The 403(b) plan is often thought of as a 401(k) plan for nonprofits. It’s probably not the only option for your not-for-profit, but it can provide certain advantages over 401(k)s. Following is a brief rundown.
Generous Contribution Limits
A 403(b) plan is a tax-favored qualified retirement plan set up for employees of not-for-profit organizations, including charities, hospitals, schools and government entities. As with other qualified plans, pre-tax contributions grow tax-free until withdrawals are made. Normally, employee contributions are deducted from their regular paychecks. Although participants will owe tax on withdrawals, the expectation is that they’ll be in a lower tax bracket in retirement. Participants generally have several investment options, such as stock and fixed-income mutual funds.
Participants can contribute as much as $20,500 to their 403(b) plan in 2022. If they’re age 50 or older, they can kick in an extra $6,500 in catch-up contributions, for an upper limit of $27,000. (Proposed legislation could increase catch-up contributions to $10,000 for certain workers near retirement.)
To further sweeten the pot, employees who’ve worked for your not-for-profit for at least 15 years can contribute an additional $3,000 a year for five years (for a lifetime total of $15,000) so long as they’ve previously made average contributions of less than $5,000 per year. Finally, not-for-profits can match a percentage of employee contributions to their 403(b)s. The limit for both employer and employee contributions in 2022 is the lesser of $61,000 ($67,500 for employees 50 years or older) or 100% of compensation.
Note: Some nonprofits also offer employees a Roth 403(b) plan. These are funded with after-tax dollars and withdrawals usually are tax-exempt.
How Withdrawals are Taxed
As with 401(k) plans, distributions from standard 403(b) plans are taxed at ordinary income rates. (Withdrawals from Roth 403(b) plans in existence for at least five years are tax-free.) Usually, distributions from 403(b) plans prior to age 59½ face a 10% penalty tax, on top of regular income tax. However, there’s no penalty for distributions made on death or disability of the participant or in cases of financial hardship.
Other exceptions to the penalty tax include:
The rule of 55. Those who stop working at age 55 or older can begin taking withdrawals from their 403(b) plan without paying a penalty tax. This exception applies only to money held in a 403(b). Distributions from other work-based retirement plans or IRAs are subject to the penalty.
SEPPs. Plan participants may take a series of “substantially equal periodic payments” (SEPPs) from a 403(b) penalty-free. This can begin at any age, but distributions must last for at least five years or until the participant turns 59½, whichever comes later.
Medical expenses. If plan participants incur unreimbursed medical expenses above the annual deduction threshold based on their adjusted gross income (AGI), the excess amount withdrawn from a 403(b) plan is exempt from the penalty. Currently, the threshold is 7.5% of AGI (recently decreased from 10% of AGI).
Comparing the Two Plans
The rules relating to contributions and distributions are often the same with both 403(b) and 401(k) plans, but there are some important differences:
Investment options. Generally, 401(k) plans offer a wider variety of investment options than 403(b) plans. Some 401(k) plans offer the option of investing in exchanged-traded funds and real estate investment trusts — choices that usually aren’t available with 403(b) plans. Because 403(b) plans are usually administered by insurance companies, they may emphasize annuities instead.
Extra catch-up contributions. As previously mentioned, 403(b) plan participants can make extra $3,000 contributions per year after working for their nonprofit for 15 years. This tax break isn’t available to 401(k) participants.
ERISA compliance. ERISA protects employees and their retirement savings. Unlike for-profit entities offering 401(k) plans, not-for-profits with 403(b) plans aren’t required to comply with ERISA.
Vesting periods. Typically, 401(k) plans require participants to meet vesting requirements — ranging from three to seven years — before they’re legally entitled to the full amount contributed by their employers. By comparison, 403(b) plans provide immediate vesting or relatively short vesting periods.
Should your nonprofit adopt a 403(b) plan? It depends on your organization’s circumstances, including the number of employees. In many cases, the tried-and-true 403(b) plan remains the optimal choice for not-for-profit organizations. But you should consult with your professional tax advisor and a benefit plans specialist before deciding.
Michael Cecere, CPA, MST is a Gray, Gray & Gray partner and chair of the firm’s Non Profit Practice Group. He can be contacted by telephone at (781) 407-0300 or via email at: email@example.com.