school administrators, professors, and doctors and nurses, among others.
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Contributions to a 403(b) plan can consist of pretax employee contributions, after-tax employee contributions, and employer contributions. Amounts contributed to a 403(b) plan and earnings thereon are not subject to income tax until withdrawn. For 2007, participants in a 403(b) plan can contribute up to $15,500 a year. Plan participants who are 50 or older may also contribute an additional $5,000 in 2007. Total contributions by the employee and employer cannot exceed $45,000.

Thanks to rules that took effect in 2006, there are now two types of 403(b) plans: traditional 403(b)s and the newer Roth 403(b) plans. A traditional 403(b) plan allows for pretax contributions so that you can defer taxes on the portion of the salary contributed to the plan until the funds are withdrawn, at which point contributions and earnings are taxed as ordinary income. Also, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which, in turn, lowers your tax burden. As noted earlier, some traditional 403(b) plans also allow for after-tax contributions, but earnings are subject to ordinary income taxes when withdrawn.

The tax treatment of a Roth 403(b) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax free; you pay no taxes on qualified distributions.

Like 401(k) plans, many 403(b) plans offer employer matching contributions whereby employers elect to match all or a portion of the employee's contribution. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, and -- like in a traditional 403(b) plan -- assets are taxable when withdrawn.
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Participants in a 403(b) plan may usually choose from a variety of investment options, as specified by the particular plan. While different plans offer different options, typical investment choices include annuity contracts or various styles of mutual funds and allow participants to diversify their holdings among different investments.
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In general, penalty-free withdrawals from a 403(b) cannot occur until the participant reaches age 59 1/2, at which point withdrawals are taxed as ordinary income. Prior to age 59 1/2, a 10% penalty tax is applied to most withdrawals in addition to ordinary income tax.

There are, however, certain exceptions. If a participant separates from service in or after the year he turns 55 (and retires), if he becomes disabled, or if he dies, the penalty does not apply. Additionally, participants may be able to make "financial hardship" withdrawals for specific IRS-approved reasons, such as the payment of unreimbursed medical expenses for the participant or his/her spouse or dependents, the down payment on a primary residence, and qualifying tuition and fees for higher education. Keep in mind that not all plans offer hardship withdrawals and other qualifying factors may apply.

Certain plans may also allow participants to borrow against their plan balance, although not all plans offer this feature. For those that do, a number of restrictions may apply, such as limits on amounts that can be borrowed and payback periods. Since rules may vary by plan, you should consult your plan administrator for details.

Most distributions from 403(b) plans must begin no later than April 1 of the year following the year in which you turn age 70 1/2, at which age distributions are subject to required minimum distribution (RMD) rules specified by the IRS.
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Although 403(b) plans are similar to 401(k) plans in many ways, there are several differences you should be aware of -- especially if you were formerly enrolled in a 401(k) plan. For instance, with a 401(k), the employer must set up and administer the plan. But with a 403(b), the employer's involvement need extend no further than the elective payroll deductions. This means that, when you leave your job, your money can stay in the plan -- an option that not all 401(k) plans offer.

For those plans with employer matching contributions, vesting is automatic in most 403(b) plans, while vesting periods of up to three years may apply to 401(k) plans. This is relevant only to the employer contribution and earnings portion of the account; employee contributions and earnings are always 100% vested.

For those long-term 403(b) plan participants who held balances prior to 1987, such balances are not subject to mandatory federal minimum distribution rules (but subsequent earnings on them are). You can defer taking a distribution on such amounts until age 75.

Keep in mind that, like 401(k) plans, 403(b) plans do vary. You should consult your plan administrator to see what specific features your plan does or does not offer. It's also advisable to contact a tax professional before withdrawing funds from your 403(b) account.