A 403(b) plan is a tax-advantaged retirement plan offered to certain employees of public schools or tax-exempt organizations. Similar to a company-sponsored 401(k) plan, a 403(b) plan allows employees to make tax-deferred contributions to an investment account and avoid tax consequences until money is taken out. Restrictions on 403(b) plans prevent early distributions except in certain special circumstances. If you do cash out of your 403(b) plan before retirement, you'll face taxes and penalties on your withdrawal.
The IRS restricts withdrawals from 403(b) plans to very specific circumstances. While you can take money out of some other retirement accounts, such as IRAs, at any time if you're willing to pay the taxes and penalties, with a 403(b) plan you can only access your money when a triggering event occurs, including a qualified military reservist distribution, disability, financial hardship, reaching age 59 1/2 or severance from employment.
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The IRS definition of an "early" 403(b) distribution is one taken before age 59 1/2. In addition, your beneficiaries can access the funds in a 403(b) if you die before reaching that age.
If you qualify for an early withdrawal from your 403(b), the process is straightforward. Contact the administrator of your plan and ask for the required forms for a distribution. Most administrators will provide a packet explaining allowable distributions and possible tax or penalty ramifications, such as this example from Oppenheimer Funds.
Taxes and Penalties
One of the benefits of a 403(b) plan is that the money that remains in the plan is untaxed. Your contributions are taken out of your paycheck before you pay tax on them, and the dividends, interest and capital gains you earn in the account are not taxed as they are earned. Withdrawals, however, are fully taxable, regardless of when you take them. You'll have to report distributions from a 403(b) plan on your taxes as ordinary income, the same as if you were paid wages or a salary.
On top of income taxes, the IRS levies a 10 percent early withdrawal penalty on certain early distributions from a 403(b) plan. You can avoid the additional penalty if you take money out of your 403(b) due to death , disability, if you are a qualified military reservist, if you have deductible medical expenses exceeding 10 percent of your adjusted gross income, if you owe money due to an IRS levy and if you leave your job for any reason and are at least age 55.
Some states tack on an additional early withdrawal penalty, such as the extra 2.5 percent California assesses. If you're in a high federal tax bracket and live in a high-tax state, an early withdrawal from a 403(b) plan could easily cost you more than 50 percent of the amount you take in taxes alone.
Accessing 403(b) Funds
Experts generally recommend that investors keep money in their 403(b) plans as long as possible to take maximum advantage of their tax-advantaged growth. According to Liz Weston at Bankrate.com, if you left $20,000 in your 403(b) plan from age 55 to age 70 it would grow to more than $40,000, assuming a five percent annual growth rate.
One option that avoids both taxes and penalties is to take a loan from your 403(b). While employers are not required to offer 403(b) loans, the IRS permits participants to borrow up to 50 percent of the value of their 403(b) accounts. Those loans typically must be paid back within five years, but any interest you pay goes back into your account with your principal. AARP notes that taking such a loan can be a better alternative to paying off high-interest debt than taking a taxable distribution.