A 403(b) is a tax-sheltered annuity plan, similar to a 401(k), for employees of non-profit and educational institutions. Contributions to a 403(b) plan are taken directly out of an employee's paycheck. The employee never sees the money, contributions are made with pretax dollars and the money accumulates tax-deferred for retirement.
The saver gets the benefit of tax leverage, thanks to the tax-deferral of contributions to the 403(b) plan. The total amount saved and compounding is greater than it would be if the contribution amount were taxed. The 403(b) plan also has the advantage of working automatically. Once the saver enrolls, contributions come out of her paycheck automatically. She does not need to take additional action.
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The 403(b) plans have some disadvantages: Access to withdrawals is restricted until age 59-1/2, except under certain limited circumstances. Early withdrawals are assessed a tax penalty of 10 percent. Additionally, withdrawals are taxed as income, not as capital gains. Contributors get the benefits of tax deferral but forfeit the more advantageous long-term capital gains treatment.
Contributions to 403(b) plans are not taxed. There is no tax liability on transfers within the plan and no income tax liability on any dividends issued within the plan. This is an advantage over taxable accounts, which generate capital gains tax liability every time you sell a holding at a profit and every time you receive a dividend or interest payment. Withdrawals are taxed as income. You must begin taking withdrawals, or distributions, and paying income taxes on distributions at age 70. If you fail to take the required minimum distribution, the IRS will assess a penalty of 50 percent of the scheduled required minimum distribution.
The 403(b) plans are attractive for their wealth-protection benefits. Assets in a 403(b) plan receive some protection against the claims of creditors. They are more difficult to attach than an equivalent sum of money outside a retirement account. However, investment options in 403(b)s can be limited. Most options in 403(b) plans are annuities. Generally, you cannot invest in stocks or individual bonds with a 403(b). If your 403(b) plan does not offer mutual funds as an investment option, you may wish to use an IRA or Roth IRA for part of your retirement savings portfolio.
Tax Diversification Issues
If you will be receiving a pension as well as your 403(b) funds, you may wish to consider diversifying your retirement income streams between taxable and nontaxable accounts. If you have the entirety of your retirement income coming from taxable sources such as traditional IRAs, annuities, 403(b) plans and traditional pensions, you could inadvertently push yourself into a higher tax bracket and render a portion of your social security income taxable. To counter this, consider moving a portion of your retirement assets into nontaxable assets, such as Roth IRAs, a Roth 403(b) if allowed by your employer or permanent life insurance.