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The 403(b) plan, named for section 403(b) of the Internal Revenue Code, is a type of qualified retirement plan. Qualified means that it is eligible to receive special tax benefits. The money contributed to a 403(b) comes from before-tax dollars. These dollars are deducted from one's paycheck before they are taxed. Thus, job earnings you contribute to one of these retirement plans are not taxed while they remain in the fund (although the amount allowable for tax-free contribution is limited).
The official name of the 403(b) is tax-deferred annuity plan. The name is somewhat misleading as either an annuity contract or a mutual fund may fund it.
This tutorial will take you through three sections designed to help you understand the basics of 403(b) retirement plans:
WHO MAY PARTICIPATE?
Employees of non-profit organizations, such as hospitals, museums, public foundations, churches, research organizations and local governments are eligible for participation in 403(b) plans. Part-time employees may participate in all qualified plans unless they are expressly prohibited because of individual plan requirements. In addition, the employer may establish eligibility guidelines for different classes of employees.
CONTRIBUTING TO A 403(B) PLAN
In most cases, contributions to a 403(b) plan are made from employees' elective deferrals. The employee signs a salary reduction agreement with the employer authorizing him or her to reduce a certain amount from the employee's wages. This money is used to purchase an annuity contract or invest in a mutual fund. This annuity or mutual fund is the vehicle in which the 403(b) plan is invested.
Before proceeding further, you will need to know what an exclusion allowance is. An exclusion allowance is the maximum amount that can be deferred to the plan free of tax. Thus, if the exclusion allowance is $2,000, up to $2,000 worth of deferrals will be tax-free. Amounts exceeding that will be taxed. The IRS issues regulations and formulas to help compute an individual's exclusion allowance for the year.
An individual may elect to defer an amount up to the exclusion allowance. This is pre-tax, so no deduction can be taken on a tax return. The employee's W2 will reflect the lower taxable income.
It should be noted that participation in a 403(b) plan qualifies as participation in an employer-sponsored retirement program. This may have consequences for an individual who is putting money into a second retirement plan. Someone who contributes to a tax-deferred annuity plan may not be eligible (depending upon his or her income) to deduct contributions to an individual retirement account.
HOW ARE 403(B) PLANS TAXED?
All deferrals within the exclusion allowance are tax-deductible. Tax is also deferred on the contributions, the net investment income, and realized capital gains that accumulate in the plan, until the individual begins making withdrawals from it. For example, imagine a teacher who paid $10,000 into a 403(b) over several years. Suppose that the account is now worth $16,000. If the teacher chooses to receive a lump-sum distribution, the entire amount ($16,000) will be taxed as ordinary income.
Instead of receiving a periodic distribution, an individual may instead elect to receive a lump-sum distribution.
This concludes the tutorial on 403(b) plans.
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