Frequently asked questions about 403(b) plans
What is a 403(b)?
The 403(b) is a tax deferred retirement plan available to employees of educational institutions and certain non-profit organizations as determined by section 501(c)(3) of the Internal Revenue Code. Contributions and investment earnings in a 403(b) grow tax deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income.
When was the 403(b) established?
The 403(b) was established in 1958 by the federal government to encourage employees in certain tax-exempt organizations to establish retirement savings programs. The name refers to the relevant section in the Internal Revenue Code.
Who can contribute to a 403(b)?
Employees of tax-exempt organizations established under section 501(c)(3) of the Internal Revenue Code. Participants include teachers, school administrators, school personnel, nurses, doctors, professors, researchers, librarians, and ministers.
Why Contribute to a 403(b)?
Most employees of educational institutions and other non-profit organizations are provided with a pension upon retirement. Few pension plans, however, provide an amount equal to salary. A 403(b) plan can provide a healthy supplement to a pension. Further, 403(b) contributions are made on a pre-tax basis which can greatly reduce your tax bill. Generally, if you contribute $100 a month to a 403(b) plan, you've reduced your Federal income taxes by roughly $27 (assuming you are in the 27% tax bracket). In effect, your $100 contribution costs you only $73 The tax savings are magnified as your 403(b) contribution increases.
How does a 403(b) plan work?
You set aside money for retirement on a pre tax basis through a salary reduction agreement with your employer. You choose from among the vendors offered by your employer where your money is to be invested. The money grows tax free until withdrawal at retirement.
Are part time employees eligible to contribute to a 403(b)?
In order to meet nondiscrimination requirements of the law, once a plan sponsor permits any employee to elect a salary deferral into the TSA, the opportunity must be extended to all employees of the organization who may elect to have the plan sponsor make contributions of more than $200 pursuant to a salary reduction agreement. This is known as universal availability. However, certain employees may be excluded. Employees who may be excluded include employees who are participants in an eligible deferred compensation plan [457 or 401(k)] or participants in another TSA, non-resident aliens, certain students and employees who normally work less than 20 hours per week.
How much can I contribute annually?
For 2007 and 2008, workers are able to contribute:
- the new elective deferral limit of $15,500, or
- up to 100% of compensation (must be less than the elective deferral limit), or
- for those with employer matches, limits are $46,000 (for 2008) or 100% of compensation (lesser amount).
- in addition, if you are 50 or older at any time during 2007 or 2008, you may contribute an additional $5,000.
What investment options are available to 403(b) participants?
- Annuity and variable annuity contracts with insurance companies
- Custodial account made up of mutual funds. This is known as a 403(b)(7)
- Retirement income accounts for churches
What's the difference between an annuity and a mutual fund?
An annuity is an insurance company contract that can be used for accumulating assets for retirement or as a method of providing an income stream at some future date. Fixed annuities guarantee your principal and a fixed rate of return and they are generally considered conservative and stable. A variable annuity's value will fluctuate because it is dependent upon the performance of the underlying investment options managed in the separate account. A mutual fund is a "pooled" investment. You can think of it as a group of people with similar investment goals who all get together and put some of their money in a single "pot". A professional money manager is hired to invest the money in stocks, bonds, and/or short-term investments.
Mutual funds are pools of money invested in many different securities and are managed according to set objectives. They are similar to the investments underlying variable annuities, but do not have the associated insurance fees of an annuity. With mutual funds, you can choose among aggressive funds for growth to more conservative funds for stability similar to that of a fixed annuity. When comparing similar investments, it is important to consider all factors of an investment, including performance, fees, risk, flexibility, time horizon and your own confidence in the investment or insurance company.
Before committing to any 403(b) investment option, what questions should I ask?
- Will I be penalized for pulling my money out? Annuities typically penalize investors who bail out. During the first few years of the contract, you may have to pay surrender charges if you transfer your money elsewhere. Often the surrender fees start at 7% or 8% and decline by a percentage point every year. If you switch employers and move the money out of an annuity with a surrender charge, you will have to pay the penalty. Certain surrender fees, however, refuse to vanish. You'll typically discover this nasty surprise with "two-tier" annuities. With one of these, you'll pay a penalty if you decide not to annuitize your payments upon retirement. If you prefer to withdraw your money and invest it elsewhere, you can, in some cases, face a 20% or higher penalty.
- What are my investment choices? The underlying investments within a variable annuity will be mutual funds. An insurance agent will probably refer to them as "subaccounts." What is the performance record of these funds? How does each compare with its appropriate benchmark? If a large-cap growth fund has consistently under performed the Standard & Poor's 500 Index, for example, stay away.
- What annual fees will I pay? You should check the yearly expense ratios for annuities as well as traditional mutual funds. Fees can dramatically erode returns over time.
- How is an insurance company rated? If you are investing in a fixed annuity, you need to know how financially sound the insurance carrier is. You'll want to review the ratings from at least two insurance-rating services such as A.M. Best, Moody's, and Duff & Phelps. You might assume that your money is protected within a fixed annuity, but there's no real guarantee. That's because the money in a fixed annuity is not segregated and therefore can be at risk if the insurer declares bankruptcy.
How do I set up a 403(b)?
Ask your employer for a list of the participating investment companies available to you. This is typically known as the vendor list. Select several investment companies from this list. Then, most importantly, research these choices with an eye toward performance and cost. Next, determine the amount of money you wish to contribute monthly. Most companies require at least $50 per month. Finally, return to your employer with the necessary investment paperwork and you're on your way.
Can I change the amount I contribute?
Yes, but you might have to wait for a specific date. Some employers limit the number of changes during a year. It's best to ask about this before you begin contributing.
Can I stop contributing altogether?
You may stop contributing at any time.
What investment companies can I invest with?
Your employer can provide you with a list of the companies which they have approved for participation.
How is a 403(b) different from a TSA (tax-sheltered annuity)?
As far as the IRS is concerned a 403(b) is a TSA, and a TSA is a 403(b). The terms are interchangeable. Either way, participants can contribute to annuities, variable annuities or mutual funds.
How is a 403(b) different from a 401(a)?
The main difference between a 401(a) and a 403(b) is eligibility. A 401(a) can be established just for administrative staff, or even as narrowly defined as for the caffeteria workers only. A 403(b) on the other hand requires universal availability.
How is a 403(b) different from a 401(k)?
The 401(k) is a tax-deferred retirement plan for private sector employees, while the 403(b) is a tax-deferred retirement plan for employees of educational institutions and certain non-profit organizations. There are other differences.
What is a 403(b)(7)?
The IRS created the 403(b) in 1958. In 1974 Congress added paragraph (7) which allowed employees to set up retirement plans directly with mutual fund companies. Prior to this change contributors were limited to investment choices offered by insurance companies. Throughout this site the term 403(b) is intended to mean all of the following: 403(b), 403(b)(7) and TSA.
When can 403(b) money be accessed without penalty?
Generally, penalty-free distribution from a 403(b) cannot occur until the participant:
- Reaches age 59 1/2
- Separates from service in the year turning 55 (and must be retired)
- Retire before age 55 eligible for Substantially Equal Periodic Payments (SEPP). Participants who have retired early (before age 55), but want access to their 403(b) without penalty can do so using SEPP. This provision requires that you take a series of substantially equal periodic payments. The key is that once you start these payments they must continue for five years or until you reach 59 1/2, whichever takes longer. If you start at age 58 you must continue until you are 63 (minimum 5 years).
- Becomes disabled
- Through a loan (some investment companies allow this, some don't)
- Suffers financial hardship
Under what circumstances may a hardship withdrawal be made?
This provision allows withdrawal of funds from a 403(b) if under severe financial distress. The participant must have no other resources available. A hardship withdrawal may be made for:
- Un-reimbursed medical expenses of the participant or his/her spouse and dependents.
- Down payment on primary residence
- Tuition and fees for higher education needs, and only for the next 12 months.
- Eviction or foreclosure on your primary residence
Hardship withdrawals are not exempt from an IRS 10% penalty. Furthermore, withdrawals are subject to ordinary income taxation in the year withdrawn. To qualify you must certify that you have no other recourse, including the possibility of taking a loan. You also are prohibited from contributing to a 403(b) for the next six months. The IRS makes it tough to access money this way for a reason: they don't want you to use the 403(b) as a form of short term savings. For exact details on your situation it is recommended that you contact both your vendor and a tax professional before proceeding.
Also, while the IRS permits withdrawals, it is allowable for a plan sponsors (the employer) to not permit them. The employer has some responsibility in making hardship withdrawals. The employer has to "OK" the hardship, based on written information provided by the employee as to the nature of the hardship. The employer has to determine, based on the facts, whether the employee has an "immediate and heavy financial need."
What are the options for a 403(b) when switching jobs?
- Move the money into your new employer's 403(b) plan. (Note, as of 2002 a 403(b) can be rolled into a 401(k) and vice versa. Not all plans allow such transfers, so check with your employer and plan provider.)
- Roll it into an IRA.
- Leave it where it is, especially if you like your investment choices. If the balance is below $5,000 some employers require you to move the money. Check with your employer.
- Take a lump sum payments, subject to fees and penalties.
How will distributions from my 403(b) be taxed?
In most cases, the payments you receive, or that are made available to you from a 403(b) are taxable in full as ordinary income. In general, the same tax rules apply to distribution from a 403(b) that apply to distributions from other retirement plans. For more detailed information refer to IRS Publication 571.
Can I leave my money in the plan indefinitely?
No. The federal government will allow you to put off paying taxes on the money for only so long. Generally, you must begin to take withdrawals no later than April 1 of the year following the year in which you turn age 70 1/2.
What about distribution requirements for 403(b) money contributed prior to December 31, 1986?
403(b) account balances that existed on December 31, 1986 are not subject to the age 70 1/2 distribution requirement. However, any earnings on that balance are. Distribution from the 12/31/86 balance needs to start at age 75. This requirement is not found in the Internal Revenue Code, but rather in a letter ruling. Also, any distributions in excess of required distributions are deemed to reduce the 12/31/86 balance. So, if any money has been taken out of the 403(b) account other than those that are required (such as a partial withdrawal or a deemed distribution), the 12/31/86 balance may be less than anticipated.