403(b)

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The 403(b) is a tax deferred, defined contribution plan available to employees of educational institutions such as public school districts and certain (Internal Revenue Code section) 501(c)(3) non-profit groups, which include colleges, universities, hospitals, charities and the clergy.

Plan basics
Contributions to a 403(b) plan are tax-deductible, and any earnings accumulate tax-free until withdrawals are made. Withdrawals are taxed at ordinary income rates, and a 10% penalty tax is assessed on withdrawals made prior to the age of 59 ½.

Employees may contribute up to 100% of their salaries, subject to the following limits:

Roth 403(b)
Beginning in 2006, 403(b) plans have been allowed the option of providing a Roth 403(b). The Roth 403(b) allows individuals to contribute after-tax dollars to grow tax free and, generally, not be taxed upon withdrawal. A qualified Roth 403(b) distribution is generally a distribution that is made after a 5-taxable-year period of participation and is either: When you roll over a distribution from a designated Roth account to a Roth IRA, the period that the rolled-over funds were in the designated Roth account does not count toward the 5-taxable-year period for determining qualified distributions from the Roth IRA. However, if you had contributed to any Roth IRA in a prior year, the 5-taxable-year period for determining qualified distributions from a Roth IRA is measured from the earlier contribution. So, if the earlier contribution was made more than 5 years ago and you are over 59 ½ a distribution of amounts attributable to a rollover contribution from a designated Roth account would be a qualified distribution from the Roth IRA. If you take a distribution from your designated Roth account before the end of the 5-taxable-year period, it is a nonqualified distribution. You must include the earnings portion of the nonqualified distribution in gross income. However, the basis (or contributions) portion of the nonqualified distribution is not included in gross income. The basis portion of the distribution is determined by multiplying the amount of the nonqualified distribution by the ratio of designated Roth contributions to the total designated Roth account balance. For example, if a nonqualified distribution of $5,000 is made from your designated Roth account when the account consists of $9,400 of designated Roth contributions and $600 of earnings, the distribution consists of $4,700 of designated Roth contributions (that are not includible in your gross income) and $300 of earnings (that are includible in your gross income). See FAQ's on Designated Roth Accounts, IRS. If the plan contains a Roth option, an employee can direct 403(b) contributions to a regular 403(b), a Roth 403(b), or some combination of the two plans; the total contribution cannot exceed the annual contribution limit.
 * 1) made on or after the date you attain age 59½
 * 2) made after your death, or
 * 3) attributable to your being disabled.

A Roth 403(b), is generally subject to required minimum distributions, after you have retired and attained age 72½. To avoid required minimum distributions, an individual can execute a trustee-to-trustee transfer of the Roth 403(b) account to a Roth IRA upon terminating employment.

A Roth 403(b) may be attractive under the following circumstances:
 * If you expect your tax rate in retirement will be higher than it had been during the years you contributed.
 * If you are young and want to use a long investment horizon to accumulate tax-free earnings under a Roth feature.
 * If you are a highly compensated individual who would like to have a pool of tax-free money to draw upon after retirement, and who are not eligible for Roth IRAs due to the income limitations.
 * If you want to leave tax-free money to heirs.

Fifteen year rule
Employees with 15 or more years of service with public school systems, hospitals, home health service agencies, health and welfare agencies, churches, or convention or associations of churches may be able to qualify for a Salary Reduction Catch-Up. This option is only available to those whose prior contributions have averaged less than $5,000 per year. If this qualification is met, the employee may be able to defer an extra $3,000 per annum in catch-up contributions (to a lifetime maximum of $15,000). In the ordering of contributions, the IRS deems that the 15 year service catch-up contributions precede the age 50 catch-up contributions.

Distributions
Basic rules regarding distributions from a 403(b) plan include:


 * A withdrawal of assets prior to age 59-1/2, will be taxable at income tax rates and will result in the IRS imposing a 10 percent penalty tax (unless certain criteria are met.)


 * Penalty-free withdrawals are allowed upon retirement (assumed to be in or after the year in which you reach age 55).
 * Generally, required minimum distributions, must begin from a 403(b) no later than April 1 of the year following the year in which an individual turns age 72. If you are still working, you can delay withdrawal from your 403(b) until April 1 following the year in which you retire.
 * 403(b) account balances that existed on December 31, 1986 are not subject to the age 70-1/2 distribution requirement. However, any earnings on that balance are. Distribution from the 12/31/86 balance needs to start at age 75. (This situation is complex, and consulting a professional tax advisor is recommended.)

If you own more than one 403(b), required minimum distributions are calculated in a manner similar to an IRA. You must calculate the RMD separately for each 403(b) contract that you own, but can take the total amount from one or more of the 403(b) contracts.

Transfers
A number of tax-free transfers and rollovers of 403(b) plans are permissible under the tax laws.


 * Contract exchanges.  If you transfer all or part of your interest from a 403(b) contract to another 403(b) contract (held in the same plan), the transfer is tax free, and is referred to as a contract exchange. This was previously known as a 90-24 transfer. A contract exchange is similar to a 90-24 transfer with one major difference. Previously, you were able to accomplish the transfer without your employer’s involvement. After September 24, 2007, all such transfers are accomplished through a contract exchange requiring your employer’s involvement. In addition, the plan must provide for the exchange and the transferred interest must be subject to the same or stricter distribution restrictions. Finally, your accumulated benefit after the exchange must be equal to what it was before the exchange.
 * If you leave your employer assets can be transferred to your new employer's defined contribution plan, if permitted by that plan.
 * After leaving your employer, assets may be moved to a Rollover Individual Retirement Account (IRA).

Advantages
The advantages a 403(b) plan offers include the following.


 * High contribution limits allow an individual to tax defer more investment dollars than can be contributed to individual retirement plans.
 * Contributions to a regular 403(b) are tax deductible. Tax deductible contributions are especially advantageous if the tax rate is lower when retirement income withdrawals are made. If a Roth option is available, contributions made at low tax rates are advantageous if the tax rate is higher when retirement withdrawals are made.
 * Contributions made to a 403(b) qualify for the Retirement Savings Contributions Credit (Saver's Credit) if you meet the filing and income requirements.
 * Employer's can make matching contributions to employee contributions.
 * Some plans may have loan provisions.
 * If a 403(b) plan offers very low-cost investment options (such as those offered by TIAA-CREF in the university retirement plan market, or by a low cost mutual fund company) investors can reap most of the returns investment markets provide. Unfortunately, the 403(b) marketplace, especially in the K-12 school environment, is primarily populated by high cost, commissioned annuity products.
 * 403(b) plans allow employees who have fifteen years of service to an employer to make up to $15,000 of catch up contributions to the plan.
 * Participants who are eligible for both a 403(b) and a 457(b) through their employer can contribute the maximum of both plans, which at $18,000 each is a combined $36,000.

Criticisms
Since the 403(b) is heavily tied to the insurance industry, History of the 403(b) Plan Sources:
 * 403(b) programs were originally created in 1958 by Congress for employees of tax-exempt corporations.
 * In 1961, public education institutions, including public school districts, became eligible to offer 403(b) plans.
 * In 1973, Congress passed a law allowing employees to make tax-free exchanges of the full account value from one 403(b) plan to another, and partial transfers have been allowed since 1992.
 * In 1974, Congress passed the Employee Retirement Income Security Act (ERISA), which included a provision allowing 403(b) plans to increase the number of their investment options and offer mutual funds in addition to annuities.
 * In 1978, a law was passed allowing employees to roll 403(b) assets into a traditional IRA.
 * Starting in 1982, with the passage of the Tax Equity and Fiscal Responsibility Act, 403(b) participants were allowed to take loans from their plans. Additionally, religious organizations were permitted to set up Retirement Income Accounts, a specialized form of 403(b) plan.
 * In 1986, another tax law imposed restrictions on withdrawals before age 59½ and made them subject to a 10 percent early withdrawal penalty. Additionally, required minimum distributions (after age 70½) were established along with new limits on elective deferrals. The limit established then, $9,500 per person per year, remained in effect until 1998.
 * A 1992 IRS ruling allowed employees to make tax-free full or partial account transfers from annuities to 403(b)(7) mutual fund accounts.
 * The 2001 tax bill, which took effect in 2002, allowed 403(b) participants to roll their money into a 401(k) or governmental 457 plan when changing jobs, in addition to an IRA or other 403(b). Similarly, employees with savings in 401(k) or governmental 457 plans may roll their contributions into a 403(b) plan, if offered by their new employer. The tax bill also simplified the formula used to calculate an employee's annual contribution limit.
 * On July 23, 2007, the IRS finalized new regulations (set to go into full effect January 1, 2009) for public 403(b) retirement plans. The main highlights include:
 * Requirement that a 403(b) program be maintained pursuant to a written plan which satisfies section 403(b) in both form and operation and contains all the terms and conditions for eligibility, limitations, and benefits under the plan.
 * End to traditional 90-24 outside-of-plan transfers.
 * Requirement to provide annual notification of eligibility
 * Clarification of universal availability
 * New information sharing requirements between employers and vendors.
 * The Source: 403(b)& 457(b) Plans, 2nd Edition, National Tax Sheltered Tax Association
 * Overview of new rules, 403(b)wise a common option of 403(b) plans is a tax-sheltered fixed annuity or a variable annuity. These products often come with an extra layer of fees and restrictions such as surrender charges; furthermore, the extra tax-deferral features of the annuity are unnecessary since the 403(b) is already a tax-deferred account.

Mutual funds are a possible option (known as 403(b)(7) custodial accounts) only if they are an available option within the plan. If mutual funds are not available in the 403(b) the participant should consider lobbying the employer to offer some lower fee mutual funds. If you are in this situation see How to campaign for a better 403(b) plan for information on how to proceed.

The following table provides a summary of 2014 year end 403(b) assets as well as the distribution of assets across annuity and mutual fund investment platforms.

Simon's commentary
W. Scott Simon, who writes a monthly Fiduciary Focus column for Morningstar has an eight part series on the 403(b) Plan universe. These plans have been affected by regulation changes effective since January 1, 2009. This series is especially valuable for 403(b) plan providers.


 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 1)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 2)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 3)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 4)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 5)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 6)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 7)
 * Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 8)