If you're a teacher, or you work at a school or nonprofit organization, you may be a bit confused by all the talk about retirement planning. When you read articles urging you to start making contributions to your 401(k) plan at work, you might even get frustrated when you discover that your employer doesn't offer such a plan. It may seem like just one more example of how teachers, school staff members, and nonprofit workers miss out on the benefits offered by private-sector employers.
But in this case, you shouldn't be alarmed. You may well have access to a retirement plan known as a 403(b), which gives teachers and other school and nonprofit employees many of the same retirement features that other employees receive through their 401(k)s.
Tax code confusion
You can thank Congress and the IRS for much of the confusion related to 403(b) plans. The section of the Internal Revenue Code from which 403(b) plans get their name was enacted in 1958, a full 20 years before private employees got access to similar plans. Only in the late 1970s did corporate America catch up with similar plans, and instead of incorporating all retirement plans into the same section, Congress put the legislation authorizing these new plans for private employers into a new code section, after which 401(k) plans were named.
In general, 403(b) plans share many of the same benefits of 401(k) plans. Both plans allow employees to elect to have part of their salaries set aside on a pre-tax basis, creating immediate tax savings over those who elect not to participate. Both plans allow these employee contributions to grow on a tax-deferred basis until the employee withdraws the money from the plan, usually at retirement. Many of the dollar limits on contributions to both plans are the same, and both plans allow employers to add their own contributions to employee accounts, either through unconditional contributions or by employer matching of employee contributions. Both plans have similar provisions penalizing early withdrawal of assets before reaching retirement age, and both share exceptions to these penalties for certain uses.
403(b) plans are so similar to 401(k) plans that some people think of 403(b) plans as 401(k)s for nonprofits. However, there are some differences between 403(b) plans and 401(k) plans.
Perhaps the most important difference is that 403(b) plans don't necessarily require substantial administration and involvement by the employer. While 401(k) plans must follow sophisticated regulations under the laws governing retirement plans, known as ERISA, 403(b) plans are not necessarily subject to ERISA. In many instances, employers don't make any contributions to 403(b) plans on behalf of their employees; employees may therefore miss out on employer matches, but the lack of employer contributions makes administration much simpler. An employer must agree to allow employees to make contributions through a salary reduction agreement.
Also, 403(b) plans that include employer contributions often have more favorable vesting provisions than private employers offer in 401(k) plans. For instance, it's not uncommon for employers to require that employees work for three years or more before they become fully vested; if they quit before then, employees may have to forfeit all or part of the contributions the employer has made on their behalf. 403(b) plans often have immediate vesting. In any event, any contributions made directly by the employee are always fully vested and not subject to forfeiture under any circumstances.
Traditionally, 403(b) plans have suffered from a lack of good investment options. Under the original 403(b) rules, employees had to invest in annuity contracts offered by insurance companies. Unfortunately, these investments often had unfavorable characteristics, including high management expenses and other costs and relatively low performance.
Subsequent amendments to the 403(b) rules now allow employees to use mutual funds within their 403(b) plan accounts as well as annuity contracts. However, many employers still initially choose insurance companies as their primary approved 403(b) providers. On the other hand, costs for some annuity providers have come down, especially those offered by discount brokers like TD Ameritrade
Specifically, there are several questions you should get answered about your 403(b) plan options. First, find out how much in annual expenses you will have to pay to invest in a particular fund or annuity. Second, ask whether there are any surrender charges or other fees if you decide to sell your investment or switch to another type of fund or annuity. These charges can be extremely high, wiping out most or all of the tax benefit of using the 403(b) plan. Third, find out what choices you have for your investments, including the various types and classes of funds. Lastly, if you choose to use annuity contracts for your investments, make sure that the insurance company your employer uses has a strong rating, so that you can feel comfortable that it won't default on your contract and drain your retirement savings.
If all else fails, some 403(b) plans allow employees to transfer assets to other investment providers, even if they're not on the employer's list of approved providers. An IRS revenue ruling lets employees choose an unapproved provider as long as the employer and the current provider allow transfers. This can sometimes help employees avoid high-cost options.
In summary, 403(b) plans give teachers and other school and nonprofit employees most of the benefits of 401(k) plans. To make the most of your 403(b) plan, you should do the same due diligence as 401(k) plan participants, with special attention to the unique features and challenges that 403(b) plans have.
Only two days left in this season's Foolanthropy campaign! Visit www.foolanthropy.com to learn about five reader-nominated charities and make a donation.
You can get basic information about retirement plans in the Motley Fool's 401(k) Center, which also covers 403(b) plans. For more even more Foolish advice for your golden years, try the Motley Fool Rule Your Retirement newsletter free for 30 days.
Fool contributor Dan Caplinger has been fighting with his wife's 403(b) provider for years, but he's still glad she participated. He doesn't own shares of the funds mentioned in this article. The Fool's disclosure policy teaches you the basics.