The Disadvantages of a 403(b)

by Michael Keenan

If you work for certain nonprofit organizations, such as a public school or a hospital, you might have the option of using a 403(b) plan to save for your golden years. Despite the high contribution limits and tax benefits of using a 403(b) plan, there are a few drawbacks you should be aware of before you decide to invest.

Investment Restrictions

Depending on your investment strategies, you might find the limitations on 403(b) plan investments too limiting for your tastes. Money in a 403(b) plan can only be invested in mutual funds, fixed annuities or variable annuities -- which doesn’t give you a lot of options. So, if you’d prefer to invest in individual stocks, bonds, real estate or anything else, you’re out of luck.

Hard to Access

Once you put the money in your 403(b) plan, it’s hard to get out before you turn 59 1/2. In fact, unless you leave your job or suffer a permanent disability, you might not be able to get at the money at all. However, some plans offer hardship distributions or loans. A hardship distribution allows you to get money out if you have an immediate and heavy financial need -- for example, if you need to pay for a funeral or save your home from foreclosure -- but not all 403(b) plans allow them. Loans allow you to take out up to $50,000 or half your account balance, whichever is smaller, and repay it with interest, usually over up to five years.

Limited Early Withdrawal Exceptions

If you do manage to tap your 403(b) plan before you turn 59 1/2, chances are you’re going to owe an extra 10 percent tax penalty on top of the income taxes on the distributions, because there aren’t many exceptions to the requirement that you pay a penalty. Even a hardship withdrawal is hit with the penalty unless a specific exception applies. These include medical expenses exceeding 10 percent of your adjusted gross income, a permanent disability or distributions made to your beneficiary after your death. For example, if you take out money in a hardship distribution to avoid foreclosure, you’re stuck paying the penalty.

Ordinary Income Distributions

While the money grows in your 403(b) plan, you don’t pay any taxes while the funds stay in the account. However, when you do take withdrawals, the distributions count as ordinary income for tax purposes, which means you pay ordinary income tax rates rather than the lower long-term capital gains rates. If instead of investing in your 403(b), you bought a stock and held it until retirement, that would be capital gains income. As of 2013, the maximum capital gains rate is 20 percent, compared to a maximum ordinary income tax rate of 39.6 percent.

About the Author

Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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