7.21 Annuities for Employees of Tax-Exempts and Schools (403(b) Plans)
If you are employed by a state or local government public school, or by a tax-exempt religious, charitable, scientific, or educational organization, or are on the civilian staff or faculty of the Uniformed Services University of the Health Sciences (Department of Defense), you may be able to arrange for the purchase of a nonforfeitable tax-sheltered annuity. Tax-sheltered annuities may also be purchased by self-employed ministers and by non-tax-exempt employers of ordained or licensed ministers or chaplains. Another name for a tax-sheltered annuity is a 403(b) plan. A 403(b) plan may invest funds for employees in mutual-fund shares as well as in annuity contracts.
The purchase of the annuity or mutual-fund shares is generally made through pre-tax salary-reduction contributions. Your plan may allow you to make after-tax contributions, and the employer may make non-elective contributions.
Caution: As the following contribution rules for tax-sheltered annuities have been stated in general terms, we suggest that you also consult your employer or the issuer of the contract. IRS Publication 571 has detailed examples.
Limit on tax-free contributions.
Tax-free salary reductions are limited to the annual ceiling for elective deferrals, and the plan may permit additional deferrals for participants who are age 50 or older (7.18).
If, in addition to a tax-sheltered annuity, you make salary deferrals to a 401(k) plan, SIMPLE plan, or simplified employee pension plan, the annual salary-reduction limit applies to the total deferrals (7.18). If you defer more than the annual limit, the excess is taxable. Further, if a salary-reduction deferral in excess of the annual limit is made and the excess is not distributed to you by April 15 of the following year, the excess will be taxed twice—not only in the year of deferral but again in the year it is actually distributed. To avoid the double tax, any excess deferral plus the income attributable to such excess should be distributed no later than April 15 of the year following the year in which the excess deferral is made (7.18).
The annual salary-reduction ceiling is generally increased by $3,000 for employees of educational organizations, hospitals, churches, home health service agencies, and health and welfare service agencies who have completed 15 years of service. However, the extra $3,000 annual deferral may not be claimed indefinitely. There is a lifetime limit of $15,000 on the amount of extra deferrals allowed. Furthermore, the extra deferrals may not be claimed after lifetime elective deferrals to the plan exceed $5,000 multiplied by your years of service. Publication 571 has a worksheet for figuring the limit on elective deferrals, including the extra amount under the 15-year rule.
The employee’s salary reduction plus any after-tax contributions and any non-elective contributions made by the employer for the year are tax free only if they do not exceed the annual limit on contributions to a defined contribution plan, which for 2012 is the lesser of 100% of compensation or $50,000.
In-plan rollover to designated Roth account.
As discussed in 7.20, your employer may allow you to make an in-plan rollover from your 403(b) plan to a designated Roth IRA within the same plan.
Distributions from tax-sheltered annuities.
Distributions attributable to salary-reduction contributions to a 403(b) tax-sheltered annuity are allowed only when an employee reaches age 59½, has experienced a severance from employment, becomes disabled, suffers financial hardship, becomes eligible for a qualified reservist distribution (7.15), or dies. The hardship distribution rules are the same as for 401(k) plans (7.19). Annuity payments are taxed under the general rules for employees (7.26). Payments are fully taxable if the only contributions to the plan were salary-reduction contributions excluded from income (pre-tax contributions) under the annual limits discussed earlier in this section.
Non-annuity distributions from a tax-sheltered annuity do not qualify for special averaging (7.4), but a tax-free rollover of a distribution may be made to another tax-sheltered annuity or traditional IRA unless the distribution is not eligible under the rollover rules (7.7). An eligible rollover distribution (7.7) from a 403(b) plan may also be rolled over to a qualified plan or governmental Section 527 plan. However, if a rollover from a 403(b) plan to a qualified plan is made, a subsequent lump-sum distribution from the qualified plan will not be eligible for special averaging (7.4) or capital gain treatment (7.5) even if you were born before January 2, 1936, and those provisions would otherwise be available. If you do not choose to have the payer of the distribution make a direct rollover, mandatory 20% withholding will be applied. You may then personally make a rollover within 60 days, but you would have to include the withheld amount in the rolled-over amount to avoid tax on the entire distribution. See 7.8 for further rollover and withholding details.
Benefits accruing after 1986 are subject to the required beginning date rules and a penalty may be imposed for failure to take minimum required distributions (7.13). Benefits accrued before 1987 are not subject to the required minimum distribution rules until the year you reach age 75.