How Do Capital Gains & Distributions Work in a 403(b)?

If you work for a qualified nonprofit organization that offers a 403b group retirement plan, you can elect to contribute a portion of your earnings into a tax-deferred account for your retirement nest egg. Until you retire, the funds in your account accumulate tax-free. It is important to understand the basics of how these accounts work with respect to contributions, growth, distributions and taxes.

Some years ago, 403b plans traditionally consisted of annuity products, but today, these accounts often contain other investments, such as mutual funds. Participants receive income tax benefits for contributions and penalties for early withdrawals prior to retirement. "You can generalize by saying the 403b is the nonprofit organization's equivalent of the 401k," explains Money-Zine.com.

Deposits into 403b plans generate an income tax deduction. For 2011, you may contribute a maximum of 100 percent of your earned income up to $16,500. Beginning in 2012, this maximum contribution amount increases by $500 per year. If you are age 50 or older, you may deposit an additional $5,500, called a “catch-up” contribution. The Internal Revenue Service has given no indication that plans are on the drawing board to increase this amount. If your employer chooses to contribute to your 403b account, total aggregate deposits cannot exceed $49,000 in 2011. Starting in 2012, the aggregate deposit limit will increase by $1,000 and continue at this pace to combat inflation.

Money in a 403b plan accumulates tax-deferred until you withdraw it. Regardless of the type of investment held in your retirement plan, any growth or increase in value remains within the account. For example, if you allocate money to a mutual fund in your 403b and that fund increases in value, the capital gains taxes that you would ordinarily pay are deferred. This deferral allows more of your money to remain in the account and continue growing.

Withdrawals from 403b accounts, as with other qualified retirement plans, may not begin until you reach age 59 1/2. Withdrawals from the account in retirement are considered income and counted toward your taxable earnings for that year. You’ll pay the prevailing income tax rates on money withdrawn from your 403b, even if some of the money in the account was earned in a fashion that would ordinarily result in capital gains taxes. The IRS confirms that "payments you receive or that are made available to you under your 403(b) account are taxable in full as ordinary income."

If you withdraw money from your 403b account before you reach age 59 1/2, the IRS will assess a penalty on the amount withdrawn. Early distributions usually result in a penalty of 10 percent in addition to any income tax due on the amounts withdrawn during that year.