What is a 403(b)?
Section 403(b) of the Internal Revenue Code (IRC) describes a special type of defined contribution retirement plan available only to public schools, tax-exempt organizations, and certain ministers. There are three categories of funding arrangements to which Section 403(b) applies: (1) annuity contracts issued by an insurance company; (2) custodial accounts (held by a bank) invested solely in mutual funds; and (3) retirement income accounts (permitted only for church plans). Employers typically adopt a 403(b)) plan by arranging to purchase contracts from one or more Section 403(b) "vendors." A 403(b) plan is sometimes referred to as a tax-deferred annuity or a tax-sheltered annuity plan (TSA).
Tax advantages of 403(b) plans
As with many other types of retirement plans, employees who participate in a 403(b) plan may enjoy significant tax benefits, including the following:
- Employees can make pretax contributions
- Employees can make after-tax Roth contributions
- Taxes deferred on employer contribution
- Tax-deferred growth
- Employees age 50 or older can contribute more than the annual deferral limit
- Long-service employees can contribute more than the annual deferral limit
- Tax-free rollovers are allowed
- Participants may qualify for the tax saver's credit
- You are not required to contribute to the plan
- Employees may find it easier to save for retirement
- Plan loans can be made available to plan participants
Annual elective deferral limit
An employee's annual elective deferral limit is the sum of three amounts: (1) the general deferral limit, (2) the age-50 catch-up contribution limit, and (3) the special 403(b) catch-up contribution limit.
- The general deferral limit: An employee may make elective deferrals (pretax and/or Roth, if permitted) of up to $18,000 of his or her compensation to a 403(b) plan in 2016 (unchanged from 2015).
- The age-50 catch-up contribution limit: You may (but are not required to) allow employees age 50 and over to make "catch-up" contributions each year ($6,000 in 2015 and 2016) over and above the general deferral limit. These individuals may therefore contribute up to $24,000 pretax for 2015 and 2016.
- The special 403(b) catch-up contribution limit: The general deferral limit is also increased by an additional amount for long-service employees (those with 15 or more years of service) of certain employers. (See "Special Section 403(b) catch-up limit," below.) The maximum annual special catch-up contribution is $3,000. The lifetime aggregate catch-up contribution under this special rule is $15,000. Employees who are eligible for both the age 50 catch-up contribution and the maximum special 403(b)) catch-up contribution may be able to make elective deferrals of up to $27,000 in 2015 and 2016.
What is a Section 457(b) plan?
A Section 457(b) plan is a type of nonqualified deferred compensation plan that certain governmental and tax-exempt organizations can establish for their employees. Like other deferred compensation plans, the purpose of a Section457(b) plan is to encourage employees to set aside funds for their retirement. Although it is a nonqualified plan, a Section 457(b) plan somewhat mimics a qualified plan in that it offers similar tax benefits for employees. These tax benefits generally include pretax salary-reduction contributions and tax-deferred growth of investment earnings.
How much can employees contribute to a Section 457(b) plan?
An employee may defer the lesser of $18,000 in 2016 (unchanged from 2015) or 100 percent of his or her gross compensation to a Section 457(b) plan. The dollar limit is indexed for inflation each year. An employer may also make nonelective contributions to a 457(b) plan on an employee's behalf. The total employer nonelective contributions and employee deferrals cannot exceed the limits described above.
An eligible 457(b) plan (both governmental and nongovernmental) can allow increased contributions during one or more of a participant's last three taxable years preceding attainment of normal retirement age (the "special" Section 457 catch-up rule). The amount of increased contributions the plan can allow may be based on previously underutilized contribution limits (in other words, participants can "make up" for the fact that they did not fully contribute in years past), but a participant's maximum deferral may not exceed twice the allowed contribution amount for the year ($36,000 in 2016).
Eligible governmental 457(b) plans can also include a separate catch-up provision that allows employees age 50 and older to contribute an additional $6,000 in 2016 (unchanged from 2015).
Tax benefits of eligible Section 457(b) plans
Tax benefits for employees
As with many other types of retirement plans, employees who participate in a Section 457(b) plan can enjoy significant tax benefits, including:
- Pretax contributions: Employees' salary deferrals to a Section 457(b) plan are made on a pretax basis. The contribution is taken directly from the employee's salary and invested in the plan before any taxes are withheld. This means that the amount each employee defers to the plan is not included in his or her gross income in the year of deferral. The employee pays less income tax because his or her taxable income is lower than it would otherwise be.
- 457(b) plans can also allow participants to make after-tax Roth contributions. There's no up-front tax benefit, but qualified distributions are totally free from federal income taxes.
- Tax-deferred growth: Funds held in a Section 457(b) plan grow tax deferred. Any earnings on plan investments are not taxable as long as they remain in the plan. Only when an employee begins to receive distributions from the plan will he or she pay income tax on the earnings.
- Possible tax credit: Some employees who participate in a governmental 457(b) plan may qualify for a partial income tax credit ("Saver's Credit") for amounts deferred to the plan. The amount of the tax credit (if any) is based on the employee's annual gross income and federal income tax filing status.