Saving for retirement is an important financial goal — but not everyone understands all of the retirement plans available. After all, it does look a little bit like alphabet soup: 401(k), IRA, 403(b) — what’s the difference?
Each type of retirement plan has its own rules, benefits and drawbacks, and understanding which type is right for an individual’s needs starts with learning what each is all about.
In this article, we’re going to dive into the nitty-gritty details of 403(b) plans, also known as tax-sheltered annuities or TSAs. What are they, how do they work and who is eligible?
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What is the 403(b) retirement plan?
The 403(b) retirement plan is a type of incentivized investment vehicle designed to help account holders save for retirement. It’s offered by certain public schools and 501(c)(3) organizations to their employees (in layman’s terms: it’s the 401(k) of the nonprofit world).
Like a 401(k), 403(b) plans facilitate regular contributions toward an employee’s retirement goal. Contributions are tax-deductible in the year they’re made, and taxes aren’t paid on the funds until they’re distributed from the plan later.
Unlike a 401(k), however, the funds in a 403(b) are sometimes invested in an annuity contract provided through an insurance company, rather than allocated toward stocks and bonds on the market. The monies may also be entrusted to a custodial account that invests in mutual funds.
Like other retirement plans, 403(b)s are governed by limits on how and when participants can take distributions, and generally, the funds can’t be touched until the account holder reaches age 59.5.
Furthermore, required minimum distributions, or RMDs, apply to 403(b) plans and kick in either in the account holder’s early 70s or when they retire.
Let’s break down the 403(b) retirement plan more thoroughly.
403(b) plan participation
Only employees of specific public and nonprofit employers are eligible to participate in 403(b)s, as are some ministers. You may have access to a 403(b) plan if you’re any of the following:
• An employee of a tax-exempt 501(c)(3) nonprofit organization.
• An employee of the public school system, including state colleges and universities, who is involved in the day-to-day operations of the school.
• An employee of a public school system organized by Indian tribal governments.
• An employee of a cooperative hospital service organization.
• A minister who works for a 501(c)(3) nonprofit organization and is self-employed, or who works for a non-501(c)(3) organization but still functions as a minister in their day-to-day professional life.
An eligible employee of a qualified employer may be automatically enrolled in a 403(b) plan, though opting out is possible. Of course, participating in an employer-sponsored retirement plan is one good way to start saving for retirement.
Contributions to a 403(b) plan are generally made only by the employer, though these contributions may include elective employee deferrals as set aside through a salary reduction agreement.
This is similar to the way it works with a 401(k) — the employee agrees to have a certain amount of their salary redirected to the retirement plan during each pay period, and it’s automatically contributed on the employee’s behalf.
However, other types of contributions are also eligible, including:
• Nonelective contributions from your employer, such as matching or discretionary contributions.
• After-tax contributions, which can be made by an employee and reported as income in the year the funds are earned for tax purposes.
These funds may or may not be designated Roth contributions, in which case separate accounting records will be needed for Roth contributions, gains and losses
One notable difference between 403(b) plans and 401(k) plans is that profit sharing is not legal in a 403(b) — workplaces that are 403(b)-eligible aren’t working toward a profit.
And even though employer matches are technically legal, they’re not common in a 403(b), since nonprofits generally have less funding available for such bonuses and don’t want to lose their Employee Retirement Income Security Act (ERISA) tax exemption.
403(b) plan investments
One way 403(b) plans do diverge from other types of retirement plans, like 401(k)s and even IRAs, is the method in which the funds are invested. Whereas many other retirement plans allow account holders to invest in stocks, bonds and ETFs, 403(b)s are commonly invested in annuity contracts, which are sold by insurance companies.
In fact, part of the reason these plans are known as “tax-sheltered annuities” is because they were once restricted to annuity investments alone — a limit which was removed in 1974.
These days, some 403(b)s are still invested in annuities. But they might also be invested in mutual funds, as managed by a third-party custodian, or in a retirement income account set up specifically for church employees.
Investment transfers and exchanges may be made while the account is still in service, given the transaction meets certain requirements and is permitted by the plan.
403(b) loan distributions
As discussed above, 403(b)s are governed by similar rules to other retirement accounts, which limit how and when the funds can be accessed.
Generally, employees (or their beneficiaries) can’t take distributions, without penalties, from their 403(b) plan until one of the following occurrences:
• They reach age 59.5
• They have an employment severance
• They become disabled
• They die
However, some 403(b) plans do allow loans and hardship distributions. Loans would be governed by the plan itself, and hardship distributions require the employee to demonstrate immediate and heavy financial need in order to avoid the typical early withdrawal penalty.
As with other retirement accounts, distributions taken outside of the permitted limits are subject to a 10% early distribution tax, as well as the regular income taxes that are still owed on the money.
403(b) written plan requirement
The IRS states that a 403(b) plan “must be maintained under a written program which contains all the terms and conditions.” In other words, in order for the plan to be legitimate, paperwork is required.
This paperwork may not necessarily be a single document, however, so an employee may get a whole packet of information as part of the onboarding process, including salary reduction agreement terms, eligibility rules, explanations of benefits and more.
In certain limited cases, an employer may not be subject to this requirement. For example, church plans that don’t contain retirement income aren’t required to have a written 403(b) plan.
Employers are required to offer 403(b) coverage to all qualified employees if they offer it to one, a policy known as “universal availability.” However, certain employees may be legally excluded from the plan, including those under the following circumstances:
• Employees working fewer than 20 hours per week.
• Employees who contribute $200 or less to their 403(b) each year.
• Employees who are participating in another employer-sponsored retirement plan, like a 401(k) or 457.
• Employees who are non-resident aliens.
• Employees who are students performing certain types of services.
However, the same laws that allow these coverage limits also require employers to meet non-discrimination standards and require employers to give employees notice of certain important plan changes, like whether or not they have the right to make elective deferrals.
An employer has the right to terminate a 403(b), but they’re required to distribute all accumulated benefits to employees and beneficiaries “as soon as administratively feasible.”
An employee may be eligible to roll their 403(b) funds over into a new retirement fund upon termination.
403(b) plans and investing in your future
Even if an employee doesn’t have access to an employer-sponsored account, there are plenty of ways to prepare for the golden years.
For instance, IRAs are a popular option among the self-employed and freelancers, who can use their tax benefits to help get a leg up on their retirement savings.
IRAs come in a variety of options, but the two most common for individuals are Roth and traditional — with after-tax and pre-tax contributions, respectively (in other words, you pay taxes on funds contributed to a Roth before they go into the account, whereas you pay taxes on funds contributed to a traditional IRA after you take the distribution).
While the tax incentives and special early distribution rules built into retirement-specific accounts are attractive, the main motivator for most retirement investors is the power of compound interest.
By regularly contributing to an investment account and keeping the funds allocated, account holders could see an exponential amount of growth over time.
If a company doesn’t offer a 401(k) or 403(b), or if an employee has financial goals to meet in addition to retirement, a regular investment account could be a great option.
No matter what your needs, and whether you’re saving purely for retirement or for another medium-term goal, like buying a new car or becoming a homeowner, investing might help turn your carefully stashed savings into a passive income stream.
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