403(b)’s: The Good, Bad, and Ugly
There are many different types of retirement accounts out there; it’s hard to keep track of all the nuances between them. Like, why do some employers offer a 401(k), and others offer a 403(b)? Is one better than the other?
If you’ve done any research on the two plans, you may have come across information that implies 403(b)’s aren’t as advantageous as 401(k)’s. Why not?
Anyway, whatever your employer gives you, you’re stuck with, right? It may not feel like there is any point in knowing the differences. I’m here to kindly disagree.
There are always good reasons to try to understand your retirement options!
What is a 403(b)?
**All numbers/laws referenced are 2019 figures. Always check the most current tax year to see if things have changed.**
A 403(b) is very similar to a 401(k). Both plans have the same maximum contribution per year ($19,000 as of 2019), and both are defined-contribution plans. You usually have access to either plan through your employer, and the contributions are deducted through payroll. Traditional 403(b)’s and Traditional 401(k)’s are considered tax-deferred retirement plans.
Defined-contribution means the amount you put in is pre-determined. Your contribution is defined . When you set up (or edit your retirement account), you choose how much will be taken from your check each pay period (usually a percentage).
This also implies, you can’t throw lump sums into your retirement account when you have the extra money. Instead, it is a steady amount taken from each check, and moved to your retirement account. However, you can edit your contributions at any time, though the changes may take a few pay periods to go into effect.
Tax-deferred means the amount you sock away in a Traditional 403(b) will not be taxed until you withdraw it (Roth 403(b)’s are taxed differently). You more than likely will not withdraw this amount until you retire (you are eligible to start withdrawing penalty-free at age 59 1/2). At that point, it will be taxed as regular income. (There are ways to withdraw these funds sooner than age 59 1/2 , without the 10% penalty, but that is outside the scope of this article.)
403(b)’s and 401(k)’s are treated the same in the eyes of law and the IRS. If you happen to have both (maybe you work 2 jobs and each offer one of these plans), your total maximum contribution is the combined dollar amount of both of these plans. Basically, even if you contribute to both plans, your grand total cannot exceed $19,000 for the tax year.
Why Not a 401(k)?
What a 401(k) is to the private sector, a 403(b) is to the public sector. Usually tax-exempt organizations and/or non-profits offer 403(b)’s.
For example, I work part-time at a University and also part-time at a Mental Health clinic. Both facilities offer 403(b)’s. Other examples of those who might be offered 403(b)’s: teachers, ministers, health care professionals, etc.
Origins of the 403(b) Plan
The difference in the naming and establishment of both the 403(b) and the 401(k), lies in the laws that founded each plan.
The 403(b) was put into place circa 1958 through section 403(b) of the IRS code. Prior to this, a tax-exempt employer might put aside money into an annuity contract for their employee. These individual annuities were owned by the employee, and could be moved when the employee left the employer.
In 1958, the IRS established section 403(b), which limited the contribution amount allowed for these annuities. Because the 403(b) originated as a plan to fund tax-sheltered annuities, you may see your plan labeled as a TSA.
However, in 1974, Congress added paragraph 7 to section 403(b), which allowed participants to invest in both mutual funds and annuities. Allowing mutual fund investments brought the 403(b) in line with the offerings of a 401(k).
The 401(k) is also known as such, due to the specific section of law (The Revenue Act of 1978) in which it was established as a plan that allowed tax advantages for deferred compensation.
Roth accounts were born later (1997).
A Quick Note About Roth’s
Roth 403(b)’s and Roth 401(k)’s operate under the same rules. Roth accounts differ from Traditional accounts in how they are taxed.
Roth 403(b)’s are not tax-deferred immediately. Instead, when you receive your paycheck, you are taxed on the entire amount earned. Then, your retirement contribution is moved to your Roth 403(b). There it stays, to grow just as a Traditional 403(b) does. The difference is, it will never be taxed again. This means when you withdraw later in life, you do not pay taxes on the withdrawals.
You can also withdraw any amount you contributed to this account before age 59 1/2 penalty-free (you cannot withdraw the growth without penalty). The advantage with a Roth is, the growth your account has seen over time (through interest, price appreciation, and dividends) is never taxed. While you do have to pay taxes immediately, you have the advantage of not paying taxes on alllll that beautiful growth afterward.
Which is Better: 403(b)’s or 401(k)’s?
Because both plans have so many similarities, it would make sense they are interchangeable, right? Not quite.
In the eyes of the law and the IRS, they are essentially interchangeable (other than which type of employer gets to offer which type of plan).
But for us, the participants in the plans, there can be a big difference. The difference lies in the types of investments each plan typically offers.
Remember, 403(b)’s were born as annuity-centric plans. Some plans still offer heavy annuity options, and little to choose from on the mutual fund side. Why does this matter?
Annuities are essentially investment funds with an insurance contract. As a result, most annuities provide insurance benefits. This translates a couple of different ways.
One approach guarantees a predetermined percentage of your premiums can be withdrawn annually. This set percentage is not contingent on how your account has performed in the market, or the account value.
Another approach allows for a guarantee that at the end of a specified period of time, the value of your account cannot drop below the amount you initially put in—regardless of how the market performs. If you make money, great. If you don’t, you won’t have lost anything.
The biggest advantage with annuities is the insurance. If you have low risk tolerance, this may be right up your alley. It sounds great, right? The insurance mitigates almost any risk!
With such a sweet deal, how do annuities stay in business? Welp. They get you with fees. Because these funds are actively managed (similar to most mutual funds), and insured, there are money management and commission fees that are several percentage points higher than what mutual funds charge.
Annuities can charge commission fees (or sales charges) of 5-7% (or even higher), compared to the 3-6% mutual funds charge.
Annuities also often levy a surrender fee if you sell out of the annuity before the agreed upon investment period has expired. Meaning, if you are invested in annuities and left employment, when trying to rollover your entire 403(b) you may have to pay a fee to do so. The fee is usually a percentage, and not a flat rate.
If you are leaning toward annuities, no problem. However, it is important to recognize any risk you trade for security, does comes with a price.
Am I Stuck With Only Annuities?
Again, this will depend on the investment fund options your 403(b) plan offers. Most plans will have some type of mutual fund offering, however, it may be you are only offered mutual funds with high expense ratios.
An expense ratio is a percentage of the amount you have in the fund that will be used for management and operating expenses. The higher the number, the more money will be taken from your account. Expense ratios of mutual funds usually range from 0-3%.
There are pretty decent fund options in many 403(b)’s across the country—especially relative to what used to be offered. However, 403(b)’s are still notorious for generally carrying poor investment fund options. These funds may have high fees, high expense ratios, high commissions, and high surrender charges.
This all translates to more of your money being diverted from your account to pay the fund for managing your money.
Side note: The lowest fee fund out there at this time is an index fund, a type of mutual fund. This is where you will see 0-0.5% expense ratios.
Is it All Bad News?
The 403(b) offered through the Mental Health entity I work for offers low-cost index funds within their plan (I do not invest in the 403(b) through the University I work for, so I am not sure of their offerings). This option is fantastic for me, and where my money is invested.
I suggest anyone who has any type of retirement plan, but especially a 403(b), check out your funds. Look at them individually and see what the expense ratios are. Check with your plan administrator about surrender fees.
If the fund options are truly horrendous, you may consider other ways to utilize your 403(b).
If you have a very short time horizon (like you are changing jobs soon) you can continue to contribute to your 403(b), but leave all contributions as cash within the account (versus investing in any funds). At least you get the tax break. Eventually, when you change jobs, you can roll it over into an IRA, and invest there. The devastating downside to this would be, your money won’t grow. The funds would have to be truly awful to constitute this, but it‘s one avenue.
You could also contribute to the 403(b), only up to the employer match. Then, you could choose to max your IRA, and/or invest in taxable accounts. If you invest in taxable accounts, you’d lose the tax break, but it may be worth it if the fund fees are too high. Again, it just depends on your 403(b) fund options.
Having poor 403(b) options is not an excuse to not save for retirement. If you don’t want to do anything else, or research other options, you might be better off saving what you can in a 403(b) and letting it ride—fees be damned.
My mom worked for the state for decades, did no research on individual funds, and retired just fine with her 403(b). If she paid a little more attention to individual funds, she might have ended up with more money. But she certainly is not destitute.
Why Work in the Public Sector?
So do public sector retirement options suck entirely? Not necessarily. There are plenty of advantages for working within the public sector, despite your 403(b). You may potentially have access to an alternative 457 retirement plan in addition to a 403(b). Your retirement might transfer to a new employer more easily, if your new employer is a similar entity (like working for two different State entities). Simply, you may love your job, and retirement benefits aren’t why you got in the game.
And who knows. You may have some great fund options within your 403(b), and this is a non-issue for you.
You’ll never know unless you check.
Here’s a fantastic resource from 403bwise.com if you want to know more about 403(b)’s!
Any information in this article is meant for entertainment purposes only. Please consult a professional if you want financial advice or retirement planning.
Does your employer offer a 403(b) instead of a 401(k)? Wanna know the difference? Let’s do this!