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Also known as a tax-sheltered annuity, a 403(b) plan is an employer-sponsored plan designed for employees of certain tax-exempt organizations (e.g., hospitals, churches, charities, and public schools) to invest for their retirement. Typically, the employer purchases annuity contracts or sets up custodial accounts for eligible employees who choose to participate. A 403(b) plan is technically not a qualified plan, but it is said to mimic a qualified plan because it shares some of the same features.
Like a 401(k) plan, a 403(b) plan enables you to make contributions to the plan on a pre-tax basis. These are known as salary-reduction contributions because they come from your salary before taxes are withheld, thus reducing your taxable income. For tax year 2020, you are allowed to defer up to $19,500 a year or 100% of your compensation, whichever is less, to the plan. If you're 50 or older, you can make an extra "catch-up" contribution of $6,500 in 2020 (additional special catch-up contribution rules may also apply). Employers will sometimes contribute to the plan as well, although employer contributions are generally not required and (if made) may be subject to a vesting schedule before you are entitled to them. Earnings (e.g., dividends and interest) on your 403(b) plan investments accrue tax deferred. Only when you withdraw your funds from the plan do you pay income tax on contributions and earnings. If you wait until after you're retired to begin withdrawing, you may be in a lower tax bracket.
Pre-tax Contributions and Tax-deferred Growth
The combination of pre-tax contributions and tax-deferred growth creates the opportunity to build an impressive retirement fund with a 403(b) plan, depending on investment performance. You may even qualify for a partial tax credit for amounts contributed if your income is below a certain level. In addition, a 403(b) plan may allow you (under certain conditions) to withdraw money from the plan while still working for your employer. Beware of these "in-service" withdrawals, however. They may be subject to both regular income tax and (if you're under age 59½) a 10% early withdrawal penalty. A plan loan, if permitted, might be a better way to obtain the cash you need.*
Note: Your employer may also allow you to make after-tax "Roth" contributions to your 403(b) plan. Because your Roth contributions are after tax, those contributions are always tax free when distributed to you. But the main attraction of Roth 403(b) contributions is that the earnings on your contributions are also tax free if your distribution is "qualified." In general, a distribution is qualified if it is made more than five years after the year you make your first Roth 403(b) contribution, and you are either 59½ or disabled when you receive the payment.
*Due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, penalty-free withdrawals of up to $100,000 may be allowed in 2020 for qualified individuals affected by COVID-19. Individuals will be able to spread the associated income over three years for income tax purposes and will have up to three years to reinvest withdrawn amounts.