A retirement plan sponsored by a non-profit
Most people are familiar with the 401k, but what’s a 403b? Basically a 403b is a retirement plan that is sponsored by a 501c3 organization, meaning a not-for-profit employer. A local school board or hospital are good examples. The employee invests in mutual funds or annuity contracts – the only choices available. If annuity contracts are the only investment choice, the plan is likely administered by an insurance company, and can also be known as a TSA, or tax-sheltered annuity.
Money can go into your account from two sources: deferrals from your paycheck (money that you could have taken in cash) and your employer can also make contributions. The employer’s contributions can be discretionary or according to a match formula. Say the employer will offer you 50 cents on the dollar of whatever you contribute, up to 6% of your earnings. That’s a fairly typical formula. We’ve seen some out there more generous, and some not quite as generous. But generally a 403b is going to be driven by your deferrals rather than the employer kicking in. 403bs are sponsored by non-profits, remember.
403b savings limits
There are several deferral limits, all of which work together. You may defer 100% of your salary If you are a participant in a 403b plan, up to a maximum of $18000 per year (2017). The overall limit is $54,000 (2017). That means that if you defer your maximum of $18,000, your employer may contribute $35,000. Furthermore, if you are age 50 or above, you may defer an additional $6000, referred to as a catch-up contribution.
What are the advantages to you? automatic savings, principally. It happens every pay cycle without you even thinking about it. You don’t have to write a check. You’re not having to make a conscious decision between saving this money or spending it on something that gives more immediate gratification.
Another big advantage to you is tax savings. As you defer money into the 403b you are not taxed on it for federal income tax purposes. You do pay payroll taxes – that is FICA, but not federal income tax.
The Roth option
Your 403b plan may offer a Roth option, in which you defer on an after-tax basis. Much like a Roth IRA, the account grows without taxation, and come retirement you can distribute your funds with no taxable event. Many taxpayers are income – phased out of contributing directly to a Roth IRA – $118,000 AGI for the single taxpayer, and $186,000 for those married filing jointly (2017). With a Roth option in a 403b or 401k account, there is no income phase-out, nor is there the $5500 annual contribution limit. Consider a Roth option carefully, as a little pain now in the loss of an immediate tax deduction is offset by a potentially huge gain: growing a retirement account with no taxes on distribution, nor any required minimum distributions.
Your employer’s contributions
Your employer’s contributions always to to a non-Roth (traditional) option. What happens to the non-Roth account at retirement? Over the years it is going to grow, and grow without federal taxation. You’re going to have compounding -earnings upon earnings – and the effect can be enormous. So if you do it purposefully, with a good serious deferral, and your employer throws in some money too, you can end up with hundreds of thousands of dollars in a retirement account – or into seven figures even – if you’re very disciplined about it.
When you retire and you take money out of your 403(b) the distributions will be taxable to you then, at ordinary income tax rates. There’s your tradeoff: you’re trading off the benefit of tax deductibility and tax deferral now on your contributions for what will probably be higher ordinary income tax rates in the future. That’s another topic, and we’ll cover that a little later.
Now, how do you invest the money once it’s there? Your employer will have a plan sponsor and that plan sponsor will give you a universe of investment choices, which will be mutual funds and annuity contracts. By statute, there are no other choices, unlike the 401k. Among the funds you’ll have pretty much all bases covered – government and corporate bond funds, US common stock funds, and some international stock funds. You’ll probably have various target date funds as well. These are sort of a default option that people choose when they don’t know what to do. A target date fund targets the date of your retirement. The account will become progressively more conservatively allocated as the years go by and retirement comes closer.
If you are in a TSP, or a plan with an annuity option, we would steer you away from any variable annuity allocation. There is nothing inherently wrong with a variable annuity – it has its uses, primarily with non-tax qualified dollars. Basically it gives non-retirement dollars tax deferral, and for this you pay an underlying contract fee. Since in your 403b account you already by definition have tax deferral, there is no reason to pay variable annuity fees.
The investment allocation you choose is a very important consideration. Your allocation should reflect how you feel about investing and what type of volatility you can take in the markets. If you are launching your career, or in the early stages of your career, and have a long working life ahead of you, we’ll generally tell you: Go aggressive. Markets will always have their ups and downs. That can work for you actually. When you have down months or down years you’re going to be buying in every month at bargain prices. When the market recovers those dollars are the ones that will work for you the hardest.
The main takeway here is to invest – defer – up to the employer match at least. Otherwise you’re just leaving money on the table that you could’ve had in your account. Increase your contributions year by year, and let the time value of money work for you.
For more information, check out my video below. If you have any questions, by all means get in touch: [email protected] Visit our website at www.cameron-downing.com, where you’ll see all of our blog entries and be able to book an appointment to come see us.
— Glenn J. Downing, MBA, CFP®