A 403(b) is a type of retirement savings plan available to employees of public school systems and tax-exempt organizations, as well as self-employed ministers. A recurring theme of 403(b)s is that they share many characteristics with 401(k) plans and IRAs. These features include the deferral of taxes on gains, tax-deductible contributions and a choice of investment options. For those who are eligible, this option can be a very beneficial retirement planning tool.
Overview of a 403(b)
If they qualify, employers can establish 403(b) plans on behalf of their employees. To make an employee contribution, the employer deducts money from their paycheck and deposits it into the account. The employer will decide what investment options to offer, but it is up to the employee to decide how they want to invest.
Withdrawals from a 403(b) before age 59 ½ will incur a 10% tax penalty in addition to income tax. But withdrawals that are taken after that age are simply taxed as ordinary income.
Planning for Retirement with your 403(b)
403(b)s are designed with retirement planning in mind. Because of this, they have certain characteristics that are important to be aware of.
The IRS has set forth specific tax treatment for 403(b) plans. Contributions are deductible from income tax in the year you make the contribution. Gains in the account are tax-deferred, which means you will not pay taxes on gains until you withdraw them.
Because there is a tax penalty for withdrawals before age 59½, it’s important that you only invest money that you know you won’t need until retirement. Along with the amount you invest, how you invest your 403(b) will be the biggest driver of how much money your account will be worth at retirement.
403(b) Investment Options
403(b) investments can include mutual funds or annuities. Those in the finance world sometimes call them “tax-sheltered annuities”. This is because, prior to 1974, annuities were the only type of investments available for 403(b)s.
Mutual funds are professionally managed portfolios that pool money from many investors and invest it according to the fund’s objective. Most mutual funds invest in stocks, bonds or a mix of the two. These funds can invest in domestic securities or foreign ones.
Insurance companies issue annuities. Fixed annuities allow money to grow at a fixed rate, while variable annuities are dependent on the performance of “subaccounts.” These function in a similar way to mutual funds. Once an annuity matures, you can convert it into a stream of lifetime income.
Types of 403(b) Plans
As with 401(k)s and IRAs, there are two main types: traditional and Roth. Traditional 403(b)s are the most common, but there are many Roth plans, too. Tax treatment is the main difference between the two plan types.
In a traditional plan, contributions are tax-deductible and withdrawals are fully taxable as ordinary income.
Roth contributions are not tax-deductible. But any qualifying withdrawals you take after age 59½ are completely tax-free.
Depending on your financial situation, one of these plan types will likely be more attractive than the other. If you’re eligible to participate in a 403(b), it’s a good idea to discuss plan types with your financial professional.