For those that work in higher education, their 403(b) plan is often the largest pool of retirement assets they own. It’s no surprise, either. A huge perk to working in higher education is generous retirement plan contributions from institutions. It’s not uncommon for a college or university to contribute 10% or more of an employee’s salary into his or her 403(b). This level of contribution is mostly unheard of outside of higher education. Thus, these employees can build up significant retirement assets over the course of their careers.
It is crucial for these savers to know how 403(b) plans work—I have found that many folks do not understand the ins and outs of their 403(b). So here are some important things to know. (For related reading, see: There Is More to 529 Plans Than Tax Benefits.)
403(b) Plan 101
A 403(b) plan is a tax-deferred employer retirement plan. It is similar to 401(k) plans, except they're only available to 501(c)(3) organizations. These include educational institutions, state agencies, and charities. These plans are a benefit to help employees build retirement assets. Accounts are individual and contributions are made by the employee, the employer, or both. The name 403(b) comes from the IRS code that regulates it.
How to Make Contributions
Contributions to 403(b) plans are typically made pre-tax. You set this up through a salary deferral agreement with your human resources office. Your contributions lower your taxable income dollar for dollar in the year of the contribution. All growth in the account is tax-deferred. You won't pay any taxes until you withdraw the funds at a later date. This helps you accumulate wealth quickly because Uncle Sam isn't eating into your account each year. Depending on the plan, contributions can also be made with after-tax money like Roth contributions. These contributions do not lower your taxable income, but they do grow tax-deferred. Roth contributions have unique tax benefits.
There are limits to how much you can contribute to your plan in any given year. The IRS adjusts the limits over time for cost of living increases.
If you are under age 50, the max an employee can contribute is $18,000. If you are over age 50, the IRS allows for employees to use catch-up contributions. In 2016 and 2017, the catch-up amount allowable is $6,000. This makes your maximum contribution limit $24,000 if you are age 50 or above. Your employee and employer contributions combined cannot exceed $54,000. It is rare for this limit to come into play, but it is still important to know.
Another item to be aware of is the 15-Year Rule. Employees with 15 years of service with their current employer and an annual average contribution of less than $5,000 per year are eligible for an additional $3,000 contribution per year. These extra contributions are limited to $15,000 over your lifetime. Employers are not required to make the 15-Year Rule available.
Employer contributions typically occur in one of two ways. The most common that I have seen in higher education is a flat percentage that the school contributes on your behalf. I have seen the percentage range anywhere from 8-11%. The other way contributions happen are through a match. For example, some schools will match the amount you contribute dollar for dollar up to a certain percent. This percentage is usually somewhere between 3-6%. (For related reading, see: How to Grow Your Retirement Plant to $1 Million.)
When you decide to withdraw funds from your 403(b), you must make sure that the withdrawal is a permissible distribution. According to the IRS, permissible distributions are when an employee:
- Reaches age 59.5
- Has a severance from employment
- Becomes disabled
- In the case of elective deferrals, encounters financial hardship
- Has a qualified reservist distribution.
Upon withdrawal, pre-tax contributions are taxed at ordinary income rates. If your distribution is not permissible, you will pay ordinary income tax AND will incur a 10% early withdrawal penalty. There are a few hardship provisions in which you can avoid the penalty even if you are under age 59.5.
If your withdrawal is permissible and involves after-tax (or Roth) contributions, then you are not taxed at all. Roth contributions grow tax-deferred and distributions are completely tax-free. With an impermissible Roth distribution, the contribution portion still comes out tax-free. The earnings are taxable and penalized at 10%. A caveat: your first Roth 403(b) contribution must be five years old before any of your Roth contributions are permissible.
How To Invest Your 403(b)
There is no one-size-fits-all solution. Every investor has different goals. I have found that many employees haven't changed their plan since the day they signed up. They have stuck with the default option, often to the detriment of growth. It’s important to do research or to work with a professional to help you decide how to invest your 403(b) assets. A sound financial plan ensures that your risk tolerance aligns with a diversified mix of assets to help you pursue your goals. It is also important to have an investment policy across all household accounts. A comprehensive approach can increase efficiency when you have many moving parts.
Advantages of 403(b)s
- Reduces taxable income. Your employee contributions lower your taxable income. This is a win/win because you are growing a nest egg for retirement while lowering your tax bill for the year.
- Tax deferral. The tax-deferred growth of your assets help you accumulate wealth quickly. In a taxable account, there are times when you will owe Uncle Sam taxes, slowing the growth of your account. In a tax-deferred account, those assets stay invested and benefit from compound interest.
- Higher contribution limits. Traditional and Roth IRAs have lower contribution limits. For IRAs, the max you can contribute in a year is $5,500 (if under age 50; $6,000 if over 50 years old). Your 403(b) contribution limit is over three times that amount. This higher amount can help you build wealth faster.
- Loans. Many 403(b) plans allow you to take loans. I do not encourage taking funds out of a plan for anything other than retirement, but it is available in the instance that you need access to capital. Plan loans, if allowed, are generally limited to 50% of your account balance or $50,000, whichever is less. You normally must pay the loans back within five years, with interest.
- Portability. A professor once told me, “the way to move up is to move out.” If you have worked for different institutions over the years, you may have several 403(b) accounts. Consolidating these accounts makes managing your money much easier. When changing positions, 403b(s) can roll into an IRA or transfer to your new 403(b) plan. (For related reading, see: How to Protect Your Assets From Litigation.)
Disadvantages of 403(b)s
- Limited investment options. Not all plans are created equal. Some 403(b) plans have many different asset classes available with low-cost, strong-performing funds. Others have limited options. It isn’t uncommon for a plan to offer 12-15 funds, total. Plans with limited options don't always offer access to an asset class you want to invest in. The glaring weakness I often find is with fixed income (bond) offerings.
- Annuities. Many 403(b) plans still offer their funds through an annuity chassis. Problem is, it is rare for someone to ever choose to annuitize their plan upon retiring. What this means is that investors are paying extra fees for something that they will never end up using. Also, these annuities make it difficult to access your funds in many situations.
- Lack of comprehensive advice. The big players in the higher education 403(b) space are TIAA and Fidelity. One thing they don’t do well is offer comprehensive advice—it’s not their business model. I believe that everyone should have a comprehensive plan that helps get their financial house in order. Your 403(b) is just one piece of your financial puzzle.
- Service. Another area that is lacking in these plans is customer service. I have met with many employees who haven't sat down with anyone since opening their account. In some instances, this has been 5-10 years or more. The model is to send a sign-up sheet around and the employees can choose to meet or not. That's not good enough! If the vast amount of a household's wealth is in this plan, shouldn't you receive more proactive service?
- RMDs. Like other qualified plans, 403(b)s are subject to required minimum distributions. When you turn age 70.5, you must begin taking distributions, whether you want to or not. The amount you must take will increase each year. RMD amounts are based on the previous year’s ending balance and your current age. Uncle Sam wants his money!
I hope this guide helps. I want to reiterate that the best way to get your financial house in order is through comprehensive planning. Your 403(b) is just one aspect of your financial life. If you don't have a comprehensive financial plan, I urge you to take action as soon as possible. Happy investing! (For related reading, see: Open Enrollment: 7 Things to Review About Your Benefits.)
Securities America and its representatives do not provide tax advice; therefore it is important to coordinate with your tax advisor regarding your specific situation.