The 403(b) in 2020 and 2021
A 403(b) account is a retirement savings plan, or tax shelter, for employees of tax exempt organizations. This includes public school systems, non-profit organizations, and employees of cooperative hospital services. Generally, the 403(b) can be considered the nonprofit organization's equivalent of the 401(k).
In this article, we're first going to discuss some of the basics of the 403(b) plan, including its benefits. Next, we'll talk briefly about eligibility rules, and the contribution limits for this type of retirement fund. Finally, we'll provide information on some of the more frequently asked questions dealing with 403(b) rollovers, distributions, and loans.
This article will be the first in a series covering 403(b) plans. We'll review the basics here, and in supplemental articles we'll dive deeper into the details of these plans.
A 403(b) is sometimes referred to as a tax-sheltered annuity plan. That's because these plans started out as annuity contracts with insurance companies. Today, 403(b) accounts are retirement plans available to certain employees of public schools and tax-exempt organizations. The account can be any one of the following types, or combinations of these types:
- An annuity contract provided by an insurance company.
- An income account set up specifically for church employees or ministers.
- A custodial account, which is usually invested in mutual funds.
Benefits of a 403(b)
Besides the obvious benefit of a self-funding retirement account, there are three additional benefits associated with 403(b) plans:
- Contributions to an account are made on a tax-deductible basis.
- Earnings on contributions are allowed to grow on a tax-deferred basis.
- Plan participants may be able to take a tax credit for elective deferrals made to their account.
Generally, an employee is eligible to participate in a 403(b) plan if they work for a not-for-profit organization. This type of organization is sometimes referred to as a 501(c)(3) organization, referencing the section of the Internal Revenue Service Code that defines this type of operating structure.
Not-for-profit organizations include employees of public schools, employees of cooperative hospitals, faculty and staff of the Uniformed Services University of the Health Sciences, and certain ministers.
Just because someone works for one of these types of public companies, does not mean they automatically have access to a 403(b) account. Only employers are allowed to establish plans.
The rules for contributing to a 403(b) account are very similar to those of a 401(k) plan. Participants cannot contribute to their account directly; instead the money is invested by their company through deductions from an employee's paycheck. Companies can also make matching contributions, or discretionary contributions, to an account.
In short, employees can contribute to a 403(b) in three different ways, or any combination of these three ways:
- Elective Deferrals: these are tax-deferred contributions to an account using money withheld from a paycheck.
- Non-Elective Contributions: these are employer contributions, which may be in the form of matching, mandatory, or discretionary contributions.
- After-Tax Contributions: this is money directed to a 403(b) account on an after-tax basis.
There are limits to the amount participants can contribute to a 403(b) plan. If they exceed these limits, then a tax penalty may apply. Generally, the plan administrator can help figure out how much someone can contribute without incurring a penalty. In most situations, the plan administrator will automatically stop contributions to help avoid a penalty.
The limit in 2020 for annual additions to a 403(b) was the smaller of $57,000 or 100% of includable compensation. In 2021, this limit increases to $58,000. In the years 2022 and beyond, this limit will be indexed for inflation and can move up in $1,000 increments.
Note: Updated contribution limits are generally available in mid to late October.
The limit on elective deferrals to a 403(b) was $19,500 in 2020. In 2021, this value remains at $19,500. In the years 2022 and beyond, this limit can move up in $500 increments based on a measure of inflation.
Finally, if an employee reaches the age of 50 or older by the end of any calendar year, they may be eligible to make additional catch-up contributions to their 403(b) account. The maximum catch-up contribution they can make in 2020 is $6,500 or their includable compensation minus their other elective deferrals for the year. In 2021, the catch-up contribution remains at $6,500.
Anyone that would like to gain a better understanding of these funding rules, including a discussion of the 15-Year Rule, and Maximum Allowable Contributions, should take a look at our article: 403(b) Contributions.
If the plan allows participants to make an after-tax contribution, this money cannot be deducted on a federal income tax return. Since the employer provides this funding to a 403(b) plan on the employee's behalf, these elective deferrals will be shown on Form W2 in Box 12. The W2 box for retirement plan will also be checked.
It's also possible to rollover a 403(b) account into several different types of retirement plans. This includes Traditional IRAs, 401(k) plans, SEP IRA, and even a Roth IRA (although accountholders may be required to include some amounts in taxable income). It's not possible to rollover a 403(b) plan into a SIMPLE IRA.
There are two ways to perform a 403(b) rollover:
- Distributions to Individuals: in this situation the money from a 403(b) plan is distributed directly to the accountholder, and they have to abide by the 60-day rule and rollover 100% of the distribution; including 20% that is withheld with a direct distribution, or they'll face tax penalties.
- Direct Rollovers: accountholders also have the option of having their 403(b) plan administrator make the rollover directly to an IRA or a new 403(b) plan. This is by far the easiest way to conduct a rollover because the 20% withholding rule does not apply. All the accountholder needs to do is coordinate the exchange of the distribution between the two financial institutions.
Generally, a 403(b) rollover needs to be completed by the 60th day following the day an accountholder received any distribution. There are also some rollover rules that deal with situations like frozen deposits and hardship withdrawals. To find out more information on those topics, take a look at our article on 403(b) rollovers.
In general, participants can take a distribution from their 403(b) account once they've satisfied one of the following requirements:
- They've reach age 59 1/2
- They've become disabled
- They've passed away
- Employment has been severed
- They've experienced a financial hardship (applies to salary reduction contributions)
Anyone that plans to take an early distribution should also plan to pay state and federal income taxes. Early distributions may also be subject to an additional 10% tax penalty.
Minimum Required Distributions
One of the big benefits of Roth IRAs is there are no minimum required distributions, but that's not the case with 403(b) plans. Participants are going to need help from their plan administrator if they started their plan before 1986. But generally, participants must take a certain amount, or possibly all, of the interest accruing in a 403(b) account by April 1st of the calendar year in which they become age 70 1/2 or the year they retire, whichever is later.
Once again, the tax penalties can be significant if someone doesn't take the minimum required distribution from a 403(b). To find out more on this topic, take a look at our article: 403(b) Distributions and Transfers.
The final topic we're going to discuss has to do with 403(b) loans. Most plans allow participants to take out a loan; however, if the rules of the 403(b) loan contract are not adhered to, then the loan may be deemed a distribution. If the accountholder is not age 59 1/2, then additional tax penalties may apply.
The exact rules of a loan are established by the company's plan, and will be available through the plan's administrator. In general, the limit on all loans cannot exceed $50,000. At a minimum, borrowers will need to make quarterly payments on the loan. The term, or length, of the 403(b) loan may not exceed 5 years, and the loan must bear a reasonable rate of interest.
Before making any decision to borrow from a 403(b), it's important to make sure that all other alternatives have been exhausted, including taking out a personal loan. Borrowing against the future to pay for expenses today is never a good approach.
Employees taking a 403(b) loan are typically prohibited from participating in their plan until all of the money is repaid. If an employer matches contributions, then they're missing that benefit. If a participant eventually decides they cannot repay the loan, then they'll owe federal income tax and pay a 10% early withdrawal penalty. More details about borrowing against a 403(b) can be found in our article: 403(b) Loans.
If anyone's wondering how much money they should be placing in their 403(b) account each year, we have over 100 online calculators, including several different types of retirement calculators. Anyone that wants to get a better feel for how much money they need to put away for retirement each year or how much income they'll need in retirement years, might want to take a look at the various financial planning tools we have to offer.
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