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Roth 403(b): After-Tax Option for Non-Profits

By Damian Davila

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
Eligible organizations to issue a Roth 403(b) will typically be structured as a corporation, community chest, fund or foundation. In general, an individual, partnership, or for-profit corporation won’t qualify for a 403(b). According to the IRS, to have a designated Roth 403(b) contribution program, the plan document must be amended to provide:
  • 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.
Variable annuities:
  • 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.
Indexed annuities:
  • 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.
Still, annuities have historically been notorious for confusing rules. A recent feature in the New York Times explained, “Even a well-caffeinated person with an advanced degree in math would have a hard time deciphering a 53-page contract called ‘Your Flexible Premium Indexed and Declared Interest Deferred Annuity Policy’”. This, in combination with the fact that many organization don’t have a lot of options when it comes to 403(b) providers, means that many of the current 403(b) plans currently in existence offer employees a confusing set of high-fee funds.

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)
Is there a chance I’ll need to withdraw before age 59 ½?
  • Yes: Roth 403(b)
  • No: Traditional 403(b)
Is there a time (before retirement) when I’ll be making less than I am now?
  • Yes: Traditional 403(b)
  • No: Roth 403(b)
For a deeper dive, see Roth 401(k) vs. Traditional 401(k) (Note: This is a guide focusing on 401(k)s but it’s a great starting point to understand the core differences of a Roth vs. a traditional 403(b).) Traditional 403(b)s are much more commonly used because Roth 403(b)s are less likely to be offered — if you’re not sure which options you have through your current 401(b) provider, be sure to ask specifically whether you can contribute to a traditional or a Roth 403(b), or possibly both. Keep in mind that even when choosing a Roth 403(b), all employer’s contributions to your account must go into a traditional 403(b). It is generally possible to transfer those employer contributions to a Roth 403(b) but you will need to pay the applicable income tax on the previously untaxed portion of the contributions and potential fees. Most financial advisors recommend paying the income tax with money outside your retirement account. Under most circumstances, you have until the day you file your tax return to come up with the applicable income tax payment. Contact your plan administrator for rules for this process known as a Roth conversion.

Should I choose a Roth IRA or Roth 403(b)?

Under most circumstances, the main reason to choose a Roth 403(b) over a Roth IRA is the higher contribution limit of the first. You can contribute up to $5,500 ($6,500 if age 50 and over) to Roth IRA in 2018. In the same year, you can contribute up to $18,500 ($24,500 if age 50 and over) to a Roth 403(b). Additionally, you may qualify for a higher limit for deferred contributions to your account made by your employer. But high income earners have one additional reason to choose a Roth 403(b). Even when an employer is eligible to set up a Roth 403(b), not everybody may be eligible to contribute to a Roth IRA. Once you reach a certain income threshold, you’ll no longer be eligible to enroll in a Roth IRA In 2018, here are the income limits to be eligible for a Roth IRA. Being able to contribute to a Roth 403(b) is good news for high-income earners looking to maximize after-tax contributions to a nest egg.

Where can employers find more information about setting up a Roth 403(b)?

Human Interest serves several non-profit organizations and we offer both 401(k)s and 403(b)s at the same price. If you would like to learn more about the process of setting up a Roth 403(b) or any other plan that better suits to your organization’s needs, please click here to contact us and we’d be happy to help!