Barbara O'Neill: 403(b) and Income Taxes
April 12, 2022
Guest post by Dr. Barbara O’Neill, CFP®, AFC®
As 2021 income tax season wraps up, now is a great time to review the tax impact of 403(b) plans. There is, perhaps, no better phrase to describe this than “pay taxes now or pay them later.”
When people are working, the government offers a choice as to when the IRS will tax 403(b) plan contributions and earnings:
- Pay taxes now on a known current income at a known tax rate, or
- Pay taxes later on an unknown future income at an unknown future tax rate.
When workers elect to pay taxes later, they gamble they'll have less income and/or a lower tax rate in retirement vs. their working years. They also benefit from decades of tax-deferred compound interest.
This post explores tax aspects of 403(b) plans on both the “front end” (while working) and “back end” (during retirement). It includes a discussion of tax-deferred investing, before- and after-tax dollar investments, traditional and Roth 403(b) plans, 403(b) plan contribution limits, required minimum distributions (RMDs), “need to knows,” research findings, and six take-away action steps.
“Front End” Tax Topics
Tax-Deferred Investing
The term “tax-deferred” means income taxes are not owed on an investment until it is sold in the future (e.g., during retirement). Until that time, untaxed earnings are added to plan contributions. Traditional 403(b) accounts and similar employer plans, along with traditional individual retirement accounts (IRAs) and SEP-IRAs, are examples of tax-deferred accounts.
Tax-deferred accounts hold funds that would otherwise be paid in taxes, often for decades. Therefore, more money is available to invest, which increases investment returns and makes savings last longer. An online search of “taxable vs. tax-deferred calculators” provides dozens of tools to use for personalized analyses.
Before- and After-Tax Dollar Contributions
Some 403(b) plan participants can choose when to pay taxes on the amount that they deposit into their account and whether to have tax-deferred contributions now or tax-free distributions later.
Before-tax dollar (a.k.a., pre-tax) investments use money that has not been taxed at the time deposits are made. They reduce a taxpayer’s current adjusted gross income (AGI), but future distributions are taxed at ordinary income tax rates that currently range from 10% to 37%. Common examples of pre-tax accounts are pensions and traditional IRAs.
Conversely, after-tax dollar investments are made with money that has already been taxed. Investors pay income tax upfront in the year investments are made, but get to keep more money in retirement. Common examples are Roth IRAs and taxable savings and brokerage accounts.
Traditional 403(b) Plans
Traditional 403(b)s are the most common plan type. Contributions are made pre-tax and participants defer taxes on their contributions and investment earnings until money is withdrawn in retirement.
The amount contributed to a traditional 403(b) is excluded from taxable income in the year it is deposited. For example, if someone earns $60,000 and contributes $5,000 to a traditional 403(b), only $55,000 is included in income tax calculations. Thus, traditional 403(b)s provide an immediate tax advantage.
Roth 403(b) Plans
Roth 403(b) plans are funded with after-tax dollars so there is no immediate tax write-off. Their advantage comes later when plan participants do not have to pay taxes again on plan contributions and investment earnings. Roth 403(b) plans, made permanent in 2006, are not available through every non-profit employer.
If an employer has both plans, employees who want to “hedge their bets” regarding present and future tax costs and benefits might consider dividing their savings between a traditional and Roth 403(b) account.
Contribution Limits
The maximum amount that can be contributed to 403(b) plans (either type) in 2022 is $20,500 for workers under age 50 and $27,000 for workers age 50+ with the $6,500 catch-up contribution. Plan deposits are known as “elective deferrals.” Individual employers typically set minimum contributions (e.g., 1% of pay).
A small percentage of non-profit employers match workers’ 403(b) contributions (e.g., 50 cents per $1 saved), resulting in additional tax-deferred savings.
The “15 Year Rule”
A unique feature of 403(b)s is an additional catch-up contribution in addition to the standard amount for all employer retirement savings plans. Plan participants who have worked for the same employer for at least 15 years can contribute up to $3,000 more per year, up to a total of $15,000, if their plan permits.
For example, a mid-career 40-year old teacher with 15 years of service could contribute up to $23,500 ($20,500 + $3,000) in 2022, again providing additional tax-deferred savings.
Early Withdrawal Tax
Like IRAs and other tax-deferred employer plans, 403(b)s have a 10% early withdrawal tax (in addition to ordinary income tax) on withdrawals made before age 59½. This tax penalty erodes investment earnings.
Certain exceptions apply, however, including death of a plan participant, disability, making a series of substantially equal payments for at least five years or until age 59½ (the IRS 72(t) rule), and high unreimbursed medical expenses.
“Back End” Tax Topics
Required Minimum Distributions
As noted in a previous post, required minimum distributions (RMDs) from 403(b) plans must begin at age 72. Withdrawals are taxed as ordinary income and are required regardless of financial need. In 2022, a new IRS Uniform Lifetime Table went into effect. Age-related divisors are a bit larger, and RMDs smaller, than the previously-used table.
Depending on the 403(b) balance, RMDs can raise the taxable income (and income taxes) of retirees modestly or significantly as shown in the example, below, with the divisor (27.4) for age 72:
- $10,000 balance: $10,000 ÷ 27.4 = $365 (rounded) RMD
- $100,000 balance: $100,000 ÷ 27.4 = $3,650 (rounded) RMD
- $1,000,000 balance: $1,000,000 ÷ 27.4 = $36,500 (rounded) RMD
Taxpayers with RMD withdrawals must make sure that there is sufficient income tax withholding on this money. This is typically done by directing their account custodian to withhold taxes and/or by sending the IRS quarterly estimated taxes using Form 1040-ES.
AGI-Sensitive Tax Impacts
RMD withdrawals, especially those stemming from large six- and seven-figure 403(b) account balances, can place someone in a higher tax bracket and trigger income tax on Social Security benefits and higher Medicare Part B and D premiums called IRMAA payments.
If you expect large RMDs in your future, consider consulting a financial advisor about tax mitigation strategies. For example, some 403(b) plan participants start withdrawals at age 59½ (after the early withdrawal penalty goes away) to reduce the size of their account at age 72.
Research Results
Studies have explored the comparative advantage of Roth and traditional retirement accounts, mostly IRAs. One study found that investment performance depends on the relationship between an individual’s tax rates at the time of investment and withdrawal. Another found that Roth account investors can achieve higher after-tax returns over traditional account investors, even when the latter invests their annual tax savings.
In a study that compared Roth and traditional 401(k) and 403(b) plans, researchers concluded that, if plan participants’ tax rate decreases in retirement, traditional accounts are superior to the Roth option until age 73. If tax rates rise during retirement, the Roth option is immediately superior.
Three (More) Things
Unlike IRAs, where taxpayers can make deposits until the April tax filing deadline, 403(b) plan contributions for each tax year must be made by December 31.
RMD taxes are serious business. The penalty for incorrect (or no) RMD withdrawals is 50% of the amount that should have been withdrawn, but wasn’t. Example: a $2,000 penalty for taxpayers who should have withdrawn $4,000.
Unlike Roth IRAs, there are no income eligibility limits for Roth 403(b) plans. Like Roth IRAs, Roth 403(b) contributions are made with after-tax dollars. Withdrawals are not taxed if the account owner is at least 59½ and the initial plan contribution was made at least five years ago.
Six Smart Strategies
No. 1: Tax-Diversify Your Portfolio
Given the tax on RMDs, don’t put all your retirement “eggs” in one tax “basket.” Instead, consider owning assets that are taxed in different ways. For example, traditional 403(b)s that are tax-deferred, Roth IRAs that are tax-free, and securities in taxable accounts that produce capital gains when they are sold.
No. 2: Project Your Future
Some older adults, especially “super-savers” and those with pensions, may have higher incomes in later life than when they were working. Their investment balances may also be larger than expected. Consider a Roth account (403(b) and/or IRA) if you expect your income and tax rate to rise in retirement.
No. 3: Play Catch Up
Between the annual age 50+ catch-up amount and the 15-year rule for 403(b)s, plan participants can save impressive amounts of additional money during the last half of their career. Online 403(b) calculators such as this one will show the amount that can be saved.
No. 4: Rebalance Within Your 403(b)
Regular saving for decades can cause tax concerns as account balances grow and larger amounts of money need to be shifted to maintain asset class weights (e.g. 50%, stock, 30% bonds, 20% cash). If rebalancing is done within a 403(b) account, however, no immediate tax is due.
No. 5: Kick It Up a Notch
Consider increasing 403(b) contributions regularly for additional tax benefits and retirement income. Two good times to do this are when income increases (e.g., a raise) or household expenses end (e.g., a car loan or child care).
No. 6: Get Help, When Needed
Many 403(b) plan providers have toll free numbers or assigned staff available to assist plan participants with tax-related issues such as the 15-year rule and RMDs. Another good source of information is “Office Hours” and webinars sponsored by 403bwise.org.
In Summary
403(b)s , like most investments, have tax consequences. However, tax-deferral “kicks the [tax] can down the road.” Over time, the gap in value between taxable and tax-deferred accounts, earning the same return, will widen as investments grow faster when earnings are added to principal without immediate taxation.
This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.
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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.