Section Guide
Feature Article
Expert Q & A
ABCs
FAQ
403b Frequently Asked Questions
General   |   Taxes   |   Eligibility   |   Distributions   |   Loans   |   Contributions   |   Investments

Taxes

  1. Do I have to pay taxes on the money I contribute to my 403(b) plan?
  2. What is the tax advantage of saving for retirement in a 403(b) plan?
  3. What's the difference between taxable, tax-deferred and tax-free investing?
  4. Aside from 403(b) plans, what are the different kinds of tax-deferred investment vehicles?
  5. Will my Social Security benefits be affected by my 403(b) plan distributions?
  6. Can I make after-tax contributions to my 403(b) plan?
  7. Will I have to pay taxes on my 403(b) plan if I leave my employer?
  8. If I make a catch-up contribution this year, what are the tax implications?

1. Do I have to pay taxes on the money I contribute to my 403(b) plan?

As long as you don't exceed the pretax limit, your contributions are deducted from your pay before federal income taxes are withheld. You don't pay federal income taxes on this money until you withdraw it from your account. However, you are required to pay Social Security tax on all 403(b) contributions.

As for state income tax, most states exempt 403(b) contributions from taxation; but depending on where you live, your contributions may be subject to local income taxes. Your company's human resources or benefits representative should be familiar with the laws in your area.

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2. What is the tax advantage of saving for retirement in a 403(b) plan?

First, the money you put into the account reduces your taxable income for the year it's contributed.

Second, the earnings credited to your account grow tax-deferred. That's a powerful tool you can use to help build your retirement nest egg. For instance, suppose you had $1,000 invested in an after-tax investment account. That money earns $80 a year in interest, an 8 percent return. Let's suppose that your annual income is $50,000, putting you in the 28 percent tax bracket. You will have to pay taxes on your interest ($22), reducing your real return to $58.

Now, instead suppose you save $1,000 in your 403(b) plan and earn $80 in interest. Because contributions and earnings in 403(b) plans grow tax-deferred, the entire $80 is reinvested in your account, helping your investments grow faster.

However, when you withdraw money you are required to pay taxes. Your income in retirement may be lower than while you are working so your tax burden may be less.

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3. What's the difference between taxable, tax-deferred and tax-free investing?

A taxable investment is one in which you pay taxes every year on the dividends, interest and appreciation of investments that you sell. A simple example of a taxable investment is a regular savings account. Every year when you file your tax return, you're required to report the interest your savings account has earned and pay taxes on it. Any time you buy a stock, bond, mutual fund, money market account, etc. that isn't part of a special tax-sheltered account (such as a 401(k), 403(b), IRA, etc.), it's most likely a taxable investment -- and you'll be required to pay taxes on its earnings every year.

A tax-deferred investment is one in which you do not have to pay taxes on the investment's earnings until you withdraw money from the account. Examples of tax-deferred investments include 401(k), 457 and 403(b) plans, and IRAs. In many cases, contributions you make to tax-deferred accounts are partially, if not completely, tax deductible. Because tax-deferred accounts are designed to help people save for specific goals -- such as retirement or a child's education -- there are hefty penalties attached to withdrawing your money from the account too soon.

A tax-free (or tax-exempt) investment is one in which you don't have to pay taxes on the income the investment earns. A municipal bond is an example of a tax-free investment. Note, however, that just because an investment is called "tax-free" does not mean that you won't have to pay any taxes on it. Some tax-free investments are exempt from only federal income taxes, while others may be exempt from only state or local taxes.

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4. Aside from 403(b) plans, what are the different kinds of tax-deferred investment vehicles?

New tax laws in recent years have increased the number of tax-deferred retirement accounts available. Because of the various rules governing eligibility, you should consult a professional tax advisor when deciding which of the following options best suits your situation.

  • 401(k) -- You may make pretax contributions of up to $11,000 in 2002, in addition to a possible employer match. You earn compound interest. Applicable taxes must be paid when money is withdrawn, and there is generally a 10 percent penalty for early withdrawal (before 59½).
  • Traditional IRA -- You may contribute up to $3,000 in 2002. Whether these contributions are tax deductible depends on whether you participate in a 401(k) and what your income level is. You earn compound interest. Applicable taxes are due when money is withdrawn, and there is generally a 10 percent penalty for early withdrawal (before 59½) of earnings and pretax contributions.
  • Roth IRA -- You may contribute up to $3,000 in 2002 if your gross income is $160,000 or below for joint filers or $110,000 or below for single filers. Contributions are not deductible, but interest grows tax-free and you pay no tax on withdrawal.
  • Spousal IRA -- A non-working spouse may contribute up to $3,000 in 2002 to a spousal IRA based on his or her spouse's earned income, even if the spouse is covered by a 401(k) plan at work. Whether contributions are tax-deductible depends on income level and participation by the working spouse in an employer-sponsored plan.
  • SIMPLE IRA -- A SIMPLE IRA works a lot like a traditional IRA except that you can contribute more (up to $7,000 in 2002) and employer-matching contributions are allowed. A self-employed person can contribute $7,000 as an individual, and his company can match his contributions dollar-for-dollar, for a total annual contribution of $14,000. Another plus -- the SIMPLE plan you set up now can grow with your company. Employers with 100 or fewer employees can use this plan.
  • SIMPLE 401(k) -- A SIMPLE 401(k) works much like the SIMPLE IRA with a few notable exceptions. On the downside, it requires a lot more reporting and administration than a SIMPLE IRA does. On the upside, a SIMPLE 401(k) allows for hardship withdrawals and loans. A SIMPLE 401(k) can be set up for companies with 100 or fewer employees. The maximum salary deferral allowed per employee in 2002 is $7,000 or a percentage of salary specified by the employer, whichever is less. The employer must make either dollar-for-dollar matching contributions up to 3 percent of compensation for each employee (for a total employer and employee contribution of up to $14,000), or nonelective contributions of 2 percent of compensation on behalf of each eligible employee who receives $5,000 or more in compensation from the employer.
  • Simplified Employee Pension IRA (SEP-IRA) -- SEP-IRAs are essentially individual retirement accounts (IRAs). The money you contribute to a SEP-IRA is tax-deductible and your investment earnings grow tax-free until you withdraw funds at retirement. For 2002, if you are the only participant in the plan, you can deduct contributions of up to 25 percent of your compensation or $40,000, whichever is less. If you have employees, in 2002, they may contribute up to 100 percent of their compensation or $40,000, whichever is less.
  • Keogh Plans -- If your business is not incorporated, you may be eligible to establish a Keogh plan. Keogh plans are generally more flexible than SEPs and may allow you to save even more toward your retirement than you can in a SEP plan. For 2002, you can save up to $40,000 a year in combined employer and employee contributions in a Keogh. Keogh plans must be set up as either a defined-contribution plan [like a 401(k) or SEP] or as a defined-benefit plan (like a traditional pension). In other words, you will need to have a plan document. For that reason if you're considering a Keogh plan, you may want to seek the advice of a pension professional.
  • 457(b) plan -- This is a tax-deferred savings plan offered to employees of state and local governments. These plans don't generally allow loans, but participants can often take what is known as an emergency withdrawal. In 2002, contribution limits were raised to $11,000 from $8,500 in 2001.

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5. Will my Social Security benefits be affected by my 403(b) plan distributions?

Not necessarily. Having a 403(b) won't reduce your Social Security benefits -- but distributions from your 403(b) taken during retirement may make your Social Security benefits subject to federal income tax, especially if you have significant other income.

If you are concerned that retirement savings distributions might affect your Social Security benefits (or the taxation of those benefits), you should consult with your tax advisor, attorney or CPA regarding your own situation.

Further, money distributed from a 403(b) plan isn't subject to FICA withholding, regardless of whether the distributions come from salary reduction contributions or an employer's nonelective contributions.

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6. Can I make after-tax contributions to my 403(b) plan?

Maybe. After-tax contributions are not permitted in custodial 403(b)(7) plans, and if made to an annuity, they count toward your maximum contribution.

Government rules don't actually outlaw after-tax contributions, but many employers no longer permit them.

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7. Will I have to pay taxes on my 403(b) plan if I leave my employer?

That depends on what you decide to do with your money. You have several options:

  1. If your vested account balance is $5,000 or more and you're under age 65, you can leave your money in your company's 403(b) plan even when you no longer work there -- and taxes won't be due until you withdraw money from the plan. If your balance is more than $1,000 and less than $5,000, your employer may decide to automatically roll it into an IRA on your behalf. If this happens, there are no tax consequences because the money is moving from one tax-deferred account to another. If your balance is $1,000 or less, it will probably be automatically distributed to you as a lump sum. In this case you will owe all applicable taxes and penalties.
  2. You can roll over your 403(b) into a traditional IRA or into a new employer's 403(b), 401(k) or governmental 457 plan. If you do a direct rollover -- have the money transferred directly into the new account -- you won't have to worry about the mandatory federal withholding of 20 percent, and you won't owe taxes until you withdraw money from the account.
  3. You can elect to take your money out of the 403(b) and not roll it over. In this case, you will owe taxes plus the 10 percent early withdrawal penalty (if you are under age 55 when you leave the employer). In addition, the plan administrator will withhold 20 percent for federal taxes before issuing the check to you.

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8. If I make a catch-up contribution this year, what are the tax implications?

If you make a catch-up contribution, you'll have a higher contribution limit for that particular year. 403(b) participants may be able to take advantage of two types of catch-up contributions in the same year.

The 15-years-of-service catch-up contribution is available to workers who have completed at least 15 years of service with their current employer and have not taken full advantage of the 403(b) plan in previous years. This type of catch-up contribution is only open to employees of educational institutions, hospitals, home health service agencies, health and welfare agencies and certain church-sponsored agencies. The formula for calculating how much you may contribute under this limit is explained more fully in the question "What are catch-up contributions?"

If you are eligible for this catch up contribution, the maximum you may contribute in 2002 is $14,000 (the regular $11,000 limit plus $3,000 catch-up). This will reduce your taxable income for the year. If you are over age 50 or turn 50 in 2002, you may take advantage of the new age-50 catch-up contribution. This allows you to put up to $1,000 extra into your 403(b), on top of all your other limits. This will further reduce your taxable income for the year. If you make both types of catch-up contribution your maximum pretax contribution is $15,000 ($11,000 + $3,000 + $1,000).