Doing good for others can be hard work. Thankfully, employees of various non-profit organizations, such as schools and other tax-exempt organizations, can benefit from enrolling in a 403(b) plan, officially known as a tax-deferred annuity.

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A 403(b) plan is a type of tax-deferred retirement plan that is similar to the 401(k) plans offered by many employers. Most contributions to a 403(b) plan are tax-deductible. The IRS regulates the operation of 403(b) plans, which must conform to certain contribution and participation rules in order to maintain tax-deferred status.

403(b) characteristics

Generally speaking, only your employer can make contributions to your 403(b) account. As with a 401(k) plan, if you participate in a 403(b) plan your employer will take money out of your paycheck before you receive it and deposit it into your 403(b) plan account. This is known as an elective deferral.

Since you do not report the amount of the deposit as taxable income on your income tax, it effectively works like a tax deduction. If your employer makes matching or other additional deposits to your account, those are also tax-deferred.

403(b) contribution limits

The IRS controls the limits on how much you can contribute to a 403(b) plan, and this amount is subject to change.

  • As of 2020, the limit on annual elective deferrals is $19,500.
  • The total annual amount that both you and your employer can contribute to your account equals $57,000.
  • The IRS allows an additional "catch-up" contribution of $6,500 if you are age 50 or older.

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Additionally, if you have at least 15 years of service with an employer and have made average annual contributions of less than $5,000, the IRS permits an additional lifetime "catch-up" amount of $15,000 that you can use in $3,000 per year increments.

Non-deductible contributions

Depending on your specific plan, you may also be allowed to make non-deductible contributions to your 403(b) account. Also known as after-tax contributions, your employer can take these payments directly out of your paycheck but you must include them in income when you file your taxes. The contribution limit on non-deductible contributions is included as part of the total annual contribution limit as set by the IRS.

Taxation upon distribution

Both contributions and earnings in a 403(b) plan grow tax-deferred, meaning you do not have to pay any tax at all if your accounts rise in value, regardless of any transactions you make within the plan.

For example, if your plan consists of a series of mutual funds, you will not have to pay tax on the account even if you sell some mutual fund shares at a gain.

However, upon distribution from the account, all of your 403(b) funds become taxable. You must report every withdrawal to the IRS and pay ordinary income tax on the amount of the distribution.