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What is a 403b?
A 403b is a type of retirement plan available to employees of government-funded education institutions such as public schools, some non-profit organizations, and self-employed ministers. It is a way for employees to save for their retirement by having a percentage of their paycheck deposited into the 403b plan. Employers can choose to match the employee's contributions and thereby help their employees save for retirement. The plan is similar to the 401k plan available to private business and industry.
For example, the Mayberry County Board of Education's 403b plan allows employees to contribute part of their paycheck into Mayberry County's plan. Mayberry County will match incrementally up to 3% of the employees' contribution. If Joe, a high school biology teacher, contributes 3%, Mayberry County will contribute 2% to Joe's account. If Joe contributes 4%, Mayberry County will contribute 2.5%, and if he contributes 5% or more, the Mayberry County will contribute 3%. Mayberry County's contributions are called matching contributions.
As you can see, if Mayberry County provides matching contributions, Joe can increase the amount of money he receives above and beyond his salary. If Joe makes $30,000 in 2007 and contributes 5%, Mayberry County will contribute an additional 3%. As a result, Joe will receive $30,000 plus $900 additional money from Mayberry County's matching contributions. Joe's total compensation will be $30,900 instead of $30,000 simply because he participates in Mayberry County's 403b plan.
Who is eligible to participate in a 403b plan?
Only certain types of workers can participate. They are:
- Employees of tax-exempt 501(c)(3) organizations, generally known as tax-exempt charities.
- Employees of public school systems who are involved in the day-to-day operations of a school.
- Employees of cooperative hospital service organizations.
- Civilian faculty and staff of the Uniformed Services University of the Health Sciences (USUHS).
- Employees of public school systems organized by Indian tribal governments.
- Certain ministers employed by 501(c)(3) organizations.
- Certain self-employed ministers.1
How does a 403b work?
Your employer withholds a certain amount of your paycheck and deposits that money, along with any matching contributions, into your account. The money is invested in various financial instruments, such as mutual funds. The money stays in the account until you reach a certain age when it is legal to withdraw the money, or under any of the several exceptions to the age rule. This causes the account to earn money through compounding, so your account grows not only through your regular contributions made from your paycheck but also by earning interest or dividends.2
How do I make contributions to a 403b?
You make a contribution through your employer. If you decide to participate in the plan, you will determine what percentage of your paycheck that you want to be deposited in your acocount, and your employer will withhold that amount from each paycheck you receive. The employer then deposits the withheld money into your ccount, along with any matching contributions.3
Are there any limitations to making a contribution to a 403b?
Yes, you are limited by IRS rules and by whatever rules your employer implements in his plan.
IRS Contribution Limitations
There are many IRS rules dictating limitations on contributions. They can get fairly complicated and involve many calculations. Check with your plan administrator or financial advisor for more detailed information, but be aware that there are limitations to the amount of money you can contribute each year.
Employer Limitations
When your employer sets up his plan, he can place limitations on contributions. The plan can be set up so that employees can only contribute up to a certain percentage of their paychecks. An employer can decide to set up his plan in a variety of ways, so be sure to get clarification and explanation of your employer's rules.
What is a company match?
A company match is when employers agree to contribute certain amounts to your 403b in addition to your own contributions. Employers may decide to make a contribution above and beyond what you decide to contribute. This is a way to reward employees for their service and is often seen as a positive benefit which can attract good employees to the organization.
If my employer goes out of business before I retire and receive my money from my 403b, what happens?
403b plans are covered by the Employee Retirement Income Security Act of 1974, or ERISA. Generally, if an employer goes out of business or becomes bankrupt, the employer's creditors receive the employer's assets to settle debts. However, ERISA protects your plan money from those creditors. The creditors generally cannot get any money from a 403b plan to settle debts of a bankrupt employer.4
When can I withdraw my money from a 403b?
You can withdraw your money at any time. However, if your withdrawal is an early distribution, you will have to pay an extra tax on the withdrawal.5
What is an early distribution?
An early distribution is any money taken out before reaching age 59 ½. Early distributions are subject to a 10% tax, so if you withdraw $5,000 when you are 45, you will have to pay $500 in taxes. However, as discussed in the following question, there are some exceptions that allow you to withdraw money before age 59 ½ without owing the 10% penalty.6
Are there any other circumstances when I can withdraw my 403b money before age 59 ½?
Yes, there are some exceptions to the age rule. You will not owe the 10% tax on an early withdrawal if the withdrawal is:
1. Made to a beneficiary after your death.
4. Made after separation from service if the separation occurred during or after the year when the employee reached age 55.
8. Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).
How do you maintain a 403b?
You maintain your account by making contributions to it through your employer. You can only make contributions through your employer. The contributions are withheld from your paycheck, and any matching contributions your employer will add to your own are deposited into the plan by your employer.
If you leave the company, you can choose to leave your account as it is or roll it over into a Traditional IRA. If your new employer has a 403b plan, you can also have your old 403b rolled over into the new plan.7
If I quit my job where I was participating in a 403b plan, what happens?
The money you contributed is always yours, regardless of how long you have worked for the employer. Generally, an employer requires that you work a certain number of years before you are vested, which simply means that you are legally entitled to the employer's matching contributions. Therefore, depending on your employer's rules, you may or may not be able to keep the employer's matching contributions.
There are several things that you can do after leaving your job. One is to leave the 403b in your employer's plan. However, your former employer may charge you fees for maintaining your account for you. Check the plan agreement for details about your former company's specific rules.
Another thing you can do is rollover your 403b into a Traditional IRA. Contributions to Traditional IRA's receive the same type of tax deferral treatment as contributions to 403b's, so you may be able to rollover your money into a Traditional IRA and not owe additional taxes.8
Another option is if your new employer has a 403b plan, you can also have your old 403b rolled over into the new plan.9
What if I am laid off or fired?
Your options include any of the solutions discussed in the previous question. It is still your money, so you keep all of your contributions to the plan. Depending on the rules of your plan, you may not be entitled to the employer matching contributions.
Can I start a 403b if I already have an IRA?
Yes, you absolutely can participate in a 403b if you also have IRA's, Traditional or Roth.
How does a 403b affect my federal income tax?
Contributions are considered "elective deferrals" of income, so you do not pay any federal income tax on them in the year you make the contribution. For example, John contributes $1,000 in 2007, and his employer contributes $200. John's salary for the year is $30,000. He will pay federal income taxes on $29,000 only, which is his salary minus his $1,000 contribution.
However, you do not get away completely tax-free. When you take distributions from your plan during retirement, you will pay federal income taxes on that money then. For example, if Susan is age 65 and receives a $10,000 distribution in 2007, she will owe taxes on the $10,000. However, when she contributed to the plan years ago, she did not have to pay any taxes on the money she contributed then.10
Do I have to withdraw money at a certain age?
Yes, you must start withdrawing money by April 1 of the year after:
- You reach age 70 ½, or
- You retire from the company maintaining the 403b plan.11
What happens to my 403b after I die?
You may designate beneficiaries who will inherit your account after your death.12
Why participate in a 403b? Why not just invest that money in mutual funds?
By participating in a 403b, you receive tax benefits that you would not receive by investing your money in mutual funds on your own. The money you contribute to your 403b is not subject to income tax. Therefore, you end up paying fewer taxes by participating than if you bought mutual funds on your own. For example, Joe works for Mayberry County Board of Education. He makes $30,000 and contributed $1,500 to his 403b. He will owe federal income taxes on $28,500 only, not on his full salary of $30,000. He gets to deduct the contributions from his income before calculating his taxes. If Joe had used the $1,500 to buy stock through his stockbroker, he would have to pay taxes on any dividends paid from the stock that year.
Another reason to participate is that in most plans, employers match a portion of your contributions, so it is as if your employer is giving you free money simply by participating in the 403b plan! For example, Joe makes $30,000 in 2007 and contributes $1,500 of that salary to his 403b plan in 2007. Mayberry County provides matching contributions of $1,000, so Joe really makes $31,000 in 2007, not just his $30,000 base salary.
This article has covered common questions investors typically have when learning about 403b plans. This article does not cover all aspects of the 403b, but it is designed to give you an overview of what the plan is and how it works. For additional information or specific questions, contact your plan administrator or financial advisor.
References
United States Internal Revenue Service, Publication 590, Individual Retirement Arrangements, "Traditional IRA's", http://www.irs.gov/publications/p590/ch01.html
United States Internal Revenue Service, Publication 560, Retirement Plans for Small Businesses, "Qualified Plans", http://www.irs.gov/publications/p560/ch04.html
United States Internal Revenue Service, Publication 575, Pension and Annuity Income, "Survivors and Beneficiaries", http://www.irs.gov/publications/p575/ar02.html#d0e4787
United States Internal Revenue Service, Publication 571, Tax Sheltered Annuity Plans (403b Plans), http://www.irs.gov/publications/p571/
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