Taxation and Regulatory Compliance

Taxes on a 403(b) Tax-Sheltered Annuity Explained

Understand how a 403(b) tax-sheltered annuity is taxed, from contributions to withdrawals, including penalties, required distributions, and rollover options.

A 403(b) tax-sheltered annuity (TSA) is a retirement plan for employees of public schools, certain nonprofits, and some religious organizations. It provides tax advantages that help individuals grow their savings. Understanding how these accounts are taxed—on contributions, withdrawals, and rollovers—is crucial for financial planning.

Tax rules determine when and how much account holders pay, especially regarding early withdrawals and required distributions. Strategic planning can reduce tax burdens and maximize retirement income.

Eligibility Criteria

A 403(b) plan is available to employees of public schools, colleges, universities, nonprofit organizations under Section 501(c)(3) of the Internal Revenue Code, and certain religious institutions. Unlike private-sector plans, eligibility is tied to the employer.

Employers must offer a 403(b) plan for employees to participate; individuals cannot open one independently like an IRA. Some organizations automatically enroll employees, while others require them to opt in. Full-time employees are typically eligible, while part-time or temporary workers may face restrictions based on hours worked or tenure.

Certain religious organizations, such as churches and church-affiliated schools, may offer a church plan, which is exempt from some regulatory requirements like nondiscrimination testing. This exemption allows greater flexibility in structuring retirement benefits.

Contributions

Employees can make pre-tax or Roth (after-tax) contributions, depending on their employer’s plan options. Pre-tax contributions lower taxable income in the year they are made, deferring taxes until withdrawal. Roth contributions do not provide an immediate tax deduction but allow for tax-free withdrawals in retirement if specific conditions are met.

For 2024, the standard contribution limit is $23,000. Employees aged 50 or older can contribute an additional $7,500, bringing their total to $30,500. A unique 15-year service catch-up provision allows employees with at least 15 years at the same eligible employer to contribute an extra $3,000 per year, up to a lifetime limit of $15,000.

Contributions are deducted directly from paychecks, ensuring consistent savings. While employer matching contributions are less common than in 401(k) plans, they do exist. Employer contributions do not count toward an employee’s contribution limit but are subject to a separate total cap. For 2024, the combined limit for employee and employer contributions is the lesser of $69,000 or 100% of the employee’s compensation.

Tax Treatment on Distributions

Withdrawals are taxed based on contribution type and the account holder’s age. Pre-tax contributions and earnings are fully taxable as ordinary income upon withdrawal.

Roth 403(b) withdrawals are tax-free if the account holder is at least 59½ and has held the account for at least five years. Otherwise, the earnings portion is taxed as ordinary income, while original contributions remain tax-free.

Large withdrawals from a traditional 403(b) can push retirees into a higher tax bracket, increasing tax liability. These withdrawals may also impact Social Security taxation. If total income, including 403(b) distributions, exceeds certain thresholds, up to 85% of Social Security benefits may become taxable.

Early Withdrawal Penalties

Withdrawing funds before age 59½ typically incurs a 10% penalty on the taxable portion, in addition to ordinary income taxes. However, exceptions exist.

Individuals who leave their job in or after the year they turn 55 can withdraw funds penalty-free under the “age 55 rule.” This does not apply to IRA rollovers.

Other exceptions include permanent disability and unreimbursed medical expenses exceeding 7.5% of adjusted gross income (AGI).

Substantially equal periodic payments (SEPP), or Rule 72(t) distributions, allow penalty-free withdrawals if taken in a series of predetermined amounts for at least five years or until age 59½, whichever is longer. Stopping or modifying payments prematurely can result in retroactive penalties.

Required Minimum Distributions

Once account holders reach a certain age, they must begin required minimum distributions (RMDs) to ensure tax-deferred savings are taxed.

For those turning 73 in 2024 or later, RMDs must begin by April 1 of the following year. After the first RMD, subsequent withdrawals must be taken annually by December 31. The required amount is based on the prior year’s account balance and the IRS Uniform Lifetime Table. Failing to take the required amount results in a 25% excise tax on the shortfall, which can be reduced to 10% if corrected within two years.

Unlike Roth IRAs, Roth 403(b) accounts are subject to RMDs, though this requirement will be eliminated starting in 2024 under the SECURE 2.0 Act.

Employees still working for the organization sponsoring their 403(b) may delay RMDs until retirement, provided they do not own more than 5% of the company. This exception does not apply to IRAs or previous employer plans. Large RMDs can push retirees into higher tax brackets, potentially increasing Medicare premiums and Social Security taxation.

Rollover Options

When leaving an employer or retiring, individuals may roll over their 403(b) funds to another retirement account, preserving tax-deferred growth and expanding investment options.

A direct rollover to a traditional IRA or another employer-sponsored plan, such as a 401(k) or 457(b), is the most tax-efficient option. Funds are transferred directly between financial institutions, avoiding mandatory withholding and immediate taxation. If an individual instead receives a distribution and deposits it into a new account within 60 days, the IRS requires a 20% withholding, which must be replaced out-of-pocket to complete a full rollover. Any portion not redeposited is taxed as income and may incur early withdrawal penalties.

Rolling over funds from a traditional 403(b) to a Roth IRA is treated as a taxable conversion, adding the transferred amount to taxable income for the year. While this creates an upfront tax burden, future withdrawals from the Roth IRA will be tax-free if conditions are met. This strategy benefits those expecting higher tax rates in retirement or seeking to minimize RMDs, as Roth IRAs are not subject to mandatory withdrawals.

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