What Are the Pros and Cons of 403b Plans?

Individual retirement plans known as 403b plans are a type offered to employees of certain organizations including public schools and nonprofit organizations and to some ministers. Since these individuals do not often have the option of a 401k plan through their employers, they can set up tax-sheltered annuities, also known as 403b plans, to save for retirement. Like any retirement plan, the 403b plan offers unique benefits and challenges to a retiree.

Three Primary Benefits of a 403b Plan

  • Contributions to a 403b plan are tax deductible. This occurs because pre-tax dollars can be deposited into the account. The net effect is a reduction of annual taxable income equal to the amount contributed. The amount you can deduct is subject to annual maximum restrictions based on your income.
  • While your money is held in the 403b plan, you can grow the sum through targeted investments. You will not pay taxes on this growth until you withdraw the funds from the account. At that time, you will be taxed at your current income rate. Ideally, your income tax rate will be lower at this point since you have retired. 
  • Certain individuals may be eligible for a tax credit based on deferred income placed in a 403b account.

Drawbacks of a 403b Account

  • You receive tax benefits on a 403b account only if you use the money for its intended purpose. As a result, withdrawing any money prior to the required minimum retirement age will result in a penalty. This penalty is equal to the taxes owed at an income tax rate equal to your current income tax bracket as well as a 10 percent penalty on the early withdrawal. Once you place money into a 403b, you have turned liquid cash into an illiquid asset.
  • You will face some restrictions on investments held in a 403b. For example, some high-risk investments may not be purchased with funds in a 403b. 
  • If you contribute too much to a 403b account, you may face penalties from the IRS. The annual maximum will limit the amount of personal savings you can deposit into a tax-deferred account.
  • Once you reach the age of 70 1/2, you will be required to make deductions at a designated amount. If you fail to withdraw funds according to your required minimum distribution schedule, you will face excess contribution penalties.
  • There are restrictions on how you designate beneficiaries on a tax-deferred account. You will have to specifically designate a beneficiary prior to your death. Due to the tax status of the account, the beneficiary may also face distribution requirements from the IRS. 
  • Ultimately, when you place your money in an account that qualifies for a specific tax status, you are removing your independence over the use of the funds. In order to receive the benefits the IRS is willing to provide, you must also follow the IRS's rules on the account. Only set up a 403b if you are willing to follow these rules because breaking the rules will result in penalties on your account and subsequent financial losses. 

Are part-time employees eligible to contribute to a 403b plan?

Part-time employees are eligible to receive tax benefits for contributions to a 403b plan. However, smaller contribution limits will apply for a part-time employee. To determine your contribution limits, determine the ratio of time you worked compared to the amount you would have worked if you were full time. If you worked the equivalent of a full-time position at any point during the year, your contribution limit would be that of a full-time salary earner for that period. For all other periods, use the ratio of part to full time and use the IRS worksheet for maximum amount contribution (MAC) to determine your allotted amount. 

What are the 403b contribution limits?

The annual 403b contribution limits are set annually by the IRS. There are two separate limits:one is set for a combination of employer and employee contributions, and one is set to limit the amount of elective deferrals an employee can make through a paycheck. The annual limit for 2009, for example, was the lesser of

  • $49,000 or
  • 100% of the employee’s includable compensation

In addition, the maximum that could be contributed through deferrals was $16,500. This amount could be increased if the individual had served in a public school or hospital for more than 15 years. The only way to truly determine annual maximums is to fill out an IRS worksheet to ensure you are claiming all eligible expansions.




Who can contribute to a 403b plan?

A 403b plan is offered only to individuals in certain public service or nonprofit roles. Generally speaking, these retirement plans are used by public school teachers, hospital workers and social workers. They may also be extended to the employees of eligible nonprofit corporations. The 403b plans are very similar to 401k plans offered to employees of other companies. Like a 401k, a 403b plan offers employees the option to reduce annual income by an amount contributed to the retirement account and, in turn, to receive a tax reduction each year. Also like a 401k, a 403b account places restrictions on when the money can be withdrawn and for what purposes. 

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