Introduction to 403(b) plans

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A 403(b) plan is a special type of employer‑sponsored retirement plan that is offered to certain religious, public education, and taxexempt organizations. Typically, the employer either purchases annuity contracts for eligible employees or establishes custodial accounts, which are invested in mutual funds or other investments. In the case of annuity contracts, a 403(b) plan is sometimes referred to as a taxdeferred annuity or a tax‑sheltered annuity (TSA) plan.




Depending on the specific type of 403(b) plan, plan contributions may be made by the employee only, the employer only, or both the employee and the employer.  These plans enjoy tax benefits similar to 401(k)s and other qualified retirement plans. The most significant benefit is that participating employees generally do not pay taxes on either their contributions or their investment earnings; they pay taxes only when they begin receiving distributions from the plan. Although an employer tax deduction may be possible, it is usually of little or no value, since the employer is already exempt from income tax.


Contribution Limits

For 2021, employees may defer up to $19,500 of their compensation to a 403(b) plan on a pretax basis.  A catch-up retirement savings provision is also available for employees age 50 and older. In 2021, these individuals may contribute an extra $6,500 pretax, for a total possible contribution of $26,000. These are the same contribution limits that apply to 401(k) plans. Also, total annual additions for anyone participating in a 403(b) plan are limited to the lesser of $58,000 (excluding the catch-up allowance) in 2021 or 100 percent of the participant’s compensation. Total annual additions are the sum of employer and employee contributions, plus any reallocated forfeitures from other employees’ accounts.


Tax Advantages of 403(b) Plans for Employees

As with many other types of retirement plans, 403(b) participants can enjoy significant tax benefits, including:

  • Pretax contributions: Employee salary‑reduction contributions to a 403(b) plan are made on a pretax basis. This results in a lower taxable income, which means the employee pays less current income tax.
  • Tax‑deferred growth: Funds held in a 403(b) plan grow tax‑deferred—meaning any earnings on plan investments are not taxable until the employee begins to receive distributions. Depending on investment performance, this creates the potential for more rapid asset growth than if the assets were invested outside a tax‑deferred plan.
  • Possible tax credit: As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), some employees who participate in a 403(b) plan may qualify for a partial income tax credit for amounts deferred to the plan. The amount of the tax credit (if any) is based on the employee’s annual gross income and federal income tax filing status.


Are In-Service Withdrawals Permitted?

Similar to other types of employer‑sponsored retirement plans, 403(b) plans are subject to restrictions on in‑service withdrawals (i.e., distributions made while a plan participant is still working for the employer). The Internal Revenue Service generally does not allow a 403(b) plan participant to withdraw salary‑reduction contributions and related earnings without penalty until the participant reaches age 59½, retires or otherwise separates from the employer’s service, dies, or becomes disabled. There is an exception, however, for financial hardship.


Frequently Asked Questions


Q: Can an employee who makes salary‑reduction contributions to a 403(b) plan also make tax‑deductible contributions to a traditional IRA?

A: Possibly. In most cases, when a traditional IRA owner is not covered by an employer‑sponsored retirement plan, his or her contributions to the traditional IRA are fully tax‑deductible for federal income tax purposes. When the traditional IRA owner (or his or her spouse) is covered by an employer‑sponsored plan (including a 403(b) plan), however, his or her ability to make tax‑deductible IRA contributions may be limited or even phased out entirely. The amount of the tax deduction (if any) depends on the IRA owner’s federal income tax filing status and modified adjusted gross income for the year.


Q: When do employees vest in their 403(b) plan accounts?

A: Vesting is the process by which participants in a 403(b) or other retirement plan earn the right to benefits under the plan. A 403(b) plan participant is immediately 100 percent vested in all salary‑reduction contributions he or she makes, as well as in any investment earnings on those contributions. With respect to employer contributions (either matching or nonelective), participants need not be immediately vested. Plans that provide employer contributions, however, are generally subject to minimum vesting standards under the Employee Retirement Income Security Act (ERISA). ERISA generally requires that employer‑matching contributions either vest 100 percent after three years of service (cliff vesting), or vest 20 percent after two years of service, increasing by 20 percent per year until 100 percent vesting is achieved after six years (graded or graduate vesting). Employer contributions other than matching contributions (i.e., nonelective contributions) generally must vest 100 percent after five years of service, or vest 20 percent after three years of service, increasing by 20 percent per year until 100 percent vesting is achieved after seven years. Of course, for either matching or nonelective contributions, an employer’s vesting schedule can always be less (but not more) restrictive than ERISA’s standards.


Q: Is a 403(b) plan subject to the Required Minimum Distribution (RMD) rules?

A: Yes. Participants in a 403(b) plan are generally subject to the same RMD rules that apply to IRAs and most employer‑sponsored retirement plans. An RMD is the amount participants must withdraw annually from his or her account, beginning no later than April 1 of the year following the year in which they reach age 72 (or, if still employed at that age, April 1 of the year following the year they retire from the employer that maintains the plan).


Q: Can funds in a 403(b) plan be rolled over to another account?

A: Yes. A participant in a 403(b) plan may generally roll over all or part of his or her vested benefits in the plan to an IRA or to another 403(b) plan that accepts rollovers. Only eligible rollover distribution amounts can be rolled over, however. An eligible rollover distribution from a 403(b) plan is any part of the taxable portion of a distribution from the plan, excluding any distribution that is (1) one of a series of substantially equal periodic payments made at least annually; (2) an RMD; (3) a hardship distribution; or (4) a distribution not includable in the participant’s gross income. A rollover can be direct or indirect. With a direct rollover, you move the funds directly from the 403(b) plan into an IRA or another 403(b) plan. With an indirect rollover, you first receive the distribution from the old 403(b) plan and then roll it over into an IRA or another 403(b) plan within 60 days. In either case, as long as rollover rules are followed, the rollover will be treated as a tax‑free transfer of assets. (In the case of an indirect rollover, a mandatory 20 percent federal income tax withholding applies. Participants will then receive a credit for tax withheld when they file a federal income tax return for the year.) In addition, one provision of EGTRRA generally permits rollovers of eligible rollover distributions among employer‑sponsored qualified retirement plans (e.g., 401(k) plans), Section 403(b) plans, governmental Section 457 plans, and IRAs. Prior to the act, the rollover rules governing 403(b) plans and other retirement savings vehicles were much more restrictive.


Commonwealth Financial Network® does not provide tax or legal advice. Please contact your tax or legal professional regarding your individual situation.


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