A 403(b) plan, also known as a tax-sheltered annuity (TSA) plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers.
Individual accounts in a 403(b) plan can be any of the following types.
• An annuity contract, which is a contract provided through an insurance company,
• A custodial account, which is an account invested in mutual funds, or
• A retirement income account set up for church employees. Generally, retirement income accounts can invest in either annuities or mutual funds.
Throughout this overview, wherever the term “403(b) account” is used, it refers to any one of these funding arrangements, unless otherwise specified.
What Are the Benefits of Contributing to a 403(b) Plan?
There are three benefits to contributing to a 403(b) plan.
• The first benefit is that you do not pay income tax on allowable contributions until you begin making withdrawals from the plan, usually after you retire. Allowable contributions to a 403(b) plan are either excluded or deducted from your income. However, if your contributions are made to a Roth contribution program, this benefit does not apply. Instead, you pay income tax on the contributions to the plan but distributions from the plan (if certain requirements are met) are tax free.
• The second benefit is that earnings and gains on amounts in your 403(b) account are not taxed until you withdraw them. Earnings and gains on amounts in a Roth contribution program are not taxed if your withdrawals are qualified distributions. Otherwise, they are taxed when you withdraw them.
• The third benefit is that you may be eligible to take a credit for elective deferrals contributed to your 403(b) account. Always consult your tax advisor.
Who Can Participate in a 403(b) Plan?
Any eligible employee can participate in a 403(b) plan.
Eligible employees. The following employees are eligible to participate in a 403(b) plan.
• Employees of tax-exempt organizations established under section 501(c)(3) of the Internal Revenue Code. These organizations are usually referred to as section 501(c)(3) organizations or simply 501(c)(3) organizations.
• Employees of public school systems who are involved in the day-to-day operations of a school.
• Employees of cooperative hospital service organizations.
• Civilian faculty and staff of the Uniformed Services University of the Health Sciences (USUHS).
• Employees of public school systems organized by Indian tribal governments.
• Certain ministers
Who Can Set Up a 403(b) Account?
You cannot set up your own 403(b) account. Only employers can set up 403(b) accounts. A self-employed minister cannot set up a 403(b) account for his or her benefit. If you are a self-employed minister, only the organization (denomination) with which you are associated can set up an account for your benefit.
How Can Contributions Be Made to My 403(b) Account?
Generally, only your employer can make contributions to your 403(b) account. However, some plans will allow you to make after-tax contributions (defined later).
The following types of contributions can be made to 403(b) accounts.
1. Elective deferrals . These are contributions made under a salary reduction agreement. This agreement allows your employer to withhold money from your paycheck to be contributed directly into a 403(b) account for your benefit. Except for Roth contributions, you do not pay income tax on these contributions until you withdraw them from the account. If your contributions are Roth contributions, you pay taxes on your contributions but any qualified distributions from your Roth account are tax free.
2. Nonelective contributions . These are employer contributions that are not made under a salary reduction agreement. Nonelective contributions include matching contributions, discretionary contributions, and mandatory contributions from your employer. You do not pay income tax on these contributions until you withdraw them from the account.
3. After-tax contributions . These are contributions (that are not Roth contributions) you make with funds that you must include in income on your tax return. A salary payment on which income tax has been withheld is a source of these contributions. If your plan allows you to make after-tax contributions, they are not excluded from income and you cannot deduct them on your tax return.
4. A combination of any of the three contribution types listed above.
403(b) Contribution Limits
Generally, contributions to an employee’s 403 (b) account are limited to the lesser of:
• The limit on annual additions, or
• The elective deferral limit
Several contribution limits apply to a 403(b) plan. A plan that includes both employer contributions and employee elective deferrals is subject to both the elective deferral limit, and the limit on annual additions. For the 2009 year, the total of employer and employee contributions (including the 15-year catch-up discussed below) cannot exceed the lesser of $49,000 or 100% of includible compensation, plus any age 50 catch-up contributions.
The limit on annual additions (the combination of all employer contributions and employee elective deferrals to all 403(b) accounts) generally is the lesser of:
• $49,000 for 2010, or
• 100% of the employee’s includible compensation for his or her most recent year of service.
The limit on elective deferrals, the most that can be contributed to a 403(b) account through employee elective deferrals by means of a salary reduction agreement is $16,500 for 2010.
If permitted by the 403(b) plan, an employee that has at least 15 years of service with a public school system, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches (or associated organization), his or her 403(b) elective deferral limit is increased by the lesser of:
2. $15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule, or
3. $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.
If an employee qualifies for the 15-year rule, his or her elective deferrals under this limit can be as high as $19,500 for 2010.
If permitted by the 403(b) plan, participants who are age 50 or over at the end of the calendar year can also make Catch-up employee elective contributions of $5,500 in 2010 beyond the basic limit on elective deferrals.
For example, assume Jan, age 50, has worked as a teacher in the XYZ School District for 15 years; is eligible for the 15 years of service catch-up; and has eligible compensation of $70,000 for 2010. The maximum employee and employer contributions to the XYZ 403(b) plan for 2010 for Pat would be $54,500:
• Jan may have elective deferrals to the 403(b) plan totaling $19,500 ($16,500 plus $3,000 15 years of service catch-up)
• Employer contribution of $29,500, bringing the total employee and employer contributions to $49,000, the annual additions limit.
• Jan may also defer an additional $5,500 age 50 catch-up contribution for 2010.
Participation in a qualified plan. Employees who participated in a 403(b) plan and a qualified plan must combine contributions made to their 403(b) accounts with contributions made to qualified plans, SEPs and SIMPLE IRAs of all corporations, partnerships and sole proprietorships in which they have more than 50% control.
Generally, includible compensation for an employee’s most recent year of service is the amount of taxable wages and benefits the employee received from the 403(b) employer during his or her most recent year of service.An employee’s most recent year of service is his or her last full year of service, ending on the last day of the employee’s tax year that he or she worked for the 403(b) employer.