|Question: I teach at a school that offers a 403(b) plan. Is this type of plan a good way to save for retirement?|
In general, yes. Also known as a tax-sheltered annuity, a 403(b) plan is an employer-sponsored plan designed for employees of certain tax-exempt organizations (e.g., hospitals, churches, charities, and public schools) to invest for their retirement. Typically, the employer purchases annuity contracts or sets up custodial accounts for eligible employees who choose to participate. A 403(b) plan is technically not a qualified plan, but it is said to mimic a qualified plan because it shares some of the same features.
Like a 401(k) plan, a 403(b) plan enables you to make contributions to the plan on a pretax basis. These are known as salary-reduction contributions because they come from your salary before taxes are withheld, thus reducing your taxable income. For tax year 2010, you are allowed to defer up to $16,500 a year or 100 percent of your compensation, whichever is less, to the plan. In addition, if you're 50 or older, you can make an extra "catch-up" contribution of $5,500 in 2010. Employers will sometimes contribute to the plan as well, although employer contributions are not required and (if made) must vest before you are entitled to them. Earnings (e.g., dividends and interest) on your 403(b) plan investments accrue tax deferred. Only when you withdraw your funds from the plan do you pay income tax on contributions and earnings. If you wait until after you're retired to begin withdrawing, you'll probably be taxed at a lower rate.
The combination of pretax contributions and tax-deferred growth creates the opportunity to build an impressive retirement fund with a 403(b) plan, depending on investment performance. You may even qualify for a partial tax credit for amounts contributed if your income is below a certain level. In addition, a 403(b) plan may allow you (under certain conditions) to withdraw money from the plan while still working for your employer. Beware of these "in-service" withdrawals, however. They may be subject to both regular income tax and (if you're under age 59½) a 10 percent early withdrawal penalty. A plan loan, if permitted, might be a better way to obtain the cash you need.
Although some 403(b) plans have a limited number of investment choices, many of these plans have been offering a broader range of investments in recent years, including many well-known mutual funds.
Note: Your employer may also allow you to make after-tax "Roth" contributions to your 403(b) plan. Because your Roth contributions are after tax, those contributions are always tax free when distributed to you. But the main attraction of Roth 403(b) contributions is that the earnings on your contributions are also tax free if your distribution is "qualified." In general, a distribution is qualified if it is made more than five years after the year you make your first Roth 403(b) contribution, and you are either 59½ or disabled when you receive the payment.