A 403(b) plan is a type of tax sheltered retirement plan which has a lot in common with the more widely recognized 401(k) plans. A 403(b) plan is for employees who work in organizations that serve certain religious, charitable, scientific, public safety testing, literary or educational purposes. If you are eligible to participate in a 403(b) plan, you should know that there are a lot of benefits. Let's take a look at the top nine benefits of a 403(b) plan. (These plans resemble 401(k) plans in many respects, but are specially designed for nonprofit entities. To learn more, read The 4-1-1 on 403(b) Plans.)
1. Contributions to a traditional 403(b) plan are tax deductible.
Contributions to a traditional 403(b) plan are deductible for federal income tax purposes. In effect, money is placed into the 403(b) plan without having to pay any taxes on it. The tax deduction can be highly valuable since it reduces the amount of income tax paid at the individual's marginal tax bracket. For example, if the last $10,000 of a worker's adjusted gross income were be taxed in the 25% tax bracket, putting that $10,000 into a traditional 403(b) would net a tax savings of $2,500.
2. Taxes are paid on distributions in retirement - a time when many people are in a lower tax bracket.
If you make traditional pretax contributions, you will have to pay taxes on distributions in retirement. The good news is that most people are in a lower tax bracket when they retire, and most retirees require less income than at their peak earning years. Many retirees have already paid off their houses and cars, and their kids are out of the house and through college. In addition, retirees don't have to pay for many work-related expenses such as a professional wardrobe and commuting costs. In addition to the decreased cost of living, many states offer varying tax advantages to the elderly.
3. Some 403(b) plans have a Roth option.
Since 2006, employers have had the option to allow Roth contributions to 403(b) plans. Unlike a traditional IRA, Roth contributions are not eligible for a tax deduction. However, when you make withdrawals from the Roth portion of your plan, those withdrawals are not taxable. Not all 403(b) plans have instituted the Roth option. The employer must elect to institute a Roth option in order to make it available to employees. (Roth accounts tend to beat Traditional plans over the long term by providing tax savings. For more information, refer to Roth Feature Boosts Benefits For 401(k) And 403(b) Plans.)
4. Savings grow tax-free.
A huge advantage of a 403(b) plan is that you do not have to pay taxes on dividends, interest and capital gains on your investments held in the 403(b) account. If you hold your retirement investments in a normal taxable brokerage account, you will lose a lot of potential earnings due to the significant drag that taxes can impose. Since you don't have to worry about tax effects in your 403(b), you can rebalance your portfolio more often without losing anything except trading fees. You also don't have to worry about the tax efficiency of any mutual funds you hold, allowing you a free hand to focus purely on high returns and low expenses.
5. Loans can be taken against a 403(b) plan.
Although it depends on the specific provisions of your 403(b) plan, most people will find they are allowed to take a loan out of their 403(b) plans. This can be a big help in certain situations, such as buying a home. If you choose to use this benefit, you must make sure you understand all of the consequences. Many advisors warn against this idea because it leaves less money in the 403(b) plan invested for your retirement. Therefore, you must make sure you have enough saved that you can afford to withdraw the loan. The requirements for the loan are very exacting. Missing even one payment on the loan can mean that you have defaulted on the entire loan amount, triggering IRS penalties for an early withdrawal.
6. Employers can offer matching contributions on a 403(b) plan.
Another big reason to put money into a 403(b) is because your employer offers matching contributions. If this is the case, you should be sure to contribute in order to take advantage of this free money. Oddly enough, employers can only contribute to your 403(b) on a pretax basis. Employers will match Roth contributions up to specified limits, but they have to do it with pretax money. Therefore, 403(b) contributions matched by an employer are subject to taxation of the initial amount and any subsequent capital gains.
7. Some 403(b) custodians will allow employees to invest in low-cost "institutional" funds, which otherwise have prohibitively high investment minimums.
Sometimes 403(b) plans can get you a better deal on your investments than you can get on your own. Why? Although financial institutions will often reject undertaking small portfolio responsibilities, taking on 403(b) fund management roles means they have access to hundreds of millions of dollars of new assets. To entice big clients, institutions sometimes waive the prohibitively high minimum investment requirements so that employees can invest in "institutional" funds, which have extremely low expenses. For example, the Vanguard Institutional Index Fund Institutional Plus Shares (VIIIX) has an expense ratio of 0.025% and normally requires an investment minimum of $200 million dollars. However, you can invest in this fund through a 403(b).
8. Contribution limits are higher than for IRAs.
The more money that you can save for your retirement on a tax-sheltered basis, the better off you will be. As an employee, you can put up to $16,500 into a 403(b) in 2010. Employees who are 50 or older may be eligible to make up to a $5,500 additional catch up contribution in 2010. These contribution limits are huge compared with the $5,000 limit and $1,000 catch up limits on IRAs. (Stay up to date on regulation amendments to avoid penalties as well as take advantage of new opportunities. Check out Tax-Law Changes: Involuntary Cash-Out and Roth 401(k) and 403(b).)
9. Some employees may be eligible to make additional contributions based on the "15-year rule."
A unique benefit of 403(b) plans is that they allow additional contributions for those that have 15 years of service with the same employer and have not contributed in excess of the cutoff point in previous years. The maximum additional cutoff point and contribution is $5,000 and $3,000 respectively for 2010. Employees must determine the amount of additional contributions they are able to make by applying a three-part rule found in the IRS Publication 571.
The Bottom Line
As you can see, there are many things to like about 403(b) plans. To best capitalize on these benefits, the key is to contribute early and frequently. Often it is possible to arrange with your payroll department to have a small percentage deposited in a 403(b) directly from your paycheck so you don't even notice it. It is sometimes difficult to get started, especially if retirement is still far off. However, even relatively small contributions made consistently over time have a way of adding up. (For more information about retirement, see Journey Through The 6 Stages Of Retirement.)
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