31 Oct Saving For Retirement Through 403(b) Plans
For all employers, offering 403(b) retirement benefits can play a fundamental role in recruiting and retaining qualified employees. Yet, despite the obvious advantages that come with helping workers save for retirement, many not-for-profit organizations neglect to provide a retirement plan or do too little to assist workers in reaching their retirement savings goals. One of the simplest options for nonprofits wishing to provide employees with access to a tax-advantaged retirement plan is the 403(b) arrangement, which has become more attractive due to recent changes in the tax laws.
Available to organizations that qualify as nonprofits under section 501(c)(3) of the Internal Revenue Code, the 403(b) plan is often regarded as the equivalent of the 401(k) for the not-for-profit sector. In fact, 403(b) plans were first established by the federal government in 1958—two decades before the 401(k) was created—and initially allowed participants to invest exclusively in tax-sheltered annuities. Over the years, the tax laws have been amended to bring 403(b) plan features more into line with those of 401(k) plans, but important differences remain.
Contributions and Distributions
Because contributions to a 403(b) plan are typically made on a pre-tax basis, money going into the plan is deducted from the employee’s salary before federal income taxes. Consequently, by lowering taxable salary, participants are able to lower their federal income tax each year they participate in the plan. Money contributed to a 403(b) account grows tax-deferred until retirement, when qualified distributions are taxed as ordinary income.
Withdrawals from a 403(b) account prior to age 59½ are only available under certain circumstances, such as a participant becoming disabled or experiencing hardship. Early withdrawals may be subject to a 10% federal income tax penalty, unless a qualified exception applies. Some 403(b) plans allow employees to borrow money from their accounts under certain circumstances, but these loans must be paid back with interest. Since January 2006, 403(b) providers may also give participants the option of making elective contributions using after-tax dollars to Roth 403(b) accounts.
The Pension Protection Act of 2006 (PPA) made permanent the previously enhanced annual contribution limit for both 401(k)s and 403(b)s, with adjustments for inflation. The 2007 elective deferral limit is set at $15,500 for workers under age 50, with a $5,000 annual catch-up contribution allowed for workers over age 50. In certain cases, employees who have been with eligible employers for at least 15 years and did not contribute the maximum amount in past years are also permitted to make an additional contribution of $3,000 a year to their 403(b) accounts.
The PPA also made permanent the saver’s tax credit, which allows low-income 403(b) plan participants to claim a credit worth up to 50% of contributions up to $2,000. The new law further permits 403(b) plan providers to expand the circumstances under which participants may make hardship withdrawals without incurring penalties to include crises or hardships befalling not just participants and their dependents, but also domestic partners and certain non-dependents.
401(k) vs. 403(b)
There are, however, some significant differences between 401(k) and 403(b) plans. For employers, establishing a 403(b) plan can be considerably easier than sponsoring a 401(k) plan. Unlike 401(k) plans, 403(b) arrangements are not necessarily governed by the complex requirements of the Employment Retirement Income Security Act (ERISA). To set up a 403(b) plan that receives only elective-deferral contributions, the nonprofit organization chooses the financial institutions that will be responsible for establishing and administering the accounts, arranges for the payroll administrator to deduct contributions from employees’ paychecks, notifies employees of their provider options, and explains to employees how salary deferrals can be arranged. The employer is generally required to offer all employees the opportunity to make 403(b) plan salary-deferral contributions.
Employers may choose to contribute to employee 403(b) accounts, usually by matching a percentage of employee contributions. But if the employer makes contributions, the 403(b) plan becomes subject to ERISA, which imposes discrimination testing, as well as other restrictions and reporting requirements.
Unlike many 401(k) plans, most 403(b) plans have no vesting schedule. The participant is, therefore, automatically entitled to all the funds in the account, including employer contributions, regardless of his or her length of service. Tax-free rollovers to IRAs and most employment-based retirement plans are allowed when the participant moves to another organization.
While 403(b) plan participants were originally permitted to invest their savings exclusively in variable or fixed annuity contracts with insurance companies, participants may now invest directly with mutual fund companies. Many nonprofits have a list of approved 403(b) investment product vendors from which participants may choose. But because many nonprofits have selected insurance companies as their primary approved 403(b) providers, participants often fail to take advantage of the mutual fund alternative, and continue to put most of their money in annuities. In 2005, 80% of 403(b) money was invested in fixed or variable annuities, while just 20% was invested in mutual funds.
Although nonprofits that offer employees access to 403(b) plans with no employer contributions do not have the same fiduciary responsibilities as 401(k) plan sponsors, organizations should nonetheless make an effort to educate employees participating in 403(b) plans about the fees, surrender charges, and risks associated with each investment option.