403(b) Plans

A 403(b) plan is a type of defined contribution plan. These plans allow participants to contribute a portion of their income into an investment fund, offering varying degrees of control on how these investments are managed.

 

Originally, participants were only allowed to contribute to annuities. However, these rules have been relaxed and now employee contributions can be used to invest in mutual funds. A 403(b) plan works in a similar way to other defined contribution plans, such as a 401(k), but with some key differences. Eligibility restrictions apply to all 403(b) plans, as well as the types of plans that are offered in different companies.

The universal availability rule applies to all 403(b) plans. Under this rule, if an employer allows one employee to make deferred contributions from their salary into the plan, they must offer the same benefit to all eligible employees. Certain employees can be excluded from contributing to a plan by an employer, but they must meet specific requirements. An employee who contributes $200 or less per year or who is already enrolled in another 403(b) or 401(k) plan can be excluded. Similarly, nonresident aliens, certain part-time employees and students are also exempt.

Eligibility

Most retirement plans have restrictions and eligibility rules on who can open an account. The rules associated with a 403(b) are more specific. Below are some of the eligible organizations and participants who can open a 403(b) retirement plan:

  • Employees of tax-exempt organizations.
  • Certain employees of public schools
  • Employees of certain cooperative hospital services
  • Certain ministers, including those who work for tax-exempt organizations and those who are self-employed
  • Particular staff member of the Uniformed Services University of the Health Sciences

Contributions

Contributions are divided into two categories: elective deferrals and non-elective deferrals. These contributions work in very similar ways to a 401(k) plan.

Elective deferrals are contributions made by the employee through their paycheck. A portion of the salary is taken out before tax and invested into a 403(b) plan. Because this money is tax deductible, the employee can enjoy certain tax breaks during the year. Ultimately, when the funds are distributed upon retirement, these funds are subject to taxation.

Non-elective contributions are made by the employer into the employee’s plan. As is the case with 401(k) plans, employers have the opportunity to match employee contributions. Depending on the plan, these matched contributions may not be available, or are only applicable if the employee contributes a certain percentage of their paycheck. Matched contributions are not taxed but are subject to taxation when withdrawn. Aside from matched contributions, employers can also contribute a separate amount to a plan, such as company profits.

The limits set on contributions are the same as a 401(k). The 2018 limits allow employees to contribute a maximum of $18,500 to their 403(b) plans per year. An employee can contribute $36,500 or less to a plan per year. The combined annual limit is $55,000. If your annual income is less than $55,000 then your limit is 100 percent of your income.

Catch-up contributions can be used when employees are approaching their retirement. They can contribute an additional $6,000 (2018). Different catch-up contribution rules apply to nonprofit organizations who are enrolled in 403(b) plans. Depending on the plan details, employees who have been with a nonprofit organization, such as a public school, for more than 15 years can contribute an additional $3,000 to their plans.

Types of Plans Available

There are three types of plans available to 403(b) participants. Unlike other defined contributions plans that offer greater flexibility, 403(b) are bound by certain criteria in how they operate. Plans must be one of the following:

  • Annuity Contracts – Contributions are made into an annuity purchased through an insurance company. This type of 403(b) plan is subject to typically annuity rules. When the participant retires, the funds are distributed in monthly payments. These contracts can either be fixed or variable.
    • A fixed rate plan guarantees a set interest rate for your retirement payment. These payments are not affected by the stock market.
    • A variable rate is subject to the investments in the annuity and may fluctuate with the stock market. There is a risk of your payments dropping, however, there is also a possibility that they can climb.
  • Custodian Accounts – Contributions are made into a mutual fund that is managed by the custodian. In this case, the custodian is the employer. These accounts can only invest in mutual funds.
  • Church Retirement Accounts – These retirement accounts are the same as defined contribution accounts but are operated by churches. They can invest in mutual funds or annuities.

Tax Benefits

You can enjoy certain tax benefits when enrolled in a 403(b) plan. The contributions you make into the plan are tax-free. These contributions are deducted from your gross income giving you a tax break during your employment years. Once the funds are released at retirement, they are subject to taxation. Roth 403(b) plans operate similarly to a Roth 401(k). They allow participants to make taxed contributions, which in turn causes their distributions to be tax-free when they retire.

The investments in a 403(b) plan are not subject to gains taxes. This allow the contributions you make to grow more rapidly and generate more money for your retirement. However, these investments are subject to taxation when withdrawn. Tax credits are also available for those in certain income brackets.

 

Employers are offered particular tax benefits when operating a 403(b) plan. They are not required to make contributions, but if they do, those contributions are tax-free.

Unlike a 401(k), these plans offer more specific benefits to certain organization. Police officer, firefighters and other public safety officers are allowed to withdraw up to $3,000 of tax-free distributions when they retire. These withdrawals must be used for certain health related purposes like insurance premiums.

Distributions

Distributions can begin without penalties at 59-and-a-half years of age. There are some exceptions to this rule, allowing certain employees to make withdrawals without consequences before their retirement age. These exceptions include, but are not limited to:

  • The termination of the plan
  • Disability
  • Termination of employment made by the employee
  • Military reservists called to active duty
  • Qualified financial hardship

Participants must start withdrawing the minimum amounts of distributions after 70-and-a-half years of age or they are subject to penalties. If withdrawals are made before 59-and-a-half years of age, and none of the above exceptions apply, the distributions are subject to additional taxes and a 10 percent penalty.

 

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