How Does a 403(b) Work When You Retire?

A 403(b) plan is a retirement savings vehicle offered to employees of public schools, certain tax-exempt organizations, and ministers. These plans are designed to help individuals save and invest for their future, with tax advantages. Understanding how to access and manage these funds in retirement is important for financial planning. This article covers distribution options, tax considerations, mandatory withdrawals, and methods for transferring your 403(b) savings in retirement.

Accessing Your 403(b) Funds

Once you reach retirement, you can begin taking money from your 403(b) plan without incurring an early withdrawal penalty. Eligibility for penalty-free distributions starts when you reach age 59½ or when you separate from service with your employer, provided you are at least age 55 in the year of separation. Distributions taken before age 59½ are subject to a 10% early withdrawal penalty.

You have several options for withdrawing funds from your 403(b). A lump-sum withdrawal involves taking the entire balance of your account at once. This option provides immediate access to all your funds but can result in a significant tax liability in the year of withdrawal.

Alternatively, you can opt for periodic payments, which are regular, scheduled withdrawals, such as monthly or quarterly distributions. This method can help create a steady income stream. Another option involves converting your 403(b) balance into an annuity, which provides a guaranteed stream of income payments, often for life.

To initiate any distribution, contact your plan administrator. They will provide the necessary forms and guide you through the procedures for requesting withdrawals. The process involves completing a distribution request form and providing supporting documentation.

Taxation of 403(b) Distributions

The tax treatment of your 403(b) distributions depends on how your contributions were made. Most 403(b) plans involve pre-tax contributions, meaning the money you contributed and any investment earnings grew tax-deferred. When you withdraw these funds, they are taxed as ordinary income at your federal and state income tax rates.

Some 403(b) plans also offer a Roth contribution option. Contributions to a Roth 403(b) are made with after-tax dollars. As a result, qualified withdrawals from a Roth 403(b) are tax-free. To be a qualified withdrawal, the account must have been open for at least five years, and you must be at least age 59½, disabled, or the distribution must be made to a beneficiary after your death.

When you receive distributions from your 403(b), federal income tax withholding applies. Plan administrators are required to withhold a percentage of your taxable distribution for federal taxes. You may adjust your withholding by submitting a Form W-4P to your plan administrator.

For tax reporting purposes, your plan administrator will issue you a Form 1099-R. This form summarizes the total amount of your distributions and any federal or state income tax withheld during the year. You will use the information on Form 1099-R to prepare your annual income tax return.

Required Minimum Distributions

Required Minimum Distributions (RMDs) are amounts the IRS mandates you withdraw from your traditional 403(b) and other tax-deferred retirement accounts once you reach a certain age. The purpose of RMDs is to ensure taxes are eventually paid on tax-deferred savings, preventing indefinite tax deferral.

The age at which RMDs must begin has changed due to legislative acts like the SECURE Act and SECURE 2.0 Act. For individuals turning age 73 in 2023 or later, RMDs begin at age 73. This age will further increase to 75 for those born in 1960 or later, effective January 1, 2033. Roth 403(b) accounts in employer plans are exempt from RMDs starting in 2024, aligning them with Roth IRAs.

The calculation of your RMD is based on your account balance at the end of the previous year and your life expectancy factor, as determined by IRS life expectancy tables. Your plan administrator may calculate and process your RMD automatically, but it is your responsibility to ensure the correct amount is withdrawn. Failing to take your RMD or taking less than the required amount can result in significant penalties.

Under SECURE 2.0, the penalty for failing to take a timely RMD was reduced from 50% to 25% of the amount not taken. This penalty can be further reduced to 10% if the RMD is taken in a timely manner and any necessary corrective steps are completed within a specified period. You have the option to delay your first RMD until April 1st of the year following the year you reach the RMD age, though this means you would take two RMDs in that subsequent year.

Rollovers and Transfers

Instead of taking taxable distributions, you may choose to move your 403(b) funds to another retirement account. A common option is to roll over your 403(b) into an Individual Retirement Account (IRA), which can be either a Traditional IRA or a Roth IRA, depending on the tax status of your 403(b) funds. Rolling over funds to an IRA can offer benefits such as a wider range of investment options and simpler management by consolidating multiple retirement accounts.

When performing a rollover, a direct rollover is the preferred method. In a direct rollover, your 403(b) plan administrator transfers the funds directly to the new IRA custodian or another eligible retirement plan. This method avoids mandatory 20% federal income tax withholding and eliminates the risk of missing the 60-day rollover deadline.

An indirect rollover involves your 403(b) funds being paid directly to you, and you then have 60 days to deposit the funds into another eligible retirement account. If you choose an indirect rollover, your plan administrator is required to withhold 20% of the distribution for federal income taxes. To complete the rollover successfully and avoid taxes and penalties, you must deposit the full original distribution amount, including the 20% that was withheld, into the new account within the 60-day window.

You may also have the option to roll over your 403(b) funds into a new employer’s qualified retirement plan, such as a 401(k) or another 403(b), if the plan accepts rollovers. Qualified rollovers are tax-free events at the time of transfer, meaning taxes are deferred until distributions are taken from the new account. However, rolling a pre-tax 403(b) into a Roth IRA is considered a Roth conversion and is a taxable event, with the entire amount rolled over taxed as ordinary income in the year of the conversion.