A 403(b) is a tax-favored retirement plan similar to a 401(k) plan, but designed for employees of school systems, nonprofit hospitals, religious organizations and other tax-exempt employers, known as 501(c)(3) organizations.
Here are the basics of 403(b) plans, although plan rules may vary:
- Participants may be able to make pretax or Roth contributions. Some organizations match these contributions.
- Participant contributions are 100% immediately vested, but matching contributions may be subjected to a vesting schedule.
- Public education organizations, including primary and secondary schools, state colleges and universities and junior colleges
- Nonprofit organizations, including hospitals, religious organizations, charitable institutions and social welfare agencies
After the first employee is permitted to participate, the employer must extend the offer to participate to all employees of the organization. The employer may exclude certain employees from the plan:
- Employees who will contribute $200 or less annually
- Nonresident aliens
- Employees who work less than 20 hours per week
- Employees who participate in a 401(k) or 457(b) plan or in another 403(b) plan
- Students performing services described in Code 3121(b)(10)
Each employee participating in the plan determines how much money is to be automatically contributed from each paycheck. Generally, participants can invest an annual maximum of $19,500 in 2020, or $26,000 for those 50 or older.
- Traditional contributions (that is, not Roth contributions) are made before taxes are deducted, which means that income taxes are not paid at the time of investment. Instead, taxes are paid when the money is withdrawn, including on any earnings.
- Plans may allow Roth contributions, which are made with money that has been taxed. Money that’s been taxed won’t be taxed again. Additionally, earnings are tax- and penalty-free for qualified distributions.*
The investments available in the plan — the most common options are mutual funds — are generally determined by the employer or the plan provisions, but participants can decide which of the options to use.
American Funds offers a wide range of investments.
As an added incentive for their employees to invest, some employers make “matching” contributions to participant accounts. Some employers match employee contributions dollar for dollar, while others contribute a percentage of what employees contribute. Employers may also make discretionary (profit-sharing) contributions into participant accounts.
Participants always own 100% of their contributions. With employer contributions, participants often become vested over time.
Distributions from 403(b) plans are generally allowed at age 59½ or in the case of disability. However, there may be ways to access money early.
Options When Employment Ends
There are a number of options an employee can take when leaving the job:
- Roll over to an IRA — Rolling 403(b) assets to an IRA can allow participants to keep the same tax benefits, avoid penalties, choose from a wider range of investment options and, with a Roth IRA, avoid having to take distributions before they’re needed.
- Stay in the old plan — If the account balance is large enough, participants may be able to remain in the plan and keep the same benefits, although fees may increase and they won’t be able to make contributions.
- Move to a new plan — If the participant’s new employer allows rollovers, participants can keep the tax benefits while consolidating their retirement plan money.
- Cash out — Participants will owe applicable taxes and, if not yet age 59½, possible penalties.