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Friday, May 24, 2024

Unraveling the 403(b): Eligibility, withdrawal rules & taxes

Unraveling the 403(b): Eligibility, withdrawal rules & taxes


What is a 403(b) plan?

A 403(b) plan is a workplace retirement plan designed to help employees save for retirement while receiving certain tax benefits.

403(b) plans are typically offered by public schools and higher education institutions, churches, and charitable entities classified as tax-exempt under the Internal Revenue Code Section 501(c)(3).

403(b) vs. other retirement plans

403(b) plans, 401(k) plans, and 457(b) plans are all workplace retirement plans that have similar tax advantages, contribution limits, and other characteristics. There are some differences in contribution rules, investment options, and other minor features, the most important difference is who can use each type of account.

As mentioned, a 403(b) is usually offered by public schools, non-profit organizations, and churches. Meanwhile, a 401(k) is offered by for-profit companies, and a 457(b) is offered by state and local governments and tax-exempt organizations (including, but not limited to, 501(c)(3) organizations).

There are fewer similarities between 403(b) plans and individual retirement plans (IRAs). They have similar tax advantages but significantly lower contribution limits.

Read more: Roth 401k vs. Roth IRA

Eligibility for a 403(b) plan

403(b) plans are generally offered by public schools, churches, and non-profit organizations. You may be eligible to participate in a 403(b) plan if you are one of the following:

  • An employee in a 501(c)(3) organization
  • An employee of a public school involved in its day-to-day operations
  • An employee of a cooperative hospital service organization
  • A minister if you’re employed by a 501(c)(3) organization, self-employed, or employed by another organization and function as a minister in your day-to-day professional responsibilities

Employers that choose to offer 403(b) plans are subject to the “universal availability rule,” which states that if they offer the plan to one employee, they must offer the plan to all employees. However, the following employees may be excluded from a workplace 403(b) plan:

  • Employees who participate in another 401(k) or 403(b) with the same employer
  • Nonresident aliens
  • Employees who work less than 20 hours per week
  • Students enrolled and regularly attention classes at an institution and working for the school or for a non-profit organization operated for the benefit of the school

How does a 403(b) work?

A 403(b) plan is a type of retirement plan that allows employees to save and invest for retirement while receiving certain tax advantages.

Most 403(b) contributions are made with pre-tax dollars, which means employees aren’t taxed on the dollars they contribute to their 403(b). This lowers their taxable income for the current year. The money then grows tax-deferred in the 403(b) plan and won’t be taxed until it’s withdrawn during retirement.

403(b) plans can also be designed to accept Roth contributions, which means the contributions are made after tax but then are eligible for tax-free growth and tax-free distributions.

403(b) plans generally have fewer investment types that can be utilized than other retirement accounts, such as 401(a) plans and IRAs. The dollars contributed can be placed in annuity contracts, custodial accounts invested in mutual funds, or retirement income accounts invested in annuities or mutual funds.

The money in a 403(b) plan is intended for retirement, meaning it’s not intended to be withdrawn until an employee reaches age 59 ½. Most distributions before that age will result in a 10% penalty tax.

403(b) contribution limits

Each employee offered a 403(b) plan can contribute $22,500 in 2023 and $23,000 in 2024. 403(b) plans may also offer two different catch-up provisions:

  • Catch-up provision for employees with 15 years of service: Employees may contribute an additional amount that’s the lesser of:
    • $3,000; or
    • $15,000, reduced by the number of additional elective deferrals made in previous years; or
    • $5,000 times the number of years of service with the organization, minus any elective deferrals made in previous years.
  • Catch-up provision for employees age 50 and older: Employees may contribute an additional $7,500.

In addition to employee contributions, employers can also contribute to their employees’ plans. Employer contributions are often made as matching contributions, meaning an organization will match an employee’s contributions up to a certain percent of that person’s salary.

Cashing out a 403(b) after leaving a job

Options for handling a 403(b) upon job departure

When you leave a job where you had a 403(b) plan, you have three different options:

  • Leave the money with the current provider: If your employer allows it, you may choose to leave the money where it is. You won’t be able to make any more contributions, but you can leave your money invested so it can continue to grow.
  • Roll over to another qualified retirement plan: You can roll the money in your 403(b) plan over into the retirement plan at your new employer, or you can choose to roll it into an IRA.
  • Cash out the 403(b) account: You can choose to take a distribution from your 403(b).

Considerations for cashing out a 403(b)

If you’re considering cashing out a 403(b) after leaving a job, there are three major downsides to consider. First, you’ll pay income taxes on any money you withdraw from your 403(b) plan. The amount you'll pay depends on your marginal tax rate. Additionally, if you’re under age 59 ½, you’ll pay a 10% penalty tax.

Another downside to consider when cashing out a 403(b) is your lost potential investment earnings. If you left the money invested, you would continue to earn money in the account until you withdrew it during retirement. But once you withdraw it, you lose out on the tax-free investment growth.

Pros and cons of a 403(b) plan

403(b) plans have some major advantages but also a few downsides to consider:

  • Tax advantages: In most cases, the money you contribute to your 403(b) will be pre-tax, meaning you’ll pay lower income taxes in the current year and enjoy tax-free investment growth. You may also make Roth contributions, which allow for tax-free withdrawals.
  • Flexibility in contributions: 403(b) plans, like most workplace retirement plans, have high contribution limits that allow you to invest far more than you could in an IRA.
  • Optional loans and hardship distributions: While you generally can’t take penalty-free withdrawals from your 403(b) before age 59 ½, there are exceptions for loans from the plan and certain hardship withdrawals.
  • Limited investment options: 403(b) plans have limited investment options as compared to 401(k) plans or IRAs. The money can only be invested in annuities or mutual funds.
  • Potential administrative costs: 403(b) plans and other workplace retirement plans often have higher administrative costs than an IRA.

Participant loans in 403(b) plans

If your employer allows it, you can take a loan from your 403(b) plan. The maximum amount you can borrow is $50,000 or half of your vested account balance, whichever is less. If your account has less than $10,000, you may be able to borrow up to the full balance.

When you take a 403(b) loan, you must generally repay it within five years with regular payments that happen at least quarterly. However, if you leave your job before the loan is repaid, you may be required to either repay it in full right away or have it count as a taxable distribution.

In-service withdrawals from a 403(b) plan

An in-service withdrawal is when you take money from your 403(b) while you still work for the employer that administers it. Most plans allow employees to take withdrawals from a plan once they reach age 59 ½. But if you’re younger and want to withdraw money from your 403(b) without leaving your employer, you can only do so under certain situations.

First, a distribution can be done if the employed individual either dies or becomes disabled. The other situation in which you can take an in-service withdrawal before you reach 59 ½ is if you have a financial hardship and the plan allows hardship withdrawals. According to the IRS,1 a hardship withdrawal must meet both of the following requirements:

  • It's due to an immediate and heavy financial need
  • It’s limited to the amount necessary to satisfy the financial need

How does a 403(b) work when you retire?

As you prepare for retirement, you’ll have to decide how you want to receive your 403(b) distributions. You should also prepare for the tax liability that will accompany those distributions.

Retirement distribution options

When it comes to choosing how to take money from your 403(b) plan, you generally have three primary options depending on the terms of the plan:

  • Lump-sum distribution: Withdraw your full 403(b) balance at the time of retirement and either roll the money into an IRA or place it into a taxable brokerage or savings account. The benefit of this option is you have control over the money, but depending on where you place it, you may also be required to pay taxes on the full balance at once.
  • Annuity payout options: An annuity is an insurance contract that provides a guaranteed income in exchange for an upfront payment. An annuity guarantees an income for the rest of your life, regardless of the economy. However, you could leave money on the table, especially if you pass away early and don’t have survivor benefits.
  • Systematic withdrawal plans: Taking systematic withdrawals from your 403(b) plan means you’ll get regular payments from the plan — these can be monthly, quarterly, semi-annually, or annually. The money still in the account can remain invested and continue to grow.

Taxation of 403(b) distributions in retirement

If you made pre-tax contributions to your 403(b) plan, you’ll have to pay income taxes on all distributions. Your distributions will be treated and taxed as ordinary income. The rate you pay will depend on what tax bracket you fall into. The federal income tax brackets in the U.S. range from 10% to 37%. However, most people have an effective tax rate — meaning the average rate at which all their income is taxed — that falls between two of those numbers.

If you made Roth — meaning after-tax — contributions to your 403(b) plan, then you’ve already paid all the taxes you need to. Assuming you meet all the rules for a qualified distribution, you won’t pay any taxes on the money you withdraw.

Read more: Retirement withdrawals


1 IRS, “Retirement Topics - Hardship Distributions,” April 2023.


The Currency editors

Staff contributors

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