The 403(b) Lifecycle Getting Money Out of a 403(b)
October 18, 2022
The goal of retirement savings accounts is to accumulate money, while working, to pay living expenses in later life. In a perfect world, 403(b) plan participants save religiously for decades without touching their savings. In the real world, “stuff happens” (e.g., illness, unemployment, and expensive repairs). Withdrawals may need to take place before retirement age to provide money for unanticipated life events.
Most 403bwise posts focus on putting money into 403(b)s and other retirement savings plans: “finding” money to save, selecting a vendor and investment asset allocation, mid-career catch-up strategies, income tax write-offs, and more. This post is different. Instead of savings accumulation, the focus is taking money out of retirement plans for a variety of reasons including financial hardship and later life living expenses.
Back-end plan distributions are as important as plan contributions and include loans, hardship withdrawals, 72(t) and Rule of 55 withdrawals, voluntary penalty-free withdrawals between ages 59½ to 71, and mandatory required minimum distributions (RMDs) starting at age 72. Other types of withdrawals include account transitions upon job changes, or to switch to a high-quality vendor, and payments to beneficiaries.
This post briefly describes occasions when plan participants (or designated beneficiaries) take money out of 403(b) accounts. Process steps and tax implications for each type of withdrawal method are described. Research results, three “need to know” facts, and six take-away action steps conclude this discussion.
403(b) Plan Loans
One way to tap a 403(b) account is borrowing money from it according to terms specified by the plan administrator. An advantage of 403(b) loans is the ability to tap retirement savings temporarily during a time of financial need without having to empty the account. A major disadvantage is forgone tax-deferred compound interest on money that is withdrawn and not invested.
Federal tax rules state that the maximum amount that can be borrowed from a 403(b) is the lesser of $50,000 or 50% of a participant’s vested account balance. For example, someone with a $90,000 balance could borrow up to $45,000 and someone with a $140,000 balance can borrow up to $50,000. Some plans may also allow participants with balances of less than $10,000 to borrow up to $10,000.
Plan participants who take out 403(b) loans must generally repay them within five years with payments made at least quarterly. There is one exception, however. Those who use a loan to buy a primary residence may extend the repayment period to 15 years. Interest charges are based on current market rates and loan payments are withheld from workers’ paychecks.
When loan payments are not made according to schedule, the outstanding balance is treated as a taxable distribution and may also be subject to the 10% early distribution penalty (for workers under age 59½). If workers leave their job before a loan is repaid, they need to repay the loan, typically by the tax filing deadline for the year of the distribution.
Hardship Distributions
With hardship distributions, money is withdrawn permanently. 403(b) plans may or may not allow them but, if they do, plan administrators set specific rules. In general, hardship distributions are only allowed if: 1. a plan participant has an “immediate and heavy” financial need (e.g., medical care, funeral expenses, necessary house repairs, payments to prevent eviction or foreclosure) and 2. the distribution is not larger than the amount necessary to cover the financial need.
With the exception of Roth 403(b) plan contributions, hardship distributions are subject to ordinary income taxes at a worker’s marginal tax rate and may also be subject to the 10% early distribution penalty. The money that is withdrawn cannot be repaid later.
Job Changes
There are four possible options for 403(b) participants who change employers. The actual number depends on what former and new employers allow. The options are: 1. leave savings in the former employer plan (if allowed), 2. roll savings into the new employer plan (if allowed), 3. roll savings into an individual retirement account (IRA), and 4. cash out the account (not recommended due to taxes and loss of tax-deferred growth).
Key factors to consider when making 403(b) account decisions are the quality of new and old employer plan vendors and investments available through these vendors. Ideally, employers should provide quality vendors (e.g., Fidelity, Vanguard, TIAA, T. Rowe Price, and Aspire) and low-cost investments such as index funds. Tools like the 403bwise vendor search tool can provide necessary background information. When money is rolled over to an IRA, there may be more investment options to choose from, but no loan provisions.
Rule 72(t) Withdrawals
Internal Revenue Code Section 72(t) allows 403(b) participants who are younger than age 59½ to avoid the 10% early distribution penalty if they take substantially equal periodic payments or SEPPs (i.e., withdrawals) that are determined by IRS formulas. Payments must continue for the later of five years from the date that withdrawals first begin or until the account owner reaches age 59½. For example, SEPPs starting at age 57 must continue to age 62 (five years) while those that begin at age 48 must continue to age 59½.
Once taxpayers start making SEPPs, they must “stick with the program,” sometimes for decades (e.g., almost 15 years if withdrawals begin at age 45). Professional assistance is advised for 72(t) withdrawals. Failure to withdraw the proper amount required can result in tax penalties and even interest due on tax penalties.
The Rule of 55
Another penalty-free way to take 403(b) withdrawals is the “Rule of 55,” which applies if 403(b) participants leave their job (voluntarily or involuntarily) during or after the calendar year they turn 55. In this case, they can elect to retire early and withdraw some or all of their savings in a lump sum. Withdrawals are, of course, taxable as ordinary income and may result in a higher tax bracket.
Not all 403(b) plans allow Rule of 55 withdrawals, however, because they can hinder employee retention efforts. There is also a risk that former employees could mismanage their withdrawals and run out of money. A key condition is that savings must remain in a current employer’s plan to make penalty-free withdrawals. It cannot be rolled over into an IRA.
Voluntary Penalty-Free Contributions
Early withdrawal penalties end at age 59½ and mandatory RMDs begin at age 72. What 403(b) participants do with their account between these two ages is up to them. Key variables to consider when deciding when to begin taxable withdrawals include financial need, health status, account balance (does it need more time to grow?), other sources of retirement income (e.g., a pension), and projected future income tax bracket.
Affluent retirees with multiple income streams may elect to start withdrawals from 403(b)s or other tax-deferred plans in their 60s to lower account balances and spread tax payments over a longer time frame.
Required Minimum Distributions
RMDs must start at age 72 and are added to taxable ordinary income. There are two key dates: December 31 (the deadline for routine annual RMD withdrawals) and April 1 of the year after the year someone turns 72 (required beginning date for first RMD). To calculate RMDs, taxpayers divide the balance in their 403(b) account on December 31 of the previous year by the appropriate divisor for their age.
Depending on size of a 403(b) balance, RMDs can raise the taxable income (and income taxes) of retirees modestly or enough to move into a higher tax bracket. Accurate tax withholding is essential. It is also important to get RMD calculations correct. If not, the IRS charges a hefty penalty equal to half the amount that should have been taken out but wasn’t.
Other 403(b) Withdrawals
Disability and Death — In addition to loans, hardship distributions, and withdrawals upon separation from an employer, 403(b) participants can also withdraw money penalty-free if they become disabled or have medical expenses that exceed 7.5% of adjusted gross income. If they die, their beneficiaries will receive distributions.
Leaving a Bad 403(b) Plan — More a transfer than a withdrawal, 403(b) participants who leave a high-cost vendor with expensive, commission-based products also move money. 403bwise has step-by-step instructions on how to do this.
Roth Account Withdrawals — Roth 403(b) accounts can only be rolled over to other Roth accounts- not pre-tax accounts. There are no taxes and penalties due on Roth 403(b) earnings withdrawals when account owners turn 59½ and have owned an account for at least five tax years.
Research Results
When accumulating money during working years, it is not uncommon for 403(b) participants to dip into their accounts. One study found that more than 25% of households dip into retirement savings plans. “Leakage” from retirement plan assets for non-retirement purposes amounts to $60 billion annually, highlighting the need for an emergency fund as well as retirement savings. Insufficient emergency savings for economic “shocks” such as medical bills and car repairs was strongly associated with breaching retirement accounts.
On the decumulation side, a study investigated strategies to draw down retirement accounts to avoid either outliving savings or scrimping on spending. The comparison found using RMDs, based on life expectancy, does as well as other strategies (e.g., spending only income) and actually outperforms the well-publicized “4% Rule.” Studies have also found that RMD rules have important effects on savings withdrawals.
Three (More) Things
- Rollovers into a qualified account (e.g., IRA) must be done within 60 days of receiving the money if a direct transfer between plan custodians is not made. Otherwise, taxes and penalties may apply.
- Plan participants in the armed forces may have payments for loans from tax-deferred accounts suspended, and the repayment period extended, during periods of active duty service.
- Rolling over money from former job 403(b) accounts into a current employer plan before leaving a final job provides access to “old” money via the Rule of 55 and will also make RMD calculations easier.
Six Smart Strategies
No. 1: Compare Borrowing Options — Consider alternative sources for cash before tapping a 403(b) and forgoing compound interest on borrowed money. This is especially true if your job is “shaky” and could end before a 403(b) loan can be repaid.
No. 2: Know the Rules — Find out how your employer plan determines an “immediate and heavy need” for hardship withdrawals. Key factors some plans might consider are whether or not the hardship was foreseeable and/or involuntary.
No. 3: Fund Some Roth Accounts — Consider Roth 403(b)s and Roth IRAs for two reasons: 1. tax diversification in later life and 2. tax-free and penalty-free withdrawals from money that was contributed to a Roth account with after-tax dollars.
No. 4: Stick With the Plan — Commit to the required withdrawals as described above if you decide to take 72(t) installments (SEPPs) to avoid the early withdrawal tax penalty. There is no flexibility if your financial situation changes as there is with the Rule of 55.
No. 5: Plan Your Start Date — Consider taking withdrawals from 403(b)s and other tax-deferred plans prior to age 72 if it makes sense tax-wise and/or there is a need for immediate income. Consult a financial advisor to minimize RMD tax impacts.
No. 6: Withhold Taxes Carefully — Remember that RMDs are taxed as ordinary income for the year they are withdrawn. Most 403(b) vendors can withhold taxes upon request. However, their withholding is only for the money that they manage. Do a mid-year tax estimate and use the IRS safe harbor rules to avoid under-withholding tax penalties.
In Summary
While plan participants are working, savings in tax-deferred retirement plans is not meant to be used for non-retirement purposes. Therefore, it is not easy to withdraw money from 403(b)s, but it is possible if rules established by employers and the IRS are followed and withdrawals meet statutory guidelines.
In later life, money must be withdrawn from 403(b)s and other tax-deferred plans via RMD rules created by Congress and enforced by the IRS. This money can be spent, gifted, or re-saved in a taxable account or Roth IRA (if qualified) as account owners desire.
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.