Though 401(k) plans and 403(b) plans are similar -- for example, they both have goofy names -- there are some important differences. A 401(k) participant may be able to purchase individual stocks, whereas a 403(b) participant cannot. And the 403(b) participant has to avoid annuities, which can be harmful to your retirement health. In this article that first ran in October of 2000, guest columnist Dan Otter provides an array of 403(b) facts.
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At first glance, 401(k) and 403(b) retirement plans look remarkably similar. Both allow participants to set aside money for retirement on a pre-tax basis. Both plans take their names from the relevant tax code governing them. Both plans, when managed Foolishly, will provide participants with significant sums of money for retirement. End of story? Not quite. While the programs seem similar on the surface, there are significant differences. How does a 403(b) work? A word of caution. While the IRA has more investment flexibility (stocks), it does have a few drawbacks. Unlike a 403(b), you can't borrow money from an IRA. Plus, asset protection (from creditors, lawsuits, etc.) with an IRA is not as strong in some states. If you're satisfied with your current 403(b) plan, the most Foolish course of action may be to just leave it alone. Note: You are permitted to roll one 403(b) plan into another. But, you may not roll an IRA into a 403(b). Want more information about 403(b)s? Visit 403bwise.com. Are you comfortable with the direction your retirement savings are going? Check out The Motley Fool's Roadmap to Retirement Seminar, and you'll be able to walk away with your own retirement plan. Dan Otter teaches fifth grade at McKinley Elementary School in Southern California. He also runs a 403(b) advocacy website called 403bwise.com, which is dedicated to educating educators and other non-profit workers about the 403(b). He can be reached at dano@403bwise.com.
Who is eligible to contribute to a 403(b)?
The biggest difference between the two plans is eligibility. While the 401(k) covers private-sector workers, only employees of public schools and certain tax-exempt organizations -- as determined by good old Section 501(c)(3) of the Internal Revenue Code -- can participate in a 403(b) plan.
A qualified employer, in the eyes of the IRS, is an organization that is "organized and operated exclusively for religious, charitable, scientific, public-safety testing, literary, or educational purposes." These types of institutions include K-12 public schools, colleges, universities, hospitals, libraries, philanthropic organizations, and churches.
If your employer is uncertain about its status, it can contact the IRS outreach program. See IRS Publication 571, which covers the 403(b), too.
What investment options are available to 403(b) participants?
Unlike 401(k) participants, 403(b) participants cannot invest in individual stocks. Instead, their choices are:
Participants set aside money on a pre-tax basis through a salary reduction agreement with their employer. The money is then directed to a financial institution selected by the employer. Like the 401(k), the money grows tax-deferred until retirement. It is taxed as ordinary income when withdrawn.
Are 403(b) participants limited to the vendors offered by their employers?
Generally, 403(b) participants can only contribute to the vendors offered or sponsored by their employers. In many cases, especially at K-12 schools, these choices are really no choice at all.
It's not uncommon for teachers to be limited to annuity products, with no direct access to mutual funds. Why should this matter? Financial planners are nearly unanimous in their aversion to annuity products within retirement plans. In addition to the higher fees, financial planners argue that it is redundant to put a tax-deferred investment (an annuity) into a tax-deferred plan (a 403(b)). Furthermore, many annuity products contain dubious exit clauses and penalties.
If you don't like your employer's offerings, there are several courses of action. The first is a frontal assault. Simply ask your employer to begin offering better choices. Enlist co-workers, and point out the differences in fees and performance. Back it up with Foolish research.
If that doesn't work, 403(b) participants can perform something called an "asset transfer" into the financial institution of their choice. The utmost caution is urged with this course of action. In theory, an asset transfer should be as simple as transferring an IRA from one financial institution to another. In practice, it rarely is.
One problem is that most annuity investments contain stiff penalties for early withdrawal. And, it's not uncommon for these charges to be in place for seven years. What is a Fool to do? Transfer only money that has been invested past the penalty phase. As new money passes the penalty threshold, transfer it.
A third, decidedly Foolish course of action has emerged that avoids exit fees and penalty phases. From your employer's list of approved vendors, find a financial institution offering a money market account. Direct your 403(b) money first into this money market account. Then periodically (every three to six months) perform an asset transfer (as described above) from the money market account of the approved vendor to the financial institution of your choice (Fidelity, Janus, Vanguard, etc.).
Typically, money market accounts charge few, if any, surrender fees -- so you don't have to worry about penalties. Of course, there may be exceptions and limitations. The financial institution you wish to transfer your 403(b) money to should be able to provide guidance on this. While this route takes time and paperwork, it does allow you to invest in the financial institutions of your choice without the worry of a penalty.
How much can be contributed annually to a 403(b)?
Generally, the maximum contribution is $10,500 or 20% of salary, whichever is less. With the passage of the Tax Relief Act of 2001, that limit will gradually increase to $15,000 by 2006.
Why is the 403(b) often called a TSA or TDA?
When the 403(b) was created in 1958, participants could only invest in annuity products, so the name tax-sheltered annuity (TSA) or tax-deferred annuity (TDA) took root. Despite the fact that Congress granted 403(b) participants mutual fund privileges in 1974, the TSA/TDA name remains very common today.
Can a 403(b) be rolled into an IRA?
Yes. This can occur when the participant:
What are the options for a 403(b) when switching jobs?
When can 403(b) money be accessed without penalty?
Generally, penalty-free distributions from a 403(b) cannot occur until the participant:
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