Retiree Portfolio Increase Your 403(b) Savings

Like a 401(k) plan, a 403(b) plan allows employees of certain organizations to make pre-tax contributions to a retirement account that grows tax-deferred. In many ways, the two types of plans are similar. Yet the 403(b) has some distinct features not found in a 401(k) plan, chiefly, plan portability and the ability to make catch-up contributions this year.

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By David Braze (TMF Pixy)
October 1, 2001

The 403(b) plan, often called a tax-sheltered annuity (TSA), is named after the section of the Internal Revenue Code that covers the legal aspects of this type of retirement program. First authorized by Congress in 1961, the 403(b) is a defined-contribution plan available only to tax-exempt educational, religious, and charitable (i.e., 501(c)(3)) organizations. A 403(b) plan allows employees of colleges, universities, schools, hospitals, and other nonprofit organizations to save for their retirement.

As a salary-reduction plan, the 403(b) operates under similar maximum contribution rules and withdrawal privileges as its much younger cousin, the 401(k) plan. When made, contributions to a 403(b) are excluded from taxable annual income, and all earnings accumulate tax-deferred. In general, distributions may be taken penalty-free after age 59 1/2, but they will be taxed at ordinary rates in the year of withdrawal. 

However, there are some differences between the two types of plans that often confuse many 403(b) participants, and sometimes the sponsoring employers, too. Major differences include:

  • For  2001, a 401(k) participant may contribute up to the lesser of $10,500 or 25% of annual compensation. A 403(b) participant may contribute up to the lesser of $10,500 or 20% of annual compensation. (Note: Due to recent changes in retirement plan law, next year both types of participants may make a maximum elective deferral of up to the lesser of $11,000 or 100% of annual compensation.)

  • A 401(k) participant may invest in any investment option available in the plan, to include individual securities like stocks. A 403(b) participant may invest only in annuities and/or mutual funds.

  • All 401(k) plans are qualified plans subject to the numerous requirements found in the Employee Retirement Income Security Act of 1974 (ERISA). Most 403(b) plans are not qualified plans, and thus are not required to comply with ERISA provisions.

  • An employer establishes the 401(k) plan, selects the available investment options within that plan, and administers the program for all participants. In a 403(b) arrangement, the employer generally just administers the payroll deduction for contributions, while the participants establish their accounts with a provider of their choice.
  • A 403(b) participant may make an additional contribution under certain conditions that would otherwise exceed this year's annual limit of $10,500. This additional contribution is to allow participants to "catch up" on missing contributions for years in which they didn't participate, a feature not found in a 401(k) plan. (Note: These 403(b) "catch-up" rules will be repealed effective Jan. 1, 2002. They will be replaced by "catch-up" limits applicable to both 401(k) and 403(b) participants who are older than age 50.)

  • A 401(k) participant is restricted to the investment choices offered within the employer's plan. That's not generally true of a 403(b) plan. Unless the employer makes a contribution to an employee's 403(b) arrangement, the 403(b) participant is free to move his or her salary-reduction contributions to any 403(b) provider without the consent of the employer.

  • Upon a job change, most employees with less than $5,000 in their 401(k) accounts are required to remove those monies from the plan. This restriction does not apply to 403(b) participants.

In 403(b) arrangements, the employer usually has very little involvement in the plan beyond ensuring contributions are deducted from a participant's paycheck and sent to the person's 403(b) provider. Because of that lack of involvement, many of these employers provide potential participants very little education or information about the 403(b) program. Unfortunately, that means employees of these organizations are largely on their own when establishing and evaluating their retirement savings options.

With 401(k) plans, the employer selects a limited number of investment options, typically from a single provider. In making these selections, the employer usually considers the fees and expenses involved with the investment, as well as historical and potential investment returns. Additionally, and by law, the employer is required to provide employees information about these options, and there must be at least three investment choices ranging from conservative to moderate to high risk. In a sense, then, a 401(k) employer prescreens the investment choices to make the final choice(s) easier for the plan participants.

Some 403(b) providers go through a similar process, particularly those that make a contribution to the plan. Most 403(b) employers, though, do not follow such a procedure. Instead, they open up the floodgates by inviting scores of 403(b) providers (usually insurance companies) to market 403(b) products to their employees.

As a consequence, the employees are faced with a dizzying array of choices from which to select. Unfortunately, most of these offerings are fixed or variable annuities. Because annuities are insurance products, these can be, and often are, very poor choices for retirement savings due to high fees, high annual expenses, and the cost of collateral life insurance that is not needed by most long-term retirement plan investors.

On the other hand, Section 403(b)(7) of the IRC allows participants to make their 403(b) contributions to a custodial account established for that purpose with a mutual fund. Thus, instead of using an annuity, a better choice for many long-term 403(b) savers may be opening a 403(b)(7) account with a mutual fund company and investing in an index fund.

Because most 403(b) plan participants are on their own when it comes to choosing their retirement investments, they should be aware of what their choices mean. Therefore, at a minimum, they should:

  • Know the investment choices offered by their employers. If the list seems too limited or fails to include mutual funds, they should request that more choices be added, and perhaps provide recommendations.

  • Know the fees and annual expenses associated with both the annuity products and the mutual funds available. These costs reduce returns, and reduced returns mean less money at retirement.

  • Know the restrictions on and/or any penalties for the transfer of 403(b) money from one investment to another.

  • If the employer refuses to add a desired investment choice, take action to periodically arrange for a transfer of your money from a "ho-hum" choice provided by the employer to a better 403(b) provider not on the employer's listing. Ensure the transfer is coordinated with the new provider so the funds flow smoothly between the old and the new investments.

If you could use some objective, expert advice on how to plan for retirement -- not to mention an informative online financial-planning tool -- check out TMF Money Advisor.

See you next week. Until then, post away as usual on the Retirement Investing or Retired Fools boards.

Best to all... Pixy

Dave Braze has never faced the intricacies of making a 403(b) investment choice. But he does remember a time when 403(b) and 401(k) plans didn't exist. That's when he worked for the buggy whip factory, which had no retirement plan at all. At least now he has The Motley Fool, which is all about investors writing for investors.