How Does a 403b Work When You Retire?
As you approach retirement, your 403(b) shifts from a savings vehicle to a source of income. Understand the framework for managing this financial transition.
A 403(b) plan is a retirement savings account for employees of public schools, certain non-profit organizations, and ministries. These accounts offer tax-advantaged growth to provide financial support during retirement. When you leave your job, you gain control over these assets, and the decisions you make will have long-term financial consequences.
Core Retirement Options for Your 403(b) Funds
Upon retirement, you have several options for your 403(b) funds. One choice is to leave the money in the existing plan, allowing your investments to potentially continue growing tax-deferred. However, some plans may require you to move the funds after you stop working. Review your plan’s documents to confirm if this option is available to you.
Another option is to roll the 403(b) balance into an Individual Retirement Account (IRA), moving the savings to an account you control directly. This gives you access to a broader array of investment choices than what is offered in most 403(b) plans. Consolidating assets from old employer plans into one IRA can also simplify financial management.
A rollover to a Traditional IRA maintains the funds’ pre-tax status, and you will pay income taxes on future withdrawals. Alternatively, you can convert the funds to a Roth IRA. This requires paying income tax on the rollover amount in the year of the conversion, but qualified withdrawals will then be tax-free. This strategy can be beneficial if you expect to be in a higher tax bracket during retirement.
You may also be able to roll your 403(b) funds into a new employer’s retirement plan, like a 401(k), if the new plan accepts them. You can also use your 403(b) assets to purchase an annuity, which is a contract with an insurance company that provides a guaranteed income stream. Many 403(b) plans are administered by insurance companies and may feature annuity products as a distribution option.
You can also take distributions directly from the 403(b) plan as cash payments. This can be a single lump-sum withdrawal of the entire account balance. Alternatively, you can arrange for systematic withdrawals on a regular schedule, such as monthly or annually, to create an income stream.
Understanding Distribution Rules and Taxation
How your 403(b) funds are taxed depends on whether it is a Traditional or Roth account. With a Traditional 403(b), contributions are pre-tax, lowering your taxable income during your career. As a result, all withdrawals of contributions and earnings are taxed as ordinary income.
A Roth 403(b) is funded with after-tax dollars, so you receive no upfront tax deduction. Consequently, qualified distributions from a Roth 403(b) are tax-free. A distribution is considered qualified if the account is at least five years old and you are at least 59½ years old.
The IRS has age-based rules for accessing retirement funds. You can begin taking distributions from your 403(b) without penalty once you reach age 59½. If you withdraw funds before this age, the taxable portion of the distribution is subject to a 10% early withdrawal penalty in addition to regular income tax.
An exception to this penalty is the “Rule of 55.” This IRS provision allows for penalty-free withdrawals from your 403(b) if you leave your job during or after the year you turn 55. This rule applies only to the 403(b) plan of the employer you just left and does not apply to IRAs or plans from previous employers. The funds must remain in that specific 403(b) for the exception to apply.
Required Minimum Distributions (RMDs) are another governing factor. The SECURE 2.0 Act raised the starting age for RMDs to 73. This rule requires you to withdraw a minimum amount from your Traditional 403(b) each year, calculated using your account balance and an IRS life expectancy factor. Failure to take the full RMD results in a 25% penalty on the amount that should have been withdrawn, which can be reduced to 10% if corrected promptly. RMD rules do not apply to Roth 403(b)s for the original owner.
Initiating Withdrawals and Rollovers
When you are ready to access your 403(b) funds, contact the plan administrator, which is the financial institution managing your account. The administrator will provide the necessary distribution or rollover forms and specific instructions. These forms are required to request access to your savings.
When executing a rollover, you can choose a direct or indirect rollover. In a direct rollover, your 403(b) plan administrator sends the funds directly to the new institution, like an IRA provider. This method is recommended as it avoids tax withholding complications, and the payment is made to the new account, not to you.
In an indirect rollover, the administrator sends a check made out to you, and you have 60 days to deposit the funds into a new retirement account. With this method, the plan must withhold 20% for federal income taxes. To complete a full rollover, you must use other funds to make up for that 20% withholding, or the withheld amount will be treated as a taxable distribution.
To request a cash distribution, complete the form from your plan administrator, specifying a lump-sum or periodic payments. You will need to provide your banking information for direct deposit or a mailing address. After submitting the paperwork, processing time can range from a few business days to several weeks. Your plan administrator will send you IRS Form 1099-R the following January for any taxable distributions, which you must use for your tax return.