What is a 403b?
A 403b plan is a retirement plan for certain public school individuals, employees of tax-exempt organizations, and ministers. Individual 403b accounts are set up by employees and managed by eligible employees.
While not as prominent as the better-known 401k, the 403b retirement framework is often used by schools systems, churches, hospitals and may other types of organizations.
The structure of the 403b is as follows.
An individual account within the 403b typically takes the form of a Tax Sheltered Annuity. This is an annuity contract offered by an insurance company. In exchange for a premium, which can be paid in a lump sum or a series of payments. The insurance company agrees to make fixed or variable payments beginning at a future date. This can be either for a specific term or for the rest of your life.
Like a pension, your contributions and your contract’s earnings from investments can consider building up your retirement income stream.
A 403b can also be structured as a custodial account that can invest in mutual funds.
Some 403b plans which are specific to churches can take the form of an account that invests in either mutual funds or annuity contracts.
You can’t contribute directly to your 403b plan. What they do instead is per your salary-reduction agreement they withhold a predetermined amount from your paycheck. This is known as an “elective deferral”. These elective deferrals are exempt from income tax, although you are still responsible for Medicare and Social Security tax on these contributions.
Plan earnings are also exempt from income tax until the participant withdraws them. This is one of the big benefits of the 403b plan and the tax-deferred annuity structure.
One thing to keep in mind is that some plans don’t allow for after-tax elective deferrals. In these cases, the deferral amounts aren’t deductible on your tax returns. Of course.
On top of elective deferrals, your employer can contribute directly to your plan via “non-elective contributions”. Current regulations allow your account to be funded through a combination of elective deferrals and employer contributions.
So how much can I contribute to my 403b?
This is going to get a little technical so bear with me. It will make sense.
Contributions to a 403b depend on each participant’s annual “Maximum Amount Contributable” or MAC. The rules for calculating your MAC are a little complicated, but the IRS provides a worksheet to help you with the steps in its Publication 571: Tax-Sheltered Annuity Plans. The MAC will test you on two major limits.
- Limits on annual additions. This is the limit on all employee and employer contributions that can be made on your behalf, including any after-tax contributions. For 2016, the limit on annual additions is the lesser of $53,000, or 100% of eligible compensation for your most recent year of service.
- Limit on elective deferrals. This is the amount you are allowed to contribute to your 403b plan through a salary reduction agreement. For 2016, the limit on elective deferrals is $18,000. Keep in mind that if you contribute to any other retirement accounts, those amounts must be accounted for when calculating your contribution limit for your 403b plan.
So your MAC will depend on the types of contributions that you have made to your account during the year. According to the IRS guidelines, if you’ve only made elective deferrals, and haven’t received any employer contributions. Your MAC will be the lesser of the limit on annual additions, or the limit on elective deferrals.
Confused, I know I was. So let’s try this. If your employer isn’t contributing to your account, you can make elective deferrals to your total eligible compensation for the year, but this is capped at $18,000.
If you have only received non-elective contributions from your employer, or if you’ve made elective deferrals and also received non-elective contributions, then your MAC is the limit on the annual additions.
Benefits of the 403b
Contributions to a traditional 403b are tax-deductible. Your federal income tax is deductible in a traditional 403b. This means that your money placed in a 403b is free from any taxes. This tax deduction is valuable because it can lower your taxable income which in turn lowers your tax bill. For example, if your last $10,000 adjusted gross income was taxed in the 25% tax bracket. This would mean that you would save $2500 in tax savings.
Taxes are paid on distributions in retirement a time when many peoples are in a lower tax bracket. Like a Traditional IRA, when you make pretax contributions your deductions in retirement will be taxed at that time. The advantage would be that when you retire you would ideally be in a lower tax bracket. Most people fall into this category and if you don’t then we don’t really need to worry about this because you have done an outstanding job saving for retirement. So if during your working career you were in a high tax bracket when you retire you will most likely fall into a lower one, which means that those retirement dollars that have been working so hard for you will now pay you big dividends without having to give Uncle Sam so much money.
Some 403b plans have a Roth. Since 2006, employers have had the option to allow Roth contributions to 403b plans. Unlike the Traditional, Roth contributions are not eligible for tax deductions. But the flip side is that when you make distributions from the Roth you will not have to pay taxes. Caution however because not all 403b plans allow Roth accounts. The employer must elect to offer a Roth option to be able to offer this to their employees.
Side note to adding a Roth option to the 403b. Studies have shown that a Roth outperforms Traditional accounts over the long-term because of tax savings.
Savings grow tax-free. A huge advantage of the 403b plan is that you don’t have to pay taxes on dividends, interest, and capital gains on investments held in your 403b account. Now if you hold your investments in a standard taxable brokerage account, you will lose potential gains from the drag of taxes on your account.
With the 403b you don’t need to worry about tax effects on your investments. You are able to rebalance your account more often without losing anything but the trading fees. You also don’t have to worry about the tax efficiency of your mutual funds that you hold and can focus on high returns and low expenses. This allows you to choose more aggressive mutual funds or index funds to help maximize your retirement savings. Without the usual consideration of the effect, taxes can have on those funds.
Loans can be taken against a 403b plan. There are certain plans that allow this, however, most financial advisors do not advise using this option as it lessens the amount of money you have in your 403b for retirement.
In certain situations, this could be a viable option. For example, buying a home. If you choose to use this option it is vital that you understand all the conditions of the loan. The requirements for these loans are very exacting if you miss even one payment it could trigger a default on the loan which would allow the IRS to declare a default and penalize you an early withdrawal penalty.
Employers can offer contributions matches on a 403b. This is a huge benefit that you should be sure to take advantage of. Simply find out what the company will match and be sure to contribute that amount from your paycheck.
Let’s show and example so you can get an idea of how much this could benefit you.
Let’s say you make $40,000 a year and you are 30 years old. You start your 403b with $1000 and you retire when you reach 65. If you contribute 6% and your company matches that contribution you final retirement number would be $375,548. This would be with a 7% return for those 35 years.
Now if we follow the same scenario and your company doesn’t offer a match your retirement funds would be $354,895.
This is a difference of $20,653 or 5.5% of your funds. This is without any increase in your salary for those 35 years. If we throw in an additional 5% annual salary increase. Wouldn’t that be nice? The numbers increase to $691,735 with the match and $653,184 without. For a difference of $38,551 or 5.5%. The point of all this I am trying to make is that would you throw away $38,000? Of course, you wouldn’t. So just contribute to get the match, all right?
Some 403b custodians allow employees to invest in low-cost “institutional funds”, which otherwise have prohibitively high investment minimums. Sometimes 403b plans can get you better investment options than you can on your own. This is because financial institutions will gladly take on the management of a 403b plan because it means access to hundreds of millions of dollars of new assets. To help entice employers they will waive requirements to access institutional funds, that will typically have prohibitively high entrance fees. This will allow the employees to invest in these funds, that they would normally not have access to.
An example would be the Vanguard Institutional Index Fund Institutional Plus Shares (VIIIX) which has an expense ratio of 0.025% and normally requires a $200 million minimum investment to get into the fund. And with your 403b you have access to this fund. Awesome.
Contribution limits are higher than for an IRA. The more money you can save for retirement in a tax-sheltered account the better for you.
As of 2016 you are allowed for elective deferrals to contribute $18.000 and if you are over 50 you can add an additional $6,000 in catch-up funds. These limits are huge over the Traditional and Roth. As of 2016, you can contribute $5500 per account and $6500 if you are over 50.
So obviously the more you are allowed to contribute the more you have invested for your retirement. And as we have shown the power of compounding will work it’s magic for you.
15 Year Rule. Some employees may be eligible to make additional contributions based on this rule.
A unique benefit of 403b plans is that they allow additional contributions for those that have 15 years of service with the same employer and have not contributed in excess of the cutoff point in previous years. Employees must calculate a number of additional contributions they are able to make by applying a three-part rule found in the IRS Publication 571.
403b or a Roth?
Which do we invest in? That is the question. The first criteria that must be met for us to consider are whether your employer matches any portion of your contributions or not.
If they do, then the choice is easy. Contribute up to the match, because even though the investment choices may not be what you want you would be crazy to turn down free money. As we have shown in earlier comments there is a ton of money to be made by accepting this free money. After you contribute up to your employer’s match then you should open a Roth IRA and contribute to that to its limit.
This will give a little control over your investments and also help with your tax burden. With the Roth, you will be able to choose any type of investment that you desire and feel comfortable with.
So, if your employer doesn’t offer a match then the decision is a little more tricky. Your best bet would be to open a Roth IRA and contribute to that first as you have many more choices of investments and the ability to change as you see fit. Once you have met the limits on the Roth then you should start contributing to your employer’s plan.
The reason for going with the Roth first is that you have more choices and flexibility as well. In addition to the tax benefits of the Roth and not tying up all of your money in your employer’s plan.
Another consideration to take into account as well would be that any investment with a public pension plan is a very big risk in today’s environment. With the public funding facing so many challenges it is a risk to put your money in these plans.
Especially for teachers who are part of a pension plan through their school districts. As they know there is a constant pressure to find money for so many programs and it would be a shame to have all of your retirement in this one egg and see it go bad and lose all or your savings. I guess what I am saying is that it would be wise to hedge your bets. And have money in a Roth IRA and your employer’s plan.
The 403b plan is more intricate than the more well-known 401k. It is little understood and not much talked about. Partly this is because the 403b plans are for public employees, teachers, and church members.
And because of this limited audience, it doesn’t get much love.
These plans are great retirement options for these employees, especially if the employer offers a match to their contributions. The plans offer many benefits, including tax benefits that help your investments grow through the years. Also, there is the benefit of much higher contribution limits than are found in either the Traditional IRA or Roth IRA. Another benefit is the access to institutional investments that others will never have access to. These investments have great potential and extremely low fees which helps the bottom line too.
Some of the limitations of the plans are they limited investment choices, such as mutual funds. And the fact that the money is tied up and there is little flexibility if you need the funds for other needs that may come up. And for teachers there is the risk of the local government that you work for may run into financial trouble which would put your investments at risk.
Overall these are good plans for the people that are able to take advantage of them. Particularly if your employer offers to match your contributions. Then the tax benefits, much higher contribution limits and the potential to invest in the institutional funds.
As always thank you for taking the time to read this post and if you think it would be of benefit to someone else, please share it with them.
Until next time.