403b plans are tax-deferred retirement accounts offered to employees of nonprofit organizations such as schools and hospitals. These plans provide a way for employees to contribute pretax earnings to grow tax-deferred until retirement. They also reduce the income tax an employee must pay since the amount of the contribution reduces employee's income thereby acting as a tax deduction.
As long as the organization offers a 403b plan, an employee can contribute. However, there are limits on the amount an employee can contribute in a year. These limits are set by the IRS and may change from one year to the next. The maximum allowed contributable (MAC) limit is based on the elective deferral, what the employee contributes from his/her paycheck and the annual additions limit which includes the elective deferral and the employer's nonelective contributions. The limit also includes a special provision unique to the 403b known as the 15 year rule. Employees who have worked more than the 15 years at their organization qualify for an increase in the elective deferral limit. In addition, a catch up contribution is allowed for employees who are 50 or older at the end of the year. This catch up is not included in the maximum limit. If the elective deferral is more than the allowed limit a penalty will be incurred. Generally, an employer will warn an employee that their contributions are in danger of going over the limit. More information about limits for the current tax year can be found in IRS Publication 571.
Additionally, if the plan allows it, an employee can make after-tax contributions to a 403b. The contributions will be taxed at the employee's current income tax rate but will then grow tax-deferred. Upon withdrawal the original after-tax contribution will not be taxed but earnings will be taxed.
403bs can be invested in annuities or mutual funds. Annuities are tax-deferred investments so there inclusion in a 403b is redundant for tax purposes. Most annuities incur sales charges and surrender charges. Also, the fees are often higher than mutual funds. Apart from that, fixed annuities can be a better option than a loaded mutual fund if the annuity has no sales charges, has no surrender charges, and has low fees. However, mutual funds offer a better option. Mutual funds can be invested in bonds, stocks, real estate, commodities, and other investments. To get the most from a mutual fund choose one that is a no-load fund, has no 12b-1 fees, and is low in total expenses. The industry average for total expenses is 1.5%.
It is wise to get prospectuses from several of the plan vendors and carefully compare fund objectives and expenses. Although this comparison can get complex with many options, research now will pay off in the future. Also, the 403b plan has two sets of fees. The fees charged by the vendors are the investment fees such as the total expenses of a mutual fund. The other fees are administrative for the management of the organization's 403b. Obviously the lower the fees, the better the return so again taking the time to compare funds is wise.
Early withdrawals and loans may be permitted from a 403b. However, employers may not allow withdrawals from the plan. One type of possible withdrawal is known as the hardship withdrawal. To qualify for such a withdrawal the employee must have no other resources and be unable to secure a loan. Also, the withdrawal is limited as to how it can be spent. Hardship withdrawals are subject to a 10% penalty from the IRS and will be taxed at ordinary income tax rates. For any loans or withdrawals it is best to consult with a tax professional.
Withdrawals after age 59 1/2 are permitted penalty-free. If the employee retires at age 55 or becomes disabled withdrawals are penalty-free as well. Once the employee turns 70 ½ he/she is required to start taking required minimum distributions (RMDs) from the 403b. RMDs are calculated based on the balance in the 403b divided by the life expectancy of the employee and his/her beneficiaries. Tables and worksheets to figure this calculation are available through the IRS website. A penalty of 50% of the remaining balance will be charged by the IRS if the correct RMD is not withdrawn or withdrawn later than the required distribution date. Distributions greater than the RMD are allowed. RMDs are taxed at ordinary income tax rates.
A 403b plan offers tax-advantages to employees of nonprofit organizations. They provide a convenient way for pre-tax earnings to grow in value to provide for a comfortable retirement. If one of these plans is offered at an employee's work, if is a wise choice for him/her to take full advantage of it.
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