403(b)’s also call tax sheltered annuities are retirement plans offered to employees of tax-exempt organizations such as K-12 schools, community colleges, universities and 501(c)3 organizations like hospitals and religious organizations. Let’s explore some of the rules and benefits of this type of account.
Investing in a 403(b) is voluntary and contributions to 403(b)’s can only be made through payroll deductions and are done using a salary reduction agreement. You choose the amount to be deducted from your paycheck and if your employer doesn’t limit the number of times, you can contribute then you are free to change that amount at any time. Contributions to 403(b)’s are made with pretax dollars and the money made on your contributions are tax deferred which means you are not taxed on them until you withdrawal the money.
Some employers offer a Roth 403(b) as well as the Traditional 403(b) and you can contribute to both. Contributions are made with after tax dollars and distributions are tax free in retirement. If your tax bracket is likely going to increase at retirement, then a Roth 403(b) might be a better choice for you.
Contributions:
There are contribution limits that change every year for both the Traditional 403(b) and Roth 403(b). In 2023 the contribution limit is $22,500 and if you are 50 or older you can make a “catch-up” contribution of $7,500. Some employers offer a match and that is essentially free money that can give your retirement savings a boost.
Distributions:
If you are 59 ½ you can withdrawal from your 403(b) without penalty. If you have separated from your employer, you would still have to wait to take your money until you are 59 ½ without penalty unless you separated in the year you turned 55. The penalty for early withdrawals is 10% which is on top of the 20% Federal tax and any state tax that might apply.
All employers have their own rules outside of the standard IRS rules so make sure to check with your benefits department to see what those rules are. For instance, you can take loans from your 403(b) but only if your employer allows it.
The maximum loan amount is 50% of your vested account balance or $50,000 whichever is less, and you must repay the loan within 5 years and payments must be made at lease quarterly. The interest rate on loans is the prime rate plus 1% so if the prime rate is 3% then you would add 1% and that is the interest you would owe on your loan.
Some employers only allow loans for hardships. There are 7 categories that constitute a hardship, and you must supply documentation for any claim.
- Expenses for medical care for you, your spouse, your children or other dependents.
- To pay for the purchase of a primary residence excluding mortgage payments.
- Post secondary education for you, your spouse, your children or other dependents.
- To prevent eviction or foreclosure of your principal residence.
- To pay funeral expenses for a parent, spouse, children or other dependents.
- To repair damage to your principal residence.
- Expenses and losses incurred by the employee on account of a disaster declared by FEMA.
Rollovers, Exchanges and Transfers:
Rolling over to an IRA does give you more investment options and you can do a direct rollover to an IRA if you are separated from service, or you have reached age 59 ½ and the plan document allows it. If you retire in the year, you turn 55 but are not yet 59 ½ it is advised you not roll over to an IRA because at age 55 the 10% tax penalty is waived so you can take normal distributions but, in an IRA, you will have to wait until you are 59 ½ to take distributions penalty free.
If you leave your employer for another that offers a 403(b) you can roll that money over to the new employer’s plan which is called a transfer. If you stay with your employer but aren’t happy with the vendor, you can do what’s called an exchange.
RMD:
403(b)’s are subject to required minimum distributions at age 73 but starting in 2024 RMD’s from Roth 403(b)’s will no longer be required. You can take your first RMD by December 31st or delay it until April 1st of next year but in doing so you would have to take 2 RMD’s in 1 tax year.
RMD’s are calculated using the prior year balance of your account and dividing it by a life expectancy factor that the IRS publishes. You are responsible for taking this RMD every year and if the RMD does not get taken, you are subject to a penalty of 25% of the distribution. The penalty may be reduced to 10% if the amount is withdrawn within 2 years.
Some people think you can only work with a financial professional if you have a lot of money and that is not the case. 403(b) accounts are very complex, and these are just some of the rules regarding them and they are subject to change every year, a financial professional can help ease the stress of trying to remember everything your plan offers and all the rules surrounding it. We are happy to meet with you to discuss any questions you may have.