The 403(b) plan, named for section 403(b) of the Internal Revenue Code, is a type of retirement plan. The money contributed to a 403(b) comes from before-tax dollars. These dollars are deducted from one's paycheck before they are taxed. Thus, job earnings you contribute to one of these retirement plans are not taxed while they remain in the fund (although how much may be contributed pre-tax is limited).
Employees of non-profit organizations, such as hospitals, museums, public foundations, churches, research organizations, and public educational systems are eligible for participation in 403(b) plans. Part-time employees may participate in all qualified plans unless they are expressly prohibited because of individual plan requirements. In addition, the employer may establish eligibility guidelines for different classes of employees.
In most cases, contributions to a 403(b) plan are made from employees' elective deferrals. The employee signs a salary reduction agreement with the employer, authorizing him or her to deduct a certain amount from the employee's wages. The employee's W2 will reflect the lower taxable income. This money is used to purchase an annuity contract or a custodial account holding mutual funds. This annuity or custodial account is the vehicle in which the 403(b) plan is invested. An employer may also make contributions to the plan even if the employee doesn't make any elective deductions.
The maximum amount contributable (MAC)—formerly called an "exclusion allowance"— is the maximum amount that can be deferred to the plan free of tax. Thus, if the MAC is $2,000, up to $2,000 worth of deferrals will be tax-free. Amounts exceeding that will be taxed. The IRS issues regulations and formulas to help compute an individual's MAC for the year. Generally, an employee can elect to defer up to $16,500 for 2009 (up from $15,500 for 2008); those over 50 are entitled to defer a "catch-up" of $5,500 for 2009 (up from $5,000 for 2008). However, both elective deferrals and employer contributions may not exceed the lesser of $49,000 in 2009 ($46,000 in 2008) or the MAC.
The individual may elect to defer an amount up to the lesser of $16,500 or the MAC. This is pre-tax, so no deduction can be taken on a tax return. The employee's W2 will reflect the lower taxable income. Tax is also deferred on the contributions, the net investment income, and realized capital gains that accumulate in the plan, until the individual begins making withdrawals from it. For example, imagine a teacher who paid $10,000 into a 403(b) over several years. Suppose that the account is now worth $16,000. If the teacher chooses to receive a lump sum payout, the entire amount ($16,000) will be taxed as ordinary income.
It should be noted that participation in a 403(b) plan qualifies as participation in an employer-sponsored retirement program. This may have consequences for an individual who is putting money into a second retirement plan. Someone who contributes to a tax-deferred annuity plan may not be eligible (depending upon his or her income) to deduct contributions to an individual retirement account.
403(b) plans offer the employees of non-profit organizations many of the same kinds of retirement investing and tax savings benefits that 401(k) plans have traditionally offered to employees of for-profit organizations.
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