403(b) Tax Deduction Rules

The IRS limits the annual tax deduction for a 403(b).

The IRS limits the annual tax deduction for a 403(b).

Nonprofits such as schools, churches and hospitals cannot set up 401(k) plans for their employees. However, they can set up a similar plan called a 403(b). These plans offer a number of tax benefits to help nonprofit employees save for retirement. One of the main advantages of putting money into your 403(b) is that you get a tax deduction for your investment.

Adding Money

Your 403(b) monthly investment comes directly out of your paycheck. Typically, you ask your employer to withhold a percentage of your salary each month. Your employer adds this money to your 403(b) before it is paid to you as taxable income. This makes it a before-tax contribution and creates an income tax deduction. To get a deduction, your 403(b) contribution needs to come out of your paycheck. If you want to add more money and get a higher deduction for the year, you can increase the percentage of your monthly salary that goes into your 403(b).

Deduction Limits

There is a limit to the amount you can add to your 403(b) each year. The IRS does not want to create too generous a tax handout for retirement plans. As of 2012, you can invest up to $17,000 a year in your 403(b) and deduct the entire investment from your taxes. The IRS lets older workers invest a bit more. When you turn 50, you can invest up to $22,500 a year in your 403(b).

Tax Benefits

The 403(b) tax benefits make it a very effective way to save for retirement. The annual tax deduction lets you save money while cutting down on your tax bill. If your employer matches your investment and adds more money to your 403(b), the employer match does not count as income. You get this extra money without paying more in taxes. Lastly, as long as your investments stay in your 403(b), you do not pay taxes on your investment gains. By avoiding taxes, your 403(b) investments will have a higher return than investments in a regular brokerage account.

Withdrawals

The 403(b) only delays taxes on your income. The tax deduction pushes your income tax bill off until you take money out of the account. When you make a withdrawal from your 403(b), you owe income tax on the entire amount. Since the 403(b) is a retirement plan, you are supposed to keep your money in the account until you retire. If you take out money before you turn 59 1/2, you owe an extra 10 percent penalty as well as income tax on the withdrawal.

About the Author

David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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