403(b) Plans and Income Taxes

March 8, 2025

By Barbara O'Neill, CFP®, AFC®

With 2025 tax season open for filing 2024 income tax returns, now is a good time to review the interface between 403(b) plans and income taxes during working years and in later life. A previous post described the 403(b) lifecycle that begins with the start of a public sector job and ends with the distribution of a deceased account holder’s 403(b) account assets. At every step along the way, there are income tax impacts.

Tax diversification is an investment strategy where money is placed in three types of accounts that are taxed differently. Ideally, retirement savers should have all three for maximum withdrawal flexibility: taxable (brokerage) accounts that produce taxable capital gains when securities are sold, tax-free accounts (e.g., Roth 403(b)s and IRAs), and tax-deferred accounts (e.g., traditional 403(b)s and IRAs), where taxes are postponed. In other words, “tax now,” “already taxed,” and “tax later” money. The latter two account types are discussed below. There is also a “tax never” investment, health savings accounts (HSAs), for those who qualify. 

This post describes tax-related retirement plan decisions and tax impacts during working years, financial gap years (age 59½ to required minimum distribution (RMD) age), and after RMDs begin. Since RMDs are taxed as ordinary income, strategies to mitigate their tax impact are also described as well as related topics such as portfolio rebalancing, rollovers, and account withdrawal methods (e.g., Rule of 55 and the 72(t) rule).

Also included is a summary of research about RMDs, which are often used as a de facto retirement savings income withdrawal strategy by older adults, and the impact of asset allocation on the volatility of RMDs. It concludes with three “need to know” facts, and six take-away action steps.

403(b) Income Tax Basics

Decisions that people make about retirement savings when they start work at a 403(b)-eligible job have tax implications for the remainder of their lives and beyond (i.e., taxes owed by heirs). When people are working, the government offers them a choice about when the IRS will tax retirement plan contributions and earnings:

• Option #1: Pay taxes now in the current tax year on a known taxable income at a known marginal tax rate under current tax legislation. There is no tax write-off, like there is for tax-deferred retirement savings, but workers can invest after-tax dollars (i.e., money that has been taxed) in taxable or tax-free Roth accounts.
• Option #2: Pay taxes later on an unknown future income at an unknown future tax rate. The pre-tax dollar amount that is contributed to a traditional 403(b) is subtracted from gross income and savers benefit from tax-deferred compound interest, often for several decades, before RMD withdrawals must be taken.

When workers elect option 2, they gamble that they will have less income and/or a lower tax rate in retirement vs. their working years. This may or may not happen. I teach personal finance courses for older adults and some students tell me the following:

• They were diligent savers for 40+ years and never expected in their 20s through 50s that they would accumulate as much wealth as they have now in their 60s and beyond, resulting in a “RMD problem.”
• They were told in early adulthood they would be in a lower tax bracket in later life and, instead, have a higher taxable income and/or tax bracket than when they were working with multiple sources of income including pensions, Social Security, taxable account interest/dividends, part-time work, and/or RMDs.

As 403(b) plan participants get older, they reach a 25-year time period with over a dozen milestone ages including those listed below related to retirement planning and income taxes:

403(b)s and Taxes: Working Years

During their working years, 403(b) plan participants can elect to contribute up to the maximum amount allowed by law to a pre-tax traditional and/or an after-tax Roth account. The maximum contribution in 2025 is $23,500, plus an additional $7,500 ($31,000 total) for workers age 50+ and an additional $11,250 for workers age 60 to 63 ($34,750 total).

Traditional 403(b) plan contributions are subtracted from employees’ gross income for the year that they are made. Taxable wages, as a result, are shown on W-2 forms in box 1 (Wages, tips, other compensation) while employees’ full gross income is shown in box 4 (Medicare wages and tips).

Example: $58,000 gross income - $12,000 (traditional 403(b) deposit) = $46,000 shown on form W-2, Line 1.

Roth 403(b)s have no up-front tax deduction when contributions are made but earnings can be withdrawn tax-free once an account owner reaches age 59 ½ and an account has been open at least five years. Taxpayers who want the benefits of both traditional and Roth accounts (i.e., a front-end tax write-off and tax-free withdrawals on the back end) may decide to split their annual deposit between both account types if their plan allows it.

If permitted by their plan, participants can take loans from a 403(b) account. The maximum amount that can be borrowed is typically the lesser of $50,000 or 50% of the vested balance (i.e., money in an account that is owned by an employee). The IRS also allows borrowers to take their full balance as a loan if the vested account balance is less than $10,000, subject to plan approval.

Borrowers must generally make payments at least quarterly and repay their loan within five years to avoid having it deemed a taxable distribution that may also be subject to a 10% early distribution penalty before age 59 ½. If employment is terminated, the full outstanding balance of a loan may become due. A 403(b) plan hardship distribution option may also be available for participants with an “immediate and heavy need” (e.g., foreclosure, eviction, funeral expenses, damage to a home). Withdrawals are taxed but not paid back into the account. They may also be subject to the 10% penalty but exceptions (e.g., disability, medical bills) apply.

There are two ways to withdraw money from 403(b) plans penalty-free prior to age 59 ½: 

• Rule of 55- If plan participants retire, quit, or are laid off from their job in the year they reach age 55 (or later), they can withdraw 403(b) funds without paying the 10% early withdrawal penalty. Of course, income taxes are owed on the withdrawn amount.
• 72(t) Rule- This rule can be used before age 55. It requires participants who want to tap their 403(b) early to take “substantially equal periodic payments” (SEPPs) for the later of at least five years or until they reach age 59 ½. For example, a 51-year old must take SEPPs until age 59 ½ while a 57-year old must take SEPPs until age 62. There are three IRS-approved methods to calculate the withdrawal amount.

403(b)s and Taxes: Financial Gap Years

Financial gap years are the time period between age 59 ½ (when early withdrawal penalties end) and the start of RMDs; i.e., 13.5 years or 15.5 years, based on birth year (see table above). During this time, withdrawals from 403(b) plans are voluntary and not penalized. Some 403(b) plan participants with defined benefit pensions may already be retired at this time and may have a lower income than they will after RMDs begin.

Some people elect to start 403(b) plan withdrawals during their financial gap years for several reasons: 

• To spread out taxable income over multiple years to prevent a big spike in income tax when RMDs begin
• To reduce the size of their account, leading to smaller RMDs and a lower tax burden in later years
• To manage future income to avoid the IRMAA Medicare surcharge and net investment income tax (NIIT)
• To provide an income bridge so Social Security can be postponed up to age 70 to earn larger benefits
• To avoid the risk of tax law changes that result in higher future tax rates (i.e., legislative risk)
• To strategically withdraw funds at a lower tax rate if pre-RMD age income is significantly reduced

403(b)s and Taxes: RMD Years

In my book, Flipping a Switch, I describe required minimum distributions (RMDs) as “the mandatory flipped switch” (i.e., life transition). Unlike many other decisions in later life that involve choices, there is no choice about RMDs. They must begin at age 73/75, unless taxpayers want to pay a hefty 25% tax penalty. RMDs are based on a taxpayer’s current age divisor and their account balance on December 31 of the previous year. 

Example: the divisor for age 73 is 26.5. Someone age 73 with a $100,000 403(b) account must withdraw at least $3,774 ($100,000 ÷ 26.5, rounded). With a $1 million account, the RMD is $37,736 (rounded). Sizable RMD withdrawals can often move plan participants into a higher tax bracket.

RMDs can be taken as one withdrawal or a series of withdrawals during the course of a year. Some people arrange automatic monthly payments through their retirement plan custodian to simulate a “paycheck” while others take their RMD quarterly or in one lump sum. As taxpayers’ age increases, the percentage of their account balance that must be withdrawn increases. At age 73, RMDs (divisor of 26.5 ) are 3.77% of an account balance. At ages 80, 90, and 100, the percentages are 4.96%, 8.20%, and 15.63%, respectively.

Taxpayers can elect to take their first RMD by April 1 of the year after the year they turn 73 (or 75). However, if they do this, they will have two distributions the following year: for the current tax year and previous tax year. It should also be noted that, since 2024, Roth 403(b) plans are not subject to mandatory withdrawals.

Below is a planning tool for RMD withdrawals. This money can be spent, gifted, or re-saved in a taxable account or possibly a Roth IRA. Many account custodians set the default amount for income tax withholding at 20% of the amount that is withdrawn. 

Some 403(b) participants have multiple 403(b) plans from work for different employers. RMDs for each 403(b) should first be calculated separately and then combined. Next, RMD amounts for all of the 403(b)s can be taken from any one or more of the 403(b) accounts. One reason to do this is for portfolio rebalancing.

Tax Mitigation Strategies

The goal of tax planning in later life is to not have RMDs bump up your tax bracket. Two common tax mitigation moves are qualified charitable distributions (QCDs) and Roth conversions. QCDs are only available for traditional IRAs- not 403(b)s- starting at age 70 ½. Money is withdrawn from the IRA (up to $108,000 in 2025) and sent directly to a qualified charity by the plan custodian. QCDs can reduce IRA assets before RMD age (e.g., during the 2 ½ years between age 70 ½ and 73) or satisfy the RMD requirement at age 73 +.

Roth conversions (i.e., moving money from a tax-deferred traditional account to a tax-free Roth account) can be done at any age for both traditional IRAs and pre-tax traditional 403(b)s if the plan has a Roth account option and permits conversions. It is generally wise to do Roth conversions in stages to avoid income bumps while converting. The converted amount is taxed as ordinary income in the year of the conversion.

Related Topics

Inherited 403(b) Accounts — Many 403(b) participants, especially “super savers,” will have money left in their plan after they pass away. Plan beneficiaries can include a spouse, non-spouse (e.g., child, parent, sibling, cousin, friend), and/or qualified charity. Surviving spouses have several options for their inheritance, the easiest being to roll inherited money into their name and start RMDs at their required age. Non-spouse beneficiaries must fully withdraw account assets by December 31 of the 10^th anniversary of the original account owner’s death. If the original owner was already taking RMDs, beneficiaries must make annual withdrawals. Charitable organization beneficiaries must withdraw account funds within five years. No federal tax is owed.

Portfolio Rebalancing — Unlike taxable brokerage accounts, 403(b) accounts can be rebalanced without triggering taxable capital gains. Rebalancing is the process of buying and selling securities to realign investors’ portfolios with their target asset allocation (e.g., 70% stock, 25% bonds, 5% cash assets). It should be done periodically as asset weights shift. Once RMDs begin, consider selling assets that have appreciated substantially in bull markets (e.g., stock) and avoid selling assets that are declining more than others during market downturns.

Rollovers — 403(b) participants who retire or leave an employer are eligible to roll over their account balance into a IRA. Many do this to leave high-cost Red vendors and to access a wide variety of investment options via low-cost vendors such as Fidelity, T.Rowe Price, and Vanguard. It may also be possible to roll over IRA assets into a 403(b), if a plan permits, if someone plans to work beyond RMD age and wants to postpone RMDs using the “still working exception.” Specific rules apply and postponed RMDs will be larger when they finally begin.

Research Results

Research by J.P. Morgan Asset Management indicates that a majority (80%) of tax-deferred account owners do not make taxable withdrawals until they are required to do so and about 84% withdraw only the minimum amount. In other words, they are using the IRS life expectancy table and their RMDs as a default decumulation strategy and letting the IRS determine the size of their annual income withdrawals.

Another study examined the impact of asset allocation on the volatility of RMDs. It found that, with more bonds and less stock in a retirement plan portfolio, RMDs are less volatile but fewer dollars can be expected to be paid out. Conversely, RMD distributions can be very volatile with a stock-heavy asset allocation.

Three (More) Things

• 403(b) participants who make contributions to Roth accounts will have lower take-home pay than if they contributed the same amount to a pre-tax dollar traditional account.
• Unlike Roth IRAs, there is no income limit for Roth 403(b) contributions. This makes them attractive for higher earners who are seeking tax-free income in later life.
• IRS rules allow 403(b) participants with at least 15 years of service to the same employer to contribute an additional $3,000 a year, up to $15,000, in addition to the standard catch-up amounts described above.

Six Smart Strategies

No. 1: Relax About Longevity Risk — Consider this: the IRS life expectancy table for RMDs goes up to age 120. Since many retirees are using their RMD as their annual income withdrawal, they are unlikely to exhaust their savings during their lifetime. 

No. 2: Prepare for Tax Season — Gather W-2 and 1099 forms (NEC, DIV, INT, etc.), organize tax information by categories (e.g., banks and brokerage accounts), and review last year’s tax return to determine differences between 2023 and 2024.

No. 3: Practice Tax Diversification — Aim to save approximately equal amounts over time in tax-deferred (traditional) accounts, tax-free Roth accounts, and taxable (brokerage) accounts. Review their percentage weightings periodically.

No. 4: Maximize Your Gap Years — Consider making Roth conversions before RMDs begin if you find yourself in a lower tax bracket in early retirement than you were when you were working full-time.

No. 5: Review Your Beneficiary Designations — Make sure contingent beneficiaries are named for your 403(b) and other retirement plans in case primary beneficiaries wish to disclaim their inheritance to avoid the associated income tax burden. 

No. 6: Get Help When Needed — Seek advice from your 403(b) plan custodian and/or a fiduciary financial planner throughout the 403(b) lifecycle when you have questions about investment asset allocation, tax planning, and taking RMDs.

In Summary

403(b) plans are a valuable tool to build wealth for financial security in later life. Plan participants should understand how they are taxed (i.e., traditional vs. Roth accounts) and associated tax minimization strategies.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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