403(b) plans aren't as well-known as other tax-favored retirement accounts, such as 401(k) plans or IRAs. But for teachers and many public-sector employees, employers often offer 403(b) plans as a way to save for retirement. With the same contribution limits as 401(k)s, 403(b) accounts can go a long way toward meeting your retirement needs. But to take maximum advantage of 403(b)s, you have to take some steps to steer clear of mistakes that many people make with these accounts.
1. Not understanding your 403(b)'s matching contribution features
One benefit that 403(b) plans offer is the ability for employers to offer matching contributions to supplement your retirement savings. For instance, one employer might match each employee's contribution on one-to-one basis up to a set percentage of compensation, often 3% to 6%. Another might offer a 50% match, contributing $1 for every $2 you contribute up to a percentage maximum.
403(b) participants often get confused with matching, and there are two mistakes that are particularly common. Many participants don't contribute enough of their salary to get the entire employer match and that simply leaves money on the table. In addition, some participants think that they can't save any more than the amount that their employer matches. Although matching contributions are limited, you can still benefit from saving more than the matched amount as part of a longer-term retirement planning strategy. Figure out how much you need to save to retire comfortably and then set aside whatever percentage of your salary that you can afford and will be most likely to help you reach your final financial goals.
2. Picking high-cost investment options in your 403(b)
403(b) plans initially had a bad reputation, because as originally drafted, the only permissible investments in 403(b)s were annuity contracts. These insurance products often come with high fees, which had the effect of watering down the tax benefits that 403(b) plan accounts provided.
Now, however, 403(b) plans can invest in regular mutual funds, many of which offer lower annual expenses than their annuity counterparts. The savings can be a full percentage point each year, and although that might not sound like much when you're first starting out, the higher balances you'll have when you approach retirement after a career of setting money aside steadily makes a 1% savings worth a lot. On a $100,000 403(b) balance, the $1,000 savings from a cheaper investment option means more money in your pocket when you retire. If your 403(b) offers even one low-cost option, take a close look at it and see if you can make it work as part of your retirement investing strategy.
3. Not understanding regular vs. Roth 403(b)s
Many people are familiar with traditional and Roth IRAs and the differences between them. Yet what many 403(b) plan participants don't know is that a similar option exists with 403(b) plans, and if your employer elects to set up both options for you, then you can pick between a regular or Roth 403(b) in making contributions.
Regular 403(b) contributions have the immediate advantage of giving you a tax break in the form of lower taxable income. So, for instance, if you earned $40,000 as a teacher and set aside $2,000 in a 403(b), then you would only be subject to federal income tax on $38,000 of your income. The trade-off for regular 403(b) plans, however, is that when you withdraw money in retirement, you have to include the full amount as taxable income in the year in which you take the money out. That's often less of a problem because most people are in a lower tax bracket in retirement, but it nevertheless can cause a long-term burden if you don't plan for it.
By contrast, Roth 403(b) contributions don't generate a tax deduction right now. However, the distributions you take from Roth 403(b)s are tax-free in retirement under most circumstances. That can be a big advantage, especially if for whatever reason, your tax bracket actually goes up after you retire. Especially if your income is low early in your career, a Roth 403(b) option can be a lot more valuable in the long run than a regular 403(b), even if it means giving up a deduction currently.
403(b) plans aren't as popular as 401(k)s and other plans, but they offer many of the same benefits. By avoiding these bad 403(b) moves, you can improve your chances of reaching your goals and enjoying a financially secure retirement.