Typically offered to private-nonprofit employees, government workers, and church employees, 403(b) plans are defined-contribution plans that allow participants to shelter money on a tax-deferred basis. 403(b) plans share many similar features from those of 401(k) plans. For example, 403(b) plan holders can contribute up to $18,500 ($24,500 if age 50 and over) in 2018 and start taking distributions at age 59 ½ (subject to a 10% early withdrawal penalty in most cases). Another feature shared by 403(b) and 401(k) plans is the ability for plan holders to make contributions with after-tax dollars. This opens up one more option for retirement savers looking to maximize their tax-free withdrawals during retirement.
What organizations can offer a Roth 403(b)?Only public schools and eligible tax-exempt organizations operated for certain purposes, such as religion, education, charity, literacy, preventing cruelty to children, and others, can offer a 403(b). In general, any entity created under the section 501(c)(3) of the Internal Revenue Code:
- Public school systems
- Cooperative hospital service organizations
- Uniformed Services University of the Health Sciences (USUHS)
- Public school systems organized by Native American tribal governments
- Certain ministers
- Any 501(c)(3) institution which might include a not-for profit university, religious organization or social service agency
- Separate accounts for designated Roth contributions
- A choice of both pre-tax and Roth elective deferrals
- That only Roth elective deferrals may be contributed to the designated Roth account (not profit-sharing or employer matching contributions or forfeitures)
Who is eligible to contribute to a Roth 403(b) plan?The following employees are eligible to participate in a 403(b) plan.
- Employees of tax-exempt organizations established under section 501(c)(3). 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.
- Employees of public school systems organized by Indian tribal governments.
- Certain ministers (see IRS Publication 571).
What are the benefits of contributing to a Roth 403(b)?There are four key benefits to contributing to a Roth 403(b) plan.
- Since you contribute with after-tax dollars, your plan distributions on the plan are tax free as long certain requirements are met. For example, plan contributions must stay on the plan for at least 5 years. You still do have to pay the 10% early distribution tax on withdrawals before age 59 ½.
- Earnings and gains on amounts in a Roth contribution program aren’t taxed if your withdrawals are qualified distributions. Otherwise, they are taxed when you withdraw them.
- Your employer may still contribute or make employer matches to your retirement account. However, all employer contributions must be on a pre-tax basis and go to a traditional Roth 403(b) account. This is a benefit due to higher contribution limits on deferral contributions.
- If you qualify for the 15-year rule (sometimes referred to as the special section 403(b) catch-up or the years-of-service catch-up), your elective deferrals under this limit can be as high as $21,500 for 2018.
- The total employee elective deferral plus after-tax contributions is limited to the lesser of $55,000 or 100% of the employee’s contributions. This limit includes the employer contributions as well.
- Holders of Roth 403 (b) plans don’t have to take Required Minimum Distributions (RMDs) once they reach age 70 1/2. The RMD requirements affecting many types of retirement accounts don’t apply to a Roth 403 (b) as long as the original account holder is alive.
Are contributions to a Roth 403(b) eligible for the Saver’s Credit?No contribution into your Roth 403(b) qualifies for the Saver’s Credit.
- Employee contributions made with after-tax dollars to an employer-sponsored Roth 403(b) aren’t eligible for the Saver’s Credit.
- Any employer contributions to your retirement accounts aren’t considered to be voluntary contributions and don’t qualify for the credit.
- Any type of rollover contributions aren’t eligible either.
What are the investment options within a Roth 403(b)?Unlike most 401(k) and IRA plans, 403(b) plans limit investment options to annuity contracts or custodial accounts in mutual funds. Some churches and religious organizations may have additional investment options. Annuities can be hard to fully grasp even in their simplest configuration in which you pay a lump sum upfront to an insurance company and receive a guaranteed stream of annual income (also known as a fixed annuity). Annuities fall under three broad types: fixed, variable, and indexed. Each type offers different income potential and is appropriate for a different purpose and reason. Fixed annuities:
- Guaranteed income, but highly limited set of investment options, if any.
- Immediate fixed annuities require a single and very substantial lump sum payment and start issuing distributions after a short period of time.
- Deferred fixed annuities require several smaller payments over several years and start issuing distributions once you turn age 59 1/2. These type of annuities have a surrender charge to be around 7% of the total investment if the annuity is cashed during the first year. The surrender charge usually decreases by 1% per year until it reaches zero.
- Unlike fixed annuities, variable annuities offer a higher income potential and don’t guarantee income.
- A minimum return on your investment is provided in case of your death (also known as death benefit).
- Variable annuities tend to have a higher minimum investment requirement than fixed annuities. However, the greater number of options comes at a higher fee, on top of the surrender charge.
- Distributions are indexed to a market benchmark, such as the Dow Jones or the S&P 500. Indexed annuities often offer a minimum return, but it varies among financial institutions.
- The return of an indexed annuity is capped and may be subject to a participation rate (percentage of annuity’s participation in the index’s return) and a spread fee (percentage subtracted from the gain linked to the market benchmark).
- Indexed annuities have just a bit more market exposure than that of fixed annuities but less than that of variable annuities.
Should I choose a Roth 403(b) or a Traditional 403(b)?There are three questions that provide you a rule of thumb when deciding between a Roth and a traditional 403(b). Will I be in a higher tax bracket today, or when I retire?
- Today (generally, high earners and older workers): Traditional 403(b)
- When I retire (generally, low earners and younger people): Roth 403(b)
- Yes: Roth 403(b)
- No: Traditional 403(b)
- Yes: Traditional 403(b)
- No: Roth 403(b)