It can be tempting to tap into money saved in a retirement account when faced with an emergency. But retirement accounts are set up in a way to encourage long-term savings. So even though many retirement accounts allow for early withdrawal, an individual might have to pay a penalty in order to do one.
A 403(b) plan, the employer-sponsored retirement plan available to employees at non-profit organizations and public schools, does provide the option of withdrawals before retirement. But there are—similar to other retirement plans—possible fees and taxes associated with withdrawing funds before retirement age.
Withdrawing from a 403(b) plan
There are several circumstances in which a person can withdraw money from a 403(b) plan, according to the IRS. Some ways don’t incur a penalty fee of 10% on the amount withdrawn, but some do. It’s worth noting that with a traditional 403(b), a person would pay regular income taxes on the withdrawn amount since the money was saved before any taxes were withheld. With a Roth 403(b), income tax is not owed on withdrawals in retirement, because the individual pays income tax on the funds when they save them.
Here are the ways someone can take money out of a 403(b) account without paying a penalty fee:
- Reach age 59 ½. This is the standard retirement age to access funds without facing a penalty. Any money taken out at this point from a traditional 403(b) account will count as income and is taxed at the person’s regular tax rate.
- Reach age 55 and leave their employer. If they turn 55 or older and are also leaving the employer sponsoring the plan, a person can access the money in their 403(b) without paying a penalty. When withdrawing from a traditional 403(b), a person will have to pay ordinary income taxes.
- Become disabled. If someone is found to be totally and permanently disabled, as defined by the IRS, they can withdraw from their 403(b) without paying a penalty. They will still owe income taxes.
- Die. If a plan participant dies, their designated beneficiaries can withdraw money penalty-free, but will owe taxes on the amount withdrawn.
Here are some circumstances where an individual can take money out of a 403(b) but would have to pay a penalty of 10% of the amount withdrawn on top of regular income taxes.
- Leave their employer and withdraws the money. If an employee is going to a new employer, they can roll over the amount in their 403(b) plan into another tax-deferred account such as a 401(k) plan. If an employee decides against a rollover and withdraws the money as a distribution, without meeting an exception, it will result in a 10% penalty on top of regular income taxes. An exception could be a disability or retirement age.
- Financial hardship. Plans will allow individuals to withdraw money in certain circumstances of financial hardship, but that would incur a 10% penalty as well as taxes.
What is a hardship withdrawal?
Some 403(b) plans allow for an early withdrawal known as a hardship withdrawal. If a person is facing financial stress, like large medical bills or foreclosure and has no other liquid assets that can be used to pay the expense, they could use their 403(b) to help cover the cost. Hardship withdrawal will still be subject to the 10% penalty and regular income taxes. These are circumstances that automatically meet the definition of an immediate and heavy financial need, according to the IRS:
- Medical expenses. Any large medical bills for the employee, their spouse, dependents, or beneficiary.
- Buying a primary residence. Funds needed for a down payment and associated costs when an employee is purchasing a principal residence.
- Educational expenses after high school. Tuition, fees, and room and board for 12 months for education expenses after high school. The employee can apply the withdrawn funds to education expenses for themselves, their spouse, children, dependents, or beneficiary.
- Avoiding eviction or foreclosure. Funds used to avoid eviction or foreclosure of the employee’s primary residence.
- Fixing damage to one’s primary home. Costs of fixing damage to the home the employee lives in.
- Funeral expenses. Funeral expenses for the employee, employee’s spouse, children, dependents, or beneficiary.
403(b) hardship withdrawal rules
To take advantage of a hardship withdrawal, the plan participant must have a large financial need that is currently due. Whether that’s the case or not is determined by their employer. An employer will review the employee’s circumstances and judge whether the financial need is urgent and pressing enough to merit an early withdrawal. After that, the employee can apply for a hardship withdrawal from the plan.
Only money contributed by the employee and employer can be used for a hardship withdrawal, meaning no earnings on the amount deposited can be withdrawn. (This is notably different from the rules governing early withdrawals from 401(k)s.) If granted permission for a hardship withdrawal, the employee must only take the amount they need to cover the specific expense.
Loans from 403(b) plans
If the 403(b) retirement plan allows it, employees can take loans out from their plan. Even though they would be borrowing from their own funds, the loan will need to be repaid with interest just like any other loan. The interest rate is set by a plan administrator based on the market rate.
A person can borrow up to $50,000 or 50% of their vested funds balance, whichever is less. In order to apply for the loan, an employee would contact the plan administrator. The vested funds balance may be different from the actual balance if the employer makes contributions that do not belong to the employee until after a certain period, which is the date the funds vest.
Repaying the loan is easy since payments are automatically withdrawn from the employee’s paycheck, just like contributions are (although payments do not need to be made each paycheck). The loan terms will determine when payments are due. The employee must make payments quarterly, at a minimum.
The loan must be paid back within five years unless the money was used to purchase the employee’s primary home. In that case, the IRS allows the loan length to be as long as 15 years. As long as the loan terms, including the amount of payments and their due dates, are adhered to, the employee will not incur taxes for the loan. However, if payments are late or not made, the outstanding balance can be taxed as a distribution.
Alternatives to withdrawing money from a 403(b) plan
There are alternatives to withdrawing from a 403(b) account to cover expenses before retirement:
- Use emergency savings. Having savings of at least six months of expenses can be a major help when facing financial difficulties. Before withdrawing funds from a retirement account, an individual might consider using any emergency savings to cover costs.
- Borrow money. An individual can obtain a personal loan from a bank or apply for a credit card. Homeowners could apply for a home equity line of credit or refinance their mortgage to borrow more money. Taking on debt isn’t something to take lightly. But someone might calculate that the costs of missing out on the tax-advantaged savings in a 403(b) and paying penalties and taxes on an early 403(b) withdrawal may be greater than the risk of taking on debt.
The bottom line
403(b) withdrawal rules allow for penalty-free early distributions in some cases. And 403(b) loans provide another option if retirement funds are your only source to cover an immediate financial need.
In most circumstances, however, taking early distributions will incur a 10% penalty on the withdrawn amount. And taking money out from a retirement fund early means the retirement income cannot continue to grow and be a part of future financial plan. As such, individuals may want to consider all the alternatives before withdrawing funds from their retirement account.
