A 403(b) plan is a type of retirement plan usually offered by schools and nonprofit organizations. Generally, you contribute to a 403(b) plan using pretax dollars, meaning that your federal income withholding tax is calculated without including the money you put into the 403(b) plan. You pay tax on the money when you take it out of the plan in retirement, not when you earn it and invest it in the plan.
Understanding How 403(b) Plans Work
A 403(b) plan is a type of retirement plan you may be offered through your employer, named for the section of the U.S. federal tax code that set it up. It works fairly similarly to 401(k) plans offered by private sector companies, but it is offered by schools, colleges, nonprofit groups and religious organizations.
Traditionally, 403(b) plans invested funds in annuities, designed to pay out a steady income to retired employees of these organizations, but more recently they've expanded to also allow investments in mutual funds. Exactly what opportunities are available through your plan depends on your employer and the company that administers the plan.
Contributions to 403(b) Plans
If you do have a 403(b) plan available at work, your employer will typically give you the option to deduct a portion of each paycheck to invest in the plan. The money that you put into the plan won't be taxed when you earn it, and your tax withholdings will automatically be adjusted accordingly, so you won't need to wait until tax return time to see the savings.
Your paystubs and Internal Revenue Service W-2 tax forms will tell you how much of each paycheck and your annual pay went to the 403(b) plan. You can also often track your deposits, usually known as contributions, to the plan and see how your investments are doing through regular statements and online portals.
403(b) Withdrawal Taxes
When you withdraw money from your 403(b) plan to spend after you retire, you will then pay tax on it as if you had earned it the year you withdrew it. That's a savings for many taxpayers, since people typically earn less money and end up in a lower income tax bracket once they are retired compared to when they are working and earning a full paycheck. A withdrawal from a retirement plan is often known as a distribution in tax terminology.
If you withdraw money from your 403(b) plan before you reach age 59 1/2, the retirement age for most tax-advantaged retirement plans, you will usually have to pay an additional 10 percent federal penalty tax to the IRS for the amount you withdrew. That's on top of whatever tax you must pay on the money you withdraw according to your normal tax rate.
Certain exceptions do apply if you are withdrawing for particular reasons, such as if you become disabled or you are in the military reserves and are called up for active duty. If you're not sure whether you can withdraw without penalty, consult a trusted tax expert or the IRS. Remember that even if you qualify to withdraw money from the plan without a penalty, you'll usually still owe money on the money you withdraw.
403(b) Rollover Rules
If you leave the job where you had the 403(b) plan, you usually have the option of keeping the money in the plan or rolling it over to another retirement plan. That can be a new 403(b) or 401(k) plan at your new job or an individual retirement arrangement, or IRA, that you set up at a financial institution of your choice. Moving to an IRA can be advantageous to get away from some of the 403(b) disadvantages, like the restrictions on what you can invest your funds in. IRAs also have more generous policies about when you can withdraw money before age 59 1/2 without a penalty, allowing some withdrawals for purposes like paying family education bills and buying your first house.
The easiest way to roll funds from one retirement plan to another is usually to work with the two institutions running the accounts to transfer the funds without you taking possession of them. You may need to liquidate your holdings in the funds in the 403(b) plan if your new plan doesn't offer the option of investing in those funds, or you may be able to transfer your holdings from one plan to another.
If you do take possession of the funds, such as by receiving a direct deposit into your normal bank account or getting a check in the mail, keep in mind that you only have 60 days to deposit the money into a retirement account, or the IRS will consider you to have withdrawn the money. That will trigger the penalty and income tax unless certain limited exceptions, generally for emergency situations and bank errors, apply.
When you take possession of the money yourself, you'll usually also see 20 percent of the funds withheld for taxes. You'll need to make up for that money from your other funds, or you will be considered to have withdrawn it and will owe taxes. Generally, you'll get the money back when you file your tax return. This doesn't apply if you have the money sent directly from one retirement account to another.
Understanding Required Minimum Distributions
Another way you can find yourself owing tax based on a 403(b) or other tax-deferred retirement account comes from failing to take what are called required minimum distributions, which are mandatory withdrawals that you must take beginning at age 70 1/2. How much you must withdraw depends on how much you have in tax-deferred accounts and how old you are. You can determine how much you must withdraw from your retirement accounts by checking tables published annually by the IRS or by using an online calculator. Since the amounts do change every year to adjust for inflation, you should make sure you're using reference materials for the right tax year.
If you don't take your required minimum distributions, you can face a tax penalty of 50 percent of the difference between the amount you withdrew and the minimum amount for you that year. Since that's more than you can owe in federal income tax even in the highest tax bracket, it's generally always worth it to take the withdrawal and pay income tax rather than pay the 50 percent penalty.
You may wish to take more than your required minimum distribution in some years or to take withdrawals before you are required to do so, either in order to reduce your tax burden by spacing out withdrawals or simply to have the money handy for living expenses.
How Roth Accounts Work
Some 403(b) accounts or portions of them may be what are called Roth accounts. With these accounts, you put post-tax money into the account and pay no additional tax when you withdraw funds in retirement, even if, thanks to wise investments, you withdraw more than you put in. They can be a good deal if you expect to be in a high tax bracket at retirement age or to earn a great deal on your investments.
You can convert a traditional retirement account to a Roth one if the plan managers support it, effectively by paying the taxes. IRAs and 401(k)s can also be Roth accounts.
- IRS: About Form W-2
- IRS: Publication 571 (01/2019), Tax-Sheltered Annuity Plans (403(b) Plans)
- 403(b) Savings Calculator | Calculators | 360 Degrees of Financial Literacy
- IRS: Retirement Plans FAQs Regarding 403(b) Tax-Sheltered Annuity Plans
- IRS: Publication 590-B (2018), Distributions from Individual Retirement Arrangements (IRAs)
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.