A 403(b) plan is a retirement savings plan designed for public school employees, ministers and workers for certain tax-exempt organizations. A 403(b) plan allows eligible participants to make tax-advantaged contributions to an investment account. Employers are also free to contribute to employee accounts.
Taxation of Contributions & Earnings
Contributions to a 403(b) plan are made on a salary reduction basis. If you choose to contribute to a 403(b), your employer will take a designated part of your pay and contribute it directly to the plan before it is taxed. All earnings generated inside a 403(b) remain tax-deferred until withdrawn, meaning you don't have to pay taxes on any dividends, interest or capital gains generated in your account from year to year. Employer contributions also have no tax consequences for employees, with earnings growing in the same tax-deferred fashion.
The amount you can contribute to a 403(b) plain is limited, but is adjusted regularly for inflation. For 2015, participants can defer up to $18,000 of salary into a 403(b) plan. The combination of employer contributions and employee salary deferrals cannot exceed $53,000, or 100 percent of an employee's compensation. The IRS provides for additional "catch-up" contributions for various classes of employees, such as those with 15 or more years or service and those aged 50 or older.
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Taxation of Withdrawals
Money taken out of a 403(b) plan is taxed as ordinary income. This applies to both contributions and earnings you take out of the account. You're eligible to take a distribution from a 403(b) plan when you turn 59 1/2 years of age, become disabled, leave your job for any reason or have a financial hardship. In most cases, withdrawals taken before age 59 1/2 incur an additional early distribution penalty of 10 percent. Limited exceptions to the penalty include distributions to qualified military reservists called to active duty, total disability or death.
One of the main risks with investing in a 403(b) plan is that your only investment options are the ones selected by your employer. Your employer chooses the manager behind the investment options in the plan, and if those choices perform poorly, you're simply out of luck. Investments in a 403(b) plan also carry general investment risk, such as stock market risk, so choose the investments best suited to your personal tolerance for risk. A poorly constructed 403(b) plan also may carry high fees, which eat into your investment returns.