What Are The 403(b) Tax Rules?

A 403(b) plan is an employer sponsored retirement account designed for tax-exempt organizations such as churches, public schools, and charities. It functions similarly to the more commonly known 401(k) savings plan for employees of for-profits, with some key exceptions. A 403(b) plan is limited to mutual funds and annuities as investment options, and includes a special provision allowing individuals employed at least 15 years with the sponsoring employer to make additional catch up contributions. 

The distinguishing factor of a 403(b) plan, however, is the type of employer that can offer it as a retirement vehicle—certain nonprofit organizations that are considered 501(c)(3). There are different types of 403(b) plans to consider, too. Their tax status can impact tax treatment.

Tax rules in a 403(b) plan

There are two basic types of 403(b) plans: regular and Roth. Not all employers offer both options but an employee may check with their plan administrator to see which is available. There are several different tax rules that apply, depending on the type of 403(b) and the contributions made, including: 

• Tax deferred contributions for regular 403(b) plans are allowed

  . When an employee contributes through salary deductions, or elective deferrals, the employer withholds money from the employee’s paycheck and it goes into the plan on a pretax basis. This effectively reduces taxable income for the year the contribution is made. Eventually, the IRS will tax the money when withdrawals (distributions) are made, typically in retirement.  

• The Roth 403(b) after-tax alternative offers future benefits

  . Some employers offer a Roth 403(b) option to employees. Contributions to a Roth are made with after-tax income. Although the employee doesn’t realize any upfront tax benefits at the time of the contribution, a Roth 403(b) offers tax advantages down the road: Qualifying distributions after age 59 ½ are tax-free, and there are no required minimum distributions. 

• Employer matches are not taxed upfront.

  When an employer makes a matching contribution, taxes are deferred and not taxed until later. The employee would pay tax only after funds are withdrawn, usually in retirement. 

• Non-deductible contributions are taxable

  . Some 403(b) plans allow employees to make voluntary non-deductible, after-tax contributions to a 403(b). Although the employer takes money directly out of an employee’s salary like an elective deferral, non-deductible contributions are reported as income when filing taxes in the year of contribution.  

Tax rules on 403(b) withdrawals

There are several 403(b) withdrawal rules covering the different circumstances in which a person can take out money. Usually, funds in a 403(b) retirement plan are withdrawn in the form of distributions once the employee retires after age 59 ½, at which point the retirement income is taxed. 

How 403(b) withdrawals in retirement are taxed

For a regular 403(b) with elective deferrals and matching contributions, income tax isn’t triggered until retirement. Distributions get reported on IRS Form 1099-R. 

The amount of taxes depends on two factors: the income tax rate at the time of distribution and whether any after-tax contributions were made while employed. 403(b) participants may be in a lower tax bracket in retirement, which results in a lower tax rate. 

Taxable income might also be less, depending on the ratio of after-tax to pretax contributions. For example, if 5% of the funds that went into the 403(b) were after-tax contributions, the IRS would tax only 95% of the withdrawal. If no after-tax contributions were made, then 100% of the withdrawal would be subject to both state and federal income tax.

Because Roth contributions are made with after-tax dollars, when the saver withdraws money, it won’t be taxed again. But if the employer made matching contributions on a pre-tax basis, then the percentage of pre-tax funds withdrawn would be taxed. Two rules are important to remember before taking Roth distributions: You must be over 59 ½ and have participated in the Roth plan for at least five years.

How early withdrawals from 403(b)s are taxed 

If the plan participant is over 59 ½, there are no penalties on withdrawals. However, if the participant is under the age of 59 ½ when making a withdrawal on a regular 403(b), the IRS will impose a 10% early withdrawal penalty plus income tax. Some states add further penalties on top of that. But there are a few exceptions to the early withdrawal penalty: 

• Terminated employment at or after age 55

  . To avoid the 10% early withdrawal penalty in this scenario, keep in mind the IRS Rule of 55: It allows a penalty-free withdrawal if made the year the employee turns 55 or older and if the employee leaves the employer, for any reason. Funds must be withdrawn only from the 403(b) plan from the sponsoring employer—and income taxes would still apply. For instance, it would not be possible to withdraw funds without penalty from a different 401(k) or 403(b) from a previous job. However, funds from previous retirement accounts could be rolled over into a 403(b) any time before employment is terminated. Not all employers allow this.

• Terminated employment before 55 and taking substantially equal periodic payments (SEPP). IRS regulation 72(t)

  stipulates that periodic payments be taken for at least five years or until reaching age 59 ½, whichever is later. An IRS approved calculation method is used to determine the amount of payment and payment schedule. 

• Health-related scenarios.

  If the account holder becomes permanently disabled, or if withdrawals are used to cover unreimbursed medical expenses that are more than 7.5% of adjusted gross income, the penalty is waived.

403(b) contribution limits 

Just like 401(k)s, there are limits on how much an employee and employer can contribute to a 403(b) account. 

2022 contribution limits

The IRS limits

the amount an employee and employer can contribute annually:

• Overall limits

  . The total contributions limit, including employee contributions and employer matching contributions, is $61,000 annually. Actually, for older and long-tenured employees, the limit can go even higher thanks to catch-up contributions.   

• Elective deferrals

  . Employees under 50 can contribute as much as $20,500 in salary deduction deferrals. This is included in the $61,000 overall number. Employees over 50 can tack on extra catch-up contributions of up to $6,500 per year. 

• Non-deductible contributions

  . Any non-deductible contributions made to a 403(b) would get included in the total annual contribution limit, too.

Catch up contributions

A 403(b) account can allow plan participants ages 50 or older to make catch-up contributions. They can save up to $6,500 extra, in effect boosting the annual employee contribution limit from $20,500 to $27,000. 

403(b) plans have a unique provision that allows additional catch-up contributions of up to $3,000 annually for employees who have worked at least 15 years for the employer and have annual contributions averaging less than $5,000 per year. These extra lifetime catch-up contributions to the plan max out at $15,000. 

The bottom line

A 403(b) plan lets employees of tax-exempt organizations benefit from the same kind of tax-advantaged retirement savings as a 401(k) plan. In a normal 403(b), the plan participant makes pre-tax elective deferrals, reducing taxable income while employed. Taxes will be paid when distributions are taken in retirement and adjusted gross income is likely to be lower. Some 403(b) plans include a 403(b) Roth option that permits after-tax contributions while employed, and distributions in retirement will be tax-free. Employees who are eligible for a 403(b) can discuss the available plan options and contribution methods with their plan administrator.