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Section 403(b) of the Internal Revenue Code established tax-protected income accounts for public school teachers and nonprofit employees in 1958. Originally limited to annuities, the accounts were amended in 1974 to include more investment options, including mutual funds. 403(b) plans became popular in the 1980s as a nonprofit alternative to 401(k) plans. Both plans allow pre-tax earnings to be placed into retirement savings, with contributions and earnings growing tax-free until withdrawal. A Roth account can also be implemented in both plans.
In the United States, the Internal Revenue Code refers to any retirement savings account established under the provisions of Section 403(b) as a “Tax Protected Income”. These accounts, commonly called plans or “403(b)” accounts, were originally limited to investing only in annuities from the time the Section was chartered in 1958 until it was amended in 1974 to allow for more investment options, including mutual funds. Available only to employees of public schools and some other nonprofit organizations, 403(b) plans became wildly popular in the 1980s as a nonprofit alternative to 401(k) retirement plans, which were instituted in 1978.
Retirement security has been a pressing issue in the United States since the Great Depression of the early 1930s, when millions of families became destitute. The Social Security institution provided a measure of security, but that plan was not intended as a retiree’s total retirement income. Company-provided retirement plans, usually of the defined benefit model, became popular after World War II and beyond mid-century, but over time the financial burden on employers of these plans became onerous . On the other hand, many non-profit employers and public school systems have not provided any retirement plans for their employees.
Section 403(b) of the Code was passed in 1958 to address the needs of public school teachers and other nonprofit employees because their employers often lacked the resources to provide defined benefit retirement plans. School systems and other non-profits could, at nearly a fraction of the cost, allow each employee to establish a tax-protected annuity and enjoy the tax benefits associated with it. In 1978, Congress passed Section 401(k) of the Internal Revenue Code, which shifted the burden of retirement savings from employers to employees themselves. These plans were generally geared towards equity investments, primarily stock and bond mutual funds and money market accounts.
Participants in both 403(b) and 401(k) plans can save money from their pre-tax earnings, meaning the money is deducted from their pay and placed into the retirement savings plan before it is taxed. Contributions, together with any earnings, can grow without being taxed until withdrawn. If withdrawn before the age of 59½, the proceeds are taxed as ordinary income and in most cases a significant penalty is added.
Another approach to retirement savings planning, the Roth account, can be implemented in both plans. Contributions to a Roth account are made after-tax, but earnings to a Roth account are tax-free. A tax protected annuity can be set up like a Roth account.
The term “Tax-Protected Annuity” used to describe 403(b) plans is perhaps archaic because not only are annuities just one of the investment options available, but every annuity is a tax-protected annuity, whether purchased through a Employer-provided plan such as a 401(k), 403(b), or other special plan, or simply independently purchased by a consumer.
Smart Asset.
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