403(b) Plan

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What is a '403(b) Plan'

A 403(b) plan is a retirement plan for specific employees of public schools, tax-exempt organizations and certain ministers. These plans can invest in either annuities or mutual funds. A 403(b) plan is another name for a tax-sheltered annuity (TSA) plan. The features of a 403(b) plan are comparable to those found in a 401(k) plan.

BREAKING DOWN '403(b) Plan'

Employees may make salary deferral contributions. However, they are bound by regulatory limits. Individual accounts in a 403(b) plan include an annuity contract, bought through an insurance company or a custodial account, which invests in mutual funds or a retirement income account established for church workers.

Employees of tax-exempt organizations are eligible to participate in the plan. Participants include teachers, school administrators, professors, government employees, nurses, doctors and librarians. A TSA is another funding source for retirement in addition to a retirement plan or pension that helps employees meet their retirement goals. Many plans vest funds over a shorter period than 401(k) plans or may allow immediate vesting of funds.

Benefits

Earnings and returns on amounts in a 403(b) plan are tax-deferred until withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions. Employees age 50 or over can make catch-up contributions to both plan types. Employees may be eligible for matching contributions, which varies by employer.

For example, an employer matches funds at 50% of any contributions an employee gives, up to 6% of an employee's salary. If an employee earns $75,000 and contributes 6%, or $4,500, the employer contributes $2,250, which is essentially free money towards the employee's retirement. This helps employees exceed the annual maximum contribution limits, receive tax deductions and accelerate their retirement goals.

How to Contribute

Different types of contributions fund TSAs, such as after-tax contributions, nonelective contributions and elective deferrals. After-tax contributions are voluntary contributions up to 25% of a participant's salary that a participant must include in income when filing taxes. Nonelective contributions are mandatory employer contributions, such as discretionary contributions that include end-of-plan-year contributions or profit-sharing contributions.

Elective deferrals are voluntary contributions set up by the employee that allows an employer to withhold money from the employee's paycheck to be paid directly into his TSA. These contributions are a percentage of the employee's salary. Another funding option is using a combination of elective, nonelective and after-tax contributions.

Disadvantages

A TSA plan withdrawal before age 59 1/2 is subject to a 10% tax penalty. A participant may avoid the 10% penalty under certain circumstances, such as separating from an employer when a person reaches age 55, a qualified medical expense, death of the employee or disability. Withdrawals assess a 20% federal income tax withholding unless the total amount is transferred to another qualified retirement plan or individual retirement account. However, if a participant wants to dissolve an annuity investment, the participant must pay a surrender charge of up to 8% of the investment.

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