Is a 403(b) Plan Right for Your Nonprofit Organization?
403(b) Plans Can Provide Certain Advantages Over 401(k)s
The 403(b) plan is commonly regarded as a 401(k) plan for nonprofits. While it’s probably not the only option for your nonprofit organization, it offers specific benefits that set it apart from 401(k) plans. The following is a brief rundown.
Generous Contribution Limits
A 403(b) plan is a retirement plan designed to provide tax advantages for employees of nonprofit organizations, which include charities, hospitals, schools, and government entities. Similar to other qualified plans, contributions made before taxes are not subject to taxation, and they accumulate until the time of withdrawal.
Typically, employee contributions are deducted from their regular paychecks. While taxes are due on withdrawals, it is anticipated that participants will be in a lower tax bracket during their retirement years. Participants in 403(b) plans generally have a variety of investment choices, including 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.)
As an added benefit, employees who have dedicated a minimum of 15 years to your nonprofit organization have the opportunity to contribute an extra $3,000 per year for a period of five years (for a lifetime total of $15,000), provided their average contributions in previous years were less than $5,000 per year. Furthermore, nonprofit organizations have the option to match a percentage of employee contributions made towards their 403(b) plans. The maximum limit for both employer and employee contributions in 2022 is the lower of $61,000 ($67,500 for employees aged 50 or above) or 100% of their 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.
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.
Tried-and-True
Is a 403(b) plan the right choice for your nonprofit organization? The answer depends on various factors, including the number of employees and your organization’s specific circumstances. In many instances, the reliable and well-established 403(b) plan continues to be the preferred option for nonprofit organizations. Seek guidance from a professional tax advisor and a benefit plans specialist to make an informed decision tailored to your organization’s needs.
Questions?
Contact a Brady Ware Nonprofit Advisor with questions about 403(b) Plans.
Questions?
Twana is the leader of Brady Ware’s nonprofit services, showcasing her 25+ years of specialized service in accounting, audit, and financial reporting matters. She also serves as Brady Ware’s Accounting and Assurance Services Quality Control Director, playing a pivotal role in upholding the firm’s commitment to excellence.