The most obvious difference between a traditional pension plan and a 403(b) program is the source of contributions. Employers typically fund pension plans, while 403(b) programs are funded by employee pretax contributions. In most cases, employers invest pension plan funds, while workers choose the investment options for 403(b) plans. Typically, for-profit companies offer pension plans, while government, public education and nonprofit employers set up 403(b) plans for employees.
Originally, 403(b) plans had investment restrictions that limited contributions to tax-sheltered annuities. These plans are still often called tax-sheltered annuities. However, plan participants can also invest in mutual funds. Annuities are typically offered by life insurance companies. The tax-sheltered variety allows employees with 403(b) plans to contribute tax-free from their income until they begin withdrawing from the plan.
Employees who participate in company pension plans that are qualified for tax benefits under the Employee Retirement Income Security Act are protected if their employer declares bankruptcy. Should an employer terminate its plan because of bankruptcy, all participants become immediately 100 percent vested in their accounts, which can't be taken by creditors during employer bankruptcy. Before 2005 bankruptcy reform legislation, 403(b) plans did not have this protection because they were not IRS-qualified programs.
Nonprofit Versus For-Profit
For employees of nonprofits, government, public schools and religious group, 403(b) programs work more like the 401(k) plans at for-profit companies than traditional pension plans. Withdrawals from each are taxed as ordinary income. Early withdrawals, defined as withdrawals made before age 59 1/2, also may face a 10 percent IRS penalty. You can get penalty waivers if you use early withdrawals to buy your first home, prevent foreclosure or pay qualified higher education costs. Some state governments sponsor pension plans instead of 403(b) programs, but many pensions have been converted to 403(b) plans.
Although 457 retirement plans aren't IRS-qualified, they are sometimes offered in addition to 403(b) programs for government and nonprofit employers. A 457 operates more like a 403(b) or 401(k) than a pension plan. They offer employees deferred compensation and pretax contributions. However, withdrawals are not subject to the 10 percent early withdrawal penalty. Independent contractors can participate in 457 programs, unlike with 401(k), 403(b) and pension plans.
Pension Plans Fading
While some governments and nonprofit organizations still offer classic pension plans, more are providing 403(b) programs to take advantage of the popularity of the similar 401(k) plans at for-profit companies. Some government employers and nonprofits offer 403(b) plans in combination with 457 programs to attract and retain employees.
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