Taxation of 403(b) Distributions

by Mark Kennan

    A 403(b) plan offers tax-sheltered growth for your retirement savings, which means your money grows tax free as long the money stays in the account. Only employees of certain nonprofit organizations, like public schools and hospitals, are eligible to participate. When it comes time for you to cash out, the amount of your distribution you're going to have to share with Uncle Sam depends on when you're taking the distribution and whether you're withdrawing from a traditional or Roth 403(b).

    Traditional 403(b) Distributions

    Typically, the entire amount of your 403(b) plan counts as taxable income because the money wasn't included in your taxable income when you made the contributions. For example, if you take out $30,000, that's $30,000 extra in taxable income for the year. However, there's an exception if you're a retired public safety officer: You can distribute up to $3,000 tax-free each year to pay for accident, health, or long-­term care insurance for yourself, your spouse or your dependents. To qualify, the payments must be made directly from your 403(b) plan. If you're younger than 59 1/2, you may owe an early withdrawal penalty as well because you're taking a non-qualified distribution.

    Qualified Roth 403(b) Distributions

    A Roth 403(b) plan allows you to make contributions with after-tax dollars, which means you don't get a tax break for your deposits. However, because you didn't receive a deduction for your contributions, when you take a qualified distribution from a Roth 403(b) plan, the money comes out without incurring a dime in taxes -- including on the earnings in the account. To take a qualified distribution, you must be at least 59 1/2 years old, permanently disabled or taking distributions as a beneficiary. Plus, your Roth 403(b) must be at least five years old. For example, if you take $30,000 in qualified distributions from your Roth 403(b), your taxes won't go up by a penny.

    Nonqualified Roth 403(b) Distributions

    If you can't satisfy both requirements for a qualified Roth 403(b) distribution, you have to prorate your distribution between your contributions and your earnings. The contribution portion comes out tax-free, but the earnings are taxable and are hit with the early withdrawal penalty. For example, if you have $75,000 of contributions and $25,000 of earnings in your Roth 403(b) plan, 75 percent of your distribution is contributions and 25 percent is earnings. So, if you take out $10,000, $7,500 is tax-free and $2,500 is taxable.

    Early Withdrawal Penalty

    When you take a non-qualified distribution, you owe an extra 10 percent penalty on the taxable portion of the distribution. For example, if you take a $10,000 distribution from your traditional 403(b) plan, you owe a $1,000 penalty on top of the taxes. If it's a $10,000 distribution from your Roth 403(b) and only $2,500 is taxable, you only owe a $250 penalty. (ref 3) You can avoid the penalty altogether if you're permanently disabled, taking a qualified reservist distribution or if you left your job after turning 55. In addition, you can avoid the penalty on the amount of your distribution up to the amount of your deduction for medical expenses. (ref 3)

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    About the Author

    Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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