403(b) Rollover Rules for Funding Your IRA

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While some retirement savings accounts are more well-known than others, in many cases the retirement account that a person can use actually depends on the type and size of the company they work for. You’ve likely heard of 401(k) plans, as they’re a popular option for employers and employees alike. But there’s another type of retirement account — a 403(b) — that sounds as though it may be similar. It largely is, but it differs in some key ways.

Essentially, 403(b) retirement accounts are the nonprofit sector’s equivalent of a 401(k). They’re only for employees of tax-exempt organizations and public schools. But when an employee transitions out of one of these roles and into the for-profit employment world, they need to be able to keep their retirement savings and collect new earnings in an account that their new employer is eligible to use.

So, what happens to the money in the 403(b) plan? Investors are able to continue investing and saving those funds by rolling over their 403(b) plan into an individual retirement account (IRA), but there’s a specific procedure for doing so. Learn more about it, along with other key details you need to know regarding 403(b) retirement plans.

How a 403(b) Works

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What does 403(b) mean? The name refers to the section of the tax code that makes this unique type of retirement account possible. A 403(b) plan is a type of tax-deferred retirement account that allows owners to save and invest money without paying taxes on it until they retire and begin withdrawing funds. This account is only available for employees who don’t work in the private sector, which includes people who work for public schools, specific hospitals, religious organizations and nonprofit organizations. In terms of the tax code, these types of organizations usually fall under 501(c) or 501(c)(3) status.

Employees contribute money into their retirement savings accounts, and many employers either match employee contributions or agree to contribute a certain amount per year. All of the deposited funds are invested and allowed to grow for decades. As long as the employee doesn’t withdraw the funds before turning 59.5 years old, the investment income is tax-deferred. Employees who withdraw their money before turning 59.5 are subject to taxes and penalty fees. Once an account holder turns 72, if they’re not already making withdrawals from the account they must start making required minimum distributions each year.

The 403(b) maximum contribution for 2021 is a total of $58,000 per year. An employee can make a maximum contribution of $19,500, and the employer can contribute no more than $38,500 or the employee’s annual salary, whichever is less. Roth 403(b) plans allow for non-penalized withdrawals before age 59.5 for certain conditions, called qualified distributions.

Why Roll Over a 403(b) Plan?

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A person who isn’t employed by a qualifying entity (religious organizations, nonprofits, public schools and some hospitals) is not eligible for a 403(b) retirement plan. This can present a challenge for someone who switches from a 403(b)-qualifying job to one that doesn’t qualify to administer this type of retirement plan. Suppose an employee worked for a nonprofit organization from ages 20 to 40. They contributed $5,000 per year in that time span and have accrued $100,000 in retirement savings from personal contributions alone.

The end of that employment relationship authorizes neither the 403(b) plan provider nor the employer to confiscate the money in the retirement account because that money belongs to the employee. However, IRS rules are very clear that anyone who withdraws money from retirement savings accounts prematurely must pay a 10% fee, and the account loses its tax-deferred status immediately, resulting in a large expense.

403(b) plans come with qualified distributions. These are specific, regulated reasons for which an employee can withdraw funds before retirement age without paying a penalty or losing tax-deferred status. Transferring money from a 403(b) plan to an IRA is a qualified distribution called a rollover.

There are very specific rules to follow. The particular type of rollover that is needed to execute this transfer is a direct rollover. The process is referred to as direct because funds flow directly from the 403(b) plan provider to the IRA plan administrator. The entire process must be completed within 60 days for the investor to avoid paying any penalties or fees.

How to Roll Over a 403(b) Plan to an IRA

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Given the 60-day time limit, anyone interested in a rollover should thoroughly familiarize themselves with the specific processes and documentation necessary from both the 403(b) plan provider and the new IRA custodian to complete the transfer. In general, this requires submitting a distribution request to the 403(b) plan provider and a contribution form to the custodian of the IRA. Depending on the company, depositing the 403(b) funds into the IRA could be the same process as making any other deposit into the account.

Some 403(b) providers will request some form of confirmation that funds were received from the custodian of the IRA, which is often called an acceptance letter. The owner of the account can expect to provide clear evidence both to the companies involved and to the IRS that the money is being deposited into an IRA and not a personal bank account.

Because the money is being transferred from one tax-deferred account to another tax-deferred account, the transferred funds aren’t considered income at tax time. However, the transfer must be noted on tax returns. While it’s fine to transfer funds to any type of IRA, the money will be taxed if it’s rolled to a Roth IRA. This is because Roth IRAs aren’t tax-deferred; you pay taxes on the income before depositing it into the account, but the advantage with a Roth account is that withdrawals made during retirement aren’t taxed.

When to Roll Over 403(b) Funds to an IRA

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Changing employment is a time when a 403(b) rollover is necessary, but there are other situations in which it’s optional. Some individuals acquire more than one 403(b) plan over time, which is acceptable. At times, it’s a strategic financial decision to roll multiple 403(b) plans into a single IRA.

The funds in a 403(b) plan are used to invest in annuities and mutual funds, whereas the money in an IRA is used to invest in stocks and bonds. There are also other forms of IRAs, such as self-directed IRAs that can be used to invest in real estate. IRAs are offered by a wider variety of employers and providers, so it’s often possible to find IRAs with fewer brokerage fees. Due to the cost and greater ability for financial diversity, some employees prefer switching to an IRA even if they’re not changing jobs.

403(b) rollovers are possible for most employees, whether as an investment strategy or in response to a job change. IRS standards, the rules of the 403(b) plan provider and the rules of the custodian of the new IRA require careful consideration to ensure compliance and prevent leveraging of penalties and fees.