403(b) Plans and How They Work
In your mid-thirties or so, you start thinking about your future. You know that you’ll be saving for the future in some way, but you’re not quite sure just how you’ll be doing that yet.
You know that you’ll have to save because you’re certain that you’re not a 30 year old millionaire.
And you’re right. You aren’t a millionaire. But you’re smart enough to know that you can be if you start saving.
You start looking at retirement plans. You read about IRA’s and 401(k)’s and begin to get a little overwhelmed.
Maybe even a little suspicious.
Each of these things talk about stocks, and bonds, and other things that you don’t really understand that much about.
And then you learn about the 403(b). And boy oh boy, you wish you learned about this thing first.
As it turns out, the 403(b) is an ideal option for learning how to invest. This account is named after the IRS section of the tax code that describes it in the IRS publication 571.
Similarities Between 403(b) and 401(k) Plans
There’s more to the similarity than just the name. Unlike 401(k) plans, 403(b) plan contributions have no income limit. This includes contractors, retirees, and employees of a non-profit organization. Employees for non-profit organizations that file Form 990-T can still contribute to the plan as well.
But there is one limit. The employee contribution limit is 20% of compensation, which is the same contribution limit for 401(k) plans.
Like 401(k) plans, 402(b) plans also offer an array of investment options, ranging from mutual funds to individual stocks. The only difference is that, in the case of a 4o2(b) plan, the employer has the option of making the investment for the employee and providing Individual Retirement Accounts (IRAs) as well.
403(b) plans also offer unique tax-treatment. Like 401(k) plans, 403(b) contributions are tax deductible as a deposit. But when withdrawals are made, earnings are taxed with a retroactive tax (if the taxes aren’t paid at the time of contribution) and then also with taxes on each year’s contribution.
Differences Between 403(b) and 401(k) Plans
- A 401(k) plan is basically a Profit-Sharing Plan
- A 403(b) plan is basically a Money Purchase Plan which is designed to provide a death benefit.
- A 401(k) plan has less defined contribution and can be converted to a defined benefit plan if the employer chooses. However, this type of conversion is not permitted for 403(b) plans.
- A 401(k) plan is portable and allows both current and former employees to receive matching contributions.
- 403(b) plans are not portable.
The source of your contributions comes into play here as well. Contributions to 401(k) plans must come from employee salary deduction. 403(b) plans allow participants to make voluntary contributions.
The favorable tax treatment of 401(k) plans is not available to 403(b) plans.
Typical 403(b) Plan Fee Structure
The average plan fee paid by 403(b) plan participants is 1.3% per year with a median plan fee of 1.04%.1,2 Plan fees generally consist of three elements: (i) administrative fees, (ii) investment fees charged to the Plan and (iii) recordkeeping fees. The following data highlights the distribution of the different fees charged by the average 403(b) plans.
The Long-Term Damage Done by High 403(b) Fees
The 403(b) market is highly regarded by investment professionals, or at least that’s what the industry groups tell us. The American 403(b) Association says its members are “dedicated to the advancement of the 403(b) plan.” The group’s mission is to “enrich the benefits and financial security of retirement plan professionals.” The Cumulus Collective says that “competition can be good for consumers.” And in the American Society of Pension Professionals & Actuaries’ position paper on fees, the group said that “By working together, we are better able to advocate for eliminating excessive fees and excessive paperwork that reduce the ability of many to save for retirement.”
Don’t believe it for a second.
Making the Best of a Bad Retirement Plan
The employees of a local school district have a state-sponsored 403(b) retirement plan through a mutual fund company. Their plan offers a wide range of funds for their employees to choose from. This has come from demands of the employees and a few years of negotiation with the company. Still, overall, the plan is subpar in comparison to other similar plans offered by other financial services firms.
Most of the employees are justifiably concerned about the performance of their investments. After all, they’re working hard and saving for retirement. They want to know that they’re being prudent and using their resources to build long-term wealth.
Like many financial services firms, this company offers a variety of funds and even commissions a fiduciary to act as an advisor. Although the advisory fees are reasonable, the majority of the employees of the school district have adopted the advisor’s recommendations and are in actively managed funds that charge steep commissions. Moreover, the advisor seems to be touting the benefits of the more highly-rated and expensive funds. He’s ignoring the lower-cost funds that may have been more appropriate for the employees’ portfolios. As a result, the employees worry that they’re paying high fees without getting much in return.
Invest your 403(b) in Mutual Funds
If you work in an organization that provides employees with a 403(b) retirement plan, then you can consider yourself very lucky. This retirement vehicle can deliver a nice amount of funds by the time that you’re ready to retire.
However, many people make mistakes by investing their retirement funds in mutual funds that charge extra fees. In this post, we’re going to talk about this type of retirement plan and look at some of the ways that you can invest your retirement funds safely.
Invest Some of Your Retirement Contribution in an IRA
One of the easiest ways to save for retirement is the 401(k) plan. It allows you to invest money, usually with a matching contribution from your company. Although a 401(k) is considered a retirement vehicle, it’s one that is subject to penalties if you need to withdraw your funds early. You will pay an early withdrawal penalty if you take money out of your 401(k) before you turn 59 1/2. That’s why it’s best to have a plan in place for how you’re going to begin funding your Roth IRA once you reach retirement age. One caveat, though; the money withdrawn from an IRA is taxed as ordinary income, so do not convert your traditional IRA into a Roth IRA before you reach retirement age.