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What is a 403(b)?

The 403(b) is a tax deferred retirement plan available to employees of educational institutions and certain non-profit organizations as determined by section 501(c) of the Internal Revenue Code. Participants contribute to either annuity contracts (often called a TSA) with insurance companies, or directly with mutual fund companies (this is known as a 403(b)(7) custodial account). Contributions and investment earnings grow tax deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income. The 403(b) was established in 1958 by the federal government to encourage employees in certain tax-exempt organizations to establish retirement savings programs.

Who is eligible to contribute to a 403(b)?

Employees of public schools and certain tax-exempt organizations - as determined by Section 501(c)(3) of the Internal Revenue Code - can participate in a 403(b) plan.

A qualified employer, in the eyes of the IRS, is an organization that is "organized and operated exclusively for religious, charitable, scientific, public-safety testing, literary, or educational purposes." These types of institutions include K-12 public schools, colleges, universities, hospitals, libraries, philanthropic organizations, and churches.

What investment options are available to 403(b) participants?

Unlike the 401(k), 403(b) participants cannot invest in individual stocks. Instead, their choices are:
  • Annuity and variable annuity contracts with insurance companies.
  • A custodial account made up of mutual funds. This is known as a 403(b)(7).
  • Retirement income accounts for churches.
Why contribute to a 403(b)?
  • A Healthy Retirement - Most employees of educational institutions and other non-profit organizations are provided with a pension upon retirement. Few pension plans, however, provide an amount equal to salary. A 403(b) plan can provide a healthy supplement to a pension.
  • Lower Taxes - 403(b) contributions are made on a pre-tax basis which can greatly reduce your tax bill. Generally, if you contribute $100 a month to a 403(b) plan, you've reduced your Federal income taxes by roughly $27 (assuming you are in the 27% tax bracket). In affect, your $100 contribution costs you only $73. The tax savings are magnified as your 403(b) contribution increases.
  • More Tax Savings - all dividends, interest and capital gains accumulate in a 403(b) account on a tax-deferred basis. This means your earnings will grow tax-free until time of withdrawal.
How does a 403(b) plan work?

Similar to a 401(k), employees set aside money for retirement on a pretax basis through a salary reduction agreement. The employees can select where their money is to be invested from among the vendors offered by the employer. The money grows tax free until withdrawal at retirement.

Will participation in a 403(b) plan reduce Social Security benefits?

No. Salary reduction contributions to a 403(b) reduce taxable compensation for federal (and in most instances, state) income tax purposes only. Those contributions do not reduce wages for the purpose of determining FICA taxes or determining social security benefits.

Are all employees eligible to contribute to a 403(b)?

In order to meet nondiscrimination requirements of the law, once a plan sponsor permits any employee to elect a salary deferral into the TSA, the opportunity must be extended to all employees of the organization who may elect to have the plan sponsor make contributions of more than $200 pursuant to a salary reduction agreement. Certain employees may be excluded. Employees who may be excluded include employees who are participants in an eligible deferred compensation plan (457 or 401(k)) or participants in another TSA, non-resident aliens, certain students and employees who normally work less than 20 hours per week. Employers must take special care to comply with this requirement. Non-compliance could result in the entire 403(b) TSA losing its tax-favored treatment.

What does a 403(b) plan cost and who is paying for it?

Typically, the plan has two kinds of expenses: administrative costs and investment management fees. Investment management fees are usually charged by the investment company as a percentage of the total assets under management.

How much can employees contribute annually?

For 2003, employees are able to contribute:
  • the elective deferral limit of $12,000 (going up to $13,000 in 2004), or
  • up to 100% of compensation (must be less than the elective deferral limit), or
  • for those with employer matches, limits are the lesser of $40,000 or 100% of compensation. Note: the employee is still limited to the employee elective deferral limit ($12,000 for 2003). An employer can add up to another $28,000.
  • in addition, individuals who are 50 or older at any time during 2003 may contribute an additional $2,000.
Note: a special 15 years of service catch-up election, known as the 15-year-rule, will remain in place. This special "catch-up" provision allows employees to increase their annual contribution by $3,000 more than the current $12,000 limit (as of 2003). To qualify the employee must have completed at least 15 years of service with the same employer (years of service need not be consecutive), and the employee cannot have contributed more than an average of $5,000 in previous years. Contributions made under this catch-up provision cannot exceed $3,000 per year, up to a $15,000 lifetime maximum (under current rules). Consulting a tax professional before participating in this provision is highly recommended.

Why is the 403(b) often called a TSA or TDA?

When the 403(b) was created in 1958, participants could only invest in annuity products, so the name Tax-Sheltered Annuity (TSA) or Tax-Deferred Annuity (TDA) took root. Despite the fact that Congress granted 403(b) participants mutual fund privileges in 1974, the TSA/TDA name remains very common today.

Can a 403(b) be rolled into an IRA?

Yes. This can occur when the participant:
  • Separates from service (job change)
  • Retires
  • Becomes disabled
  • Dies
When can 403(b) money be accessed without penalty?

Generally, penalty-free distribution from a 403(b) cannot occur until the participant:
  • Reaches age 59 1/2
  • Separates from service in the year turning 55 (and must be retired)
  • Retire before age 55 - eligible for Substantially Equal Periodic Payments (SEPP). Participants who have retired early (before age 55), but want access to their 403(b) without penalty can do so using SEPP. This provision requires that you take a series of substantially equal periodic payments. The key is that once you start these payments they must continue for five years or until you reach 59 1/2, whichever takes longer. If you start at age 58 you must continue until you are 63 (minimum 5 years).
  • Becomes disabled
  • Through a loan (some investment companies allow this, some don't)
  • Suffers financial hardship
  • Dies
How is a 403(b) different from a TSA (tax-sheltered annuity)?

As far as the IRS is concerned a 403(b) is TSA, and a TSA is a 403(b). The terms are interchangeable. Either way, participants can contribute to annuities or mutual funds. While there are differences, you may want to think of a 403(b) as a 401k, its better-known and better-utilized private sector sibling.

How is a 403(b) different from a 401(k)?

The 401(k) is a tax-deferred retirement plan for private sector employees, while the 403(b) is a tax-deferred retirement plan for employees of educational institutions and certain non-profit organizations.

What is a 457(b) plan?

A 457(b) plan is a deferred compensation plan for employees of an eligible employer - a state, local, or municipal governmental entity. Public school districts are eligible employers and may maintain a 457(b) plan in addition to a 403(b) plan.

What is the maximum amount an employee can contribute to a 457 plan?

The regular 457 deferral limit is $12,000 in 2003 and increases by $1,000 per year through 2006. For employees age 50 and older the contribution limit is $14,000 in 2003 and increase by $2,000 per year through 2006.

Additionally, employees within three years of normal retirement age may be eligible to contribute a maximum of $22,000 under a special "catch-up" arrangement.

How are contributions treated for Social Security purposes?

Deferrals into a 457 plan reduce compensation for federal and state income purposes only. Employer and employee Social Security and Medicaid taxes are computed on total salary.

Can funds be withdrawn during employment?

If allowed under the plan, participants in the plan who have less than $5,000 and have not made any contributions to the plan for two years may withdraw their entire account.

If a participant experiences an "unforeseeable" or unexpected illness, accident, uninsured loss of property, or other extraordinary circumstance beyond the control of the participant then they may withdraw the amount of the hardship.

There is no 10% excise tax assessed against any withdrawal from a 457 plan.

What is a 457(f) plan?

A 457(f) plan is a deferred compensation plan for a select group of highly compensated employees (HCE's) of an ineligible employer, generally a tax-exempt or not-for-profit organization. Because these plans are limited to HCE's they are exempt from the ERISA requirements imposed on 401(k) and 403(b) plans.

Who qualifies as a highly compensated employee (HCE) for the purpose of participation in a 457(f) plan?

Generally, only HCE's with sufficient clout to protect their own interests can qualify. HCE's must constitute a small percentage to ensure that the group is "select" and their average compensation is substantially higher than that of other employees. The safe harbor generally amounts to about 10% of total employees.

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