Instead of offering 401(k) plans like for-profit companies, public schools, religious institutions and other charities can create 403(b) plans to help their employees save for retirement. The money contributed to the plan isn’t counted as taxable income that year, and the money grows income-tax free while it remains in the account. However, when you cash out, that’s when the taxes, and potential early withdrawal penalties, are imposed. If you aren’t prepared for the tax hit, you can find yourself owing a lot of money when you file your tax return.
Distributions from 403(b) plans are taxed as ordinary income on your taxes, no matter how the money was invested in the account. Your ordinary income tax rate varies depending on your total taxable income: The higher your income, the higher your tax rate. Your tax rate also varies depending on your filing status because the tax rates for couples filing jointly are lower than for singles who make the same amount of money.
Also, you’ll pay both federal and state income taxes on the distributions. For example, if your federal income tax rate is 24 percent and your state income tax rate is 5 percent, you’ll lose 29 percent of your distribution from your 403(b) plan to taxes off the top. If you were cashing out $20,000, that means you’ll pay $5,800 in income taxes.
Early Withdrawal Penalties
If you’re under 59 ½ years old when you cash out your 403(b) plan, you’ll pay not only the income taxes but also a 10 percent tax penalty unless an exception applies. For example, say you’re cashing out $50,000. In addition to the federal and state income taxes, you also would pay $5,000 in tax penalties.
Early withdrawal penalty exceptions include suffering a permanent disability, medical expenses exceeding a certain percentage of your adjusted gross income, payments to an ex-spouse under a Qualified Domestic Relations Order and distributions taken if you leave your job after you turn 55 years old. Other financial hardships, such as losing your job or having to rebuild your home, don’t qualify for an exception from the penalty.
If you’re considering cashing out your 403(b) plan because you’re changing jobs, but don’t need the money yet, consider rolling the money into another qualified retirement plan. That way, you won’t pay any taxes on the money now and it can continue to grow tax-free until you need the money in retirement. Plus, you avoid any early withdrawal penalties. You can roll the money into another 403(b) plan or 401(k) plan at your new job, or roll it into a traditional IRA that you can set up at a financial institution of your choice without any taxes or penalties.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."