Taxation of 403(b) Distributions

It is not uncommon for there to be some confusion regarding the differences between 401(k) and 403(b) retirement savings plans. Although both of these powerful savings platforms are widely used by working adults today, a 403(b) provides a stricter set of eligibility parameters that ensure a smaller section of employed individuals can qualify for it.

403(b) Vs 401(k) Retirement Plans

Unlike a 401(k), a 403(b) is typically reserved for individuals who work within nonprofits, school districts, religious groups or within the government. Much like a 401(k), however, a 403(b) is funded using pretax dollars. Simply put, individuals can contribute money to their 403(b) without being required to pay tax on the initial deposit.

This does not mean to imply, however, that these accounts will forever be immune to taxation. Once an individual is eligible to begin withdrawing funds from their 403(b), they will be required to pay tax on any money they receive. With that in mind, taking the time to thoroughly understand taxation law as it pertains to 403(b) distributions can help individuals better prepare for this period of their life and ensure that their transition into retirement is as smooth as possible.

Basics of 403(b) Contributions

Individuals who are employed in any of the occupations for which 403(b) plans are allowed can choose to make regular contributions to this retirement platform throughout their working years. In fact, the federal government allows individuals to contribute up to $19,000 of their own salary to their 403(b) plan for tax year 2019. As you can see, the size of these contributions will allow individuals to quickly begin developing a stable financial platform for their retirement years.

For individuals aged 50 and over, catch-up 403(b) contributions of an additional $6,000 are also allowed. With an annual contribution limit of $25,000 for those in the final years before retirement, it is plain to see why 403(b) plans attract such a large number of future retirees on an annual basis. Those who are looking for a low-risk, stable form of investment for their future are particularly drawn to 403(b) accounts.

403(b) Contribution Limits

That being said, if an individual contributes to a 403(b) in addition to a 401(k) or various other qualified plans, they cannot exceed a combined total contribution limit of $19,000. In some situations, an employer may choose to match the contributions an employee made into their retirement plan, effectively doubling the size of the total contribution. In situations such as this, the contribution limit of $19,000 still applies. Of course, if an individual is over the age of 50, their employer-matched contributions can still qualify for an additional $6,000 of funding.

403(b) Withdrawals

As mentioned previously, the funds that are contributed to a 403(b) are not taxed before entering the retirement fund. Taxes are paid on these funds during the withdrawal process. In order to become eligible for a penalty-free withdrawal from their 403(b), individuals must have reached the age of 59 1/2. Certain penalty exemptions are available for individuals 55 and older who have extenuating circumstances that require the early disbursement of these funds. Generally speaking, however, future retirees should wait until the standard withdrawal period begins in order to avoid lofty penalties. Currently, a 10 percent penalty is applied to all early, nonexempt withdrawals.

Evaluating 403(b) Taxation Policy

When the time comes to begin withdrawing funds from your 403(b), you will be required to pay tax on all distributions you initiate. Fortunately, these distributions are considered ordinary income rather than capital gains, which may help you avoid a higher tax rate than you would otherwise be subjected to. When money is withdrawn from a 403(b), the funds are added into your total income for the year. This means that your tax bill for the year will reflect your standard income plus any funds received from your 403(b).

Because of this, it is important to plan your distributions wisely so as to maximize the amount of money you receive from your retirement account following your tax payments. For example, although it may be tempting to take a lump sum of your 403(b) retirement savings once you are eligible, this could dramatically raise your ordinary income for the year and place you in a significantly higher tax bracket than usual. Because of this, your tax rates could greatly increase and a larger than necessary portion of your 403(b) funds will be lost in taxes.

Moving Forward With Your Retirement Plans

As a general rule, you should only withdraw as much money as is needed to maintain your quality of life. Think carefully about how much money you anticipate you will need for each year of retirement, and determine how much of your 403(b) savings will be used to fund this. If you withdraw more money than you need from your 403(b) for a given year, not only will this money lose any potential for gains as part of your other funds that remain invested, but it will also be subjected to tax.

If you remain unsure as to how 403(b) rules apply to you, or how you can maximize your 403(b) withdrawal earnings, it may be in your best interest to speak with a retirement professional and/or a financial adviser. These individuals can carefully assess your current worth and the value of your retirement savings accounts as part of a general distribution strategy for your golden years. The prospect of running out of money during retirement can be daunting, which is precisely why it is in your best interest to discover the most efficient method for withdrawing your 403(b) funds and avoiding excessive taxation.

Other Retirement Strategy Options

If your retirement strategy consists solely of 403(b) contributions, you may be missing out on a variety of other lucrative opportunities. It is worth your time to explore how other investment tools, such as mutual funds and Roth IRAs, may help you develop an even more fortified plan that ensures a happy and satisfying retirement for years to come.

Similarly, nonretirement account tools such as money market accounts, Certificates of Deposit (CDs) and general stock market investing may prove beneficial to you depending upon your retirement timeline and risk tolerance. More information about these particular programs should also be available through your financial adviser. If you have specific questions about your 403(b) plan you should also be able to speak directly to your employer. If you have yet to begin contributing to a 403(b), you should consult with your employer as soon as possible to determine the best method for getting this account established and organizing a contribution schedule.