Updated: Nov 3, 2020
What is a 403b Plan?
A 403b plan is a retirement plan offered to employees of non-profit organizations, schools, hospitals, religious organizations, and tax-exempt organizations.
It’s very similar to a 401k plan, however, there are some major differences between the two.
Similar to a 401k plan, in a 403b you can contribute directly through payroll deduction and invest in many different options inside your account. Also, you do not pay taxes on the money you contribute to your 403b in the year of the contribution so this will reduce your taxable income (Unless you have a Roth 403b option available).
So for example, if you make $50,000 a year and contribute $5,000 in your 403b, you’ll only pay taxes on $45,000 that year. However, you’ll have to pay taxes whenever you take distributions (withdrawals) out of your 403b account in retirement.
All of this so far is very similar to a 401k, but there are differences.
403b vs 401K: What’s the Difference
One difference is that a 403b plan is for employees of non-profit organizations and other tax-exempt organizations like school districts, hospitals, and churches. 401k's on the other hand are for employees of for-profit organizations and other companies.
A big difference between a 403b plan as compared to a 401k is that most 403b plans do not have an employer match. Now there are some that do, but in the K-12 school districts or community college schools, there’s rarely anyone who provides an employee match. Some hospitals or non-profit organizations could provide a match but it is the exception rather than the rule.
Another big difference is the investment options. 403b plans are also called TSA (Tax Sheltered Annuity) accounts because in most 403b plans you will find annuity products as the investment options. These annuity products have their own pros and cons (mostly cons).
Pros of Annuity Products in 403b Plans
A good side to these annuity products is that they have a high fixed account with a good interest rate. If you want to keep a part of your portfolio safe and secure then that fixed account pays much more than a regular savings account and also has no risk. So it can also be a better option than a bond allocation with rates at historic lows.
In retirement, this fixed account within your annuity could prove to be very valuable if interest remain at the current level. For example, in many annuities offered in school districts, the fixed rate has a minimum guaranteed rate of 3% interest. Compared to a 10 Treasury Bond that currently has a yield of 0.75% that fixed account looks very attractive.
Cons of Annuity Products in 403b Plans
The downside with 403b plans is that these annuity products can be really expensive. A good 401k plan might have very low-cost investment options like Vanguard funds with less than 0.50% expense ratio, the 403b tax-sheltered annuities could have total expenses upward of 2.5%.
If you look at that amount over a 30 year period, then you’ll see that it kills the growth in your account, and you end up paying thousands of dollars in expenses.
Another major downside with a 403b plan is the surrender schedules in these annuities. A surrender schedule is when you put money or make a contribution, it has to be in that account for a certain number of years before you could either roll it out to another account or take a distribution from it without having to pay a penalty.I have seen surrender schedules as long as 12 years. And the penalty that you have to pay can be anywhere from 1%all the way up to 10% of the total amount depending on how long the money has been in the account.
What to Keep in Mind Before You Sign Up
Okay, so we discussed what a 403b plan is, and the pros and cons. Now let’s see what are some things you should be aware of and keep in mind before you sign up for a 403b plan.
1. Think Long and Hard Before You Decide to Actually Go for it
If all you have available are insurance companies and annuities then I do not think it’s in your best interest to even enroll in the 403b plan. The better option would be to go for IRAs, either a traditional Roth IRA depending on your individual circumstances.
After you’ve exhausted those two and you still want to save money for retirement above and beyond that, then you might not have any other option but to use your employer-sponsored 403b plan.
2. Look at the Vendors Available to You
If you’ve decided that you want to go with opening a 403b then do extensive research and go through the list of vendors available to you through your employer. Try to pick out companies that offer low-cost options.
For example, if your district offers either Fidelity, Vanguard, or Aspire in the plan then any one of these might be a great option for you.
The key is to do your own research and not just listen to a co-worker or the salesperson walking around the school. See what’s involved, what are the costs, what are the fees, and choose the best option.
3. Look outside of the 403b plan
Okay, I don’t want to beat a dead horse but still, the last tip would be to look outside of 403b and see what other options are available to you.
If you can’t get any low-cost option for your 403b plan and if its gonna cost you 2.5% year after year, and if you’re gonna have those long surrender charges, then It’s honestly not worth the other benefits. You could save more outside of the 403b for your retirement.
403b’s are very similar to 401k’s in the way they are taxed and the way they are structured. What we focused on today were things you should watch out for before you sign up for a 403b plan. The key here is to try to keep your costs low, and if you can’t, then start with an IRA and go back to the 403b once you have no other options available.
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Rich McCormack, CFP®