One mistake that many teachers make is relying on their pension as their only source of retirement income.
This practice might have been more acceptable in the past, but in today’s climate, teacher pension plans are well underfunded and benefit packages are rapidly being reduced.
Additionally, for those on the path toward financial freedom that are looking for lifestyle flexibility and choices in the future, depending on a pension that comes only after 30+ years of work is not the way to go.
For this reason, teachers should supplement their retirement income with an additional savings tool.
Enter the 403b plan.
The 403b is an excellent retirement savings tool that allows teachers to invest up to $19,500 a year of pre-tax money in tax deferred retirement accounts.
Don’t be fooled though. The 403b is only a great savings tool if you know where to invest your money.
403b plans are filled with investment companies that do not have your best financial interest in mind. Salespeople for these companies will try to sell you investment products that give them a commission and leave you feeling more confused than when you started.
By mindlessly signing up and contributing, you risk losing HUNDREDS OF THOUSANDS of dollars in returns over the course of your career.
And No, that number is not an exaggeration.
Don’t be just another sucker.
This post will focus on everything you need to know about the 403b plan so that you can make smart decisions that maximize your retirement savings.
Let’s jump in.
What is a 403b?
A 403b is an employer sponsored tax-advantaged retirement plan offered to public educational institutions and non-profit organizations. A 403b is similar to the commonly known 401k, which is the tax-advantaged retirement account offered by private and for-profit companies.
Investment contributions to a 403b are automatically deducted pre-tax (traditional) or after tax (roth) from your paycheck, and grow tax-deferred in your investment account.
Unlike a pension, the employee assumes the investment risk and participation in the plan is self-directed and at the discretion of the employee.
What are the benefits of a 403b?
In a traditional 403b, money you contribute is pre-tax. Pre-tax investing is valuable since it maximizes the amount of money you can contribute. Taxes are paid on your contributions and capital gains when you withdraw.
Also, traditional 403b contributions reduce your taxable income for the fiscal year that you contribute. So not only are you paying yourself first but you don’t have to pay as much in federal income tax at the end of year. That’s a HUGE win for you.
In a Roth 403b, money you contribute is after-tax. Income earned on the account is tax-free and withdrawals are not taxed. Contributions to a Roth 403b do not reduce your taxable income for the year you contribute.
Automatic Payroll Deductions
Contributions to a 403b are made directly from your paycheck. This is beneficial as you are automatically paying yourself first before you have the ability to spend.
A 403b can be a large contributor to your retirement savings. It can be combined with other retirement saving options (like a 457b and pension) to maximize your retirement nest egg.
What other things to keep in mind?
The max amount that you can contribute to a 403plan is determined annually by the IRS.
In 2020, the contribution limits for each plan is $19,500 if you are below the age of 50.
If you are above the age of 50, the annual contribution limit is $26,000.
Additionally, if you have 15 years of service with your current employer and an annual average contribution of less than $5,000 per year, then you are eligible to contribute an additional $3,000 per year up to a lifetime maximum catch up of $15,000.
In most cases, you cannot withdraw money from your 403b until you reach age 59.5.
Early withdrawals from a 403b are subject to a 10% early withdrawal penalty.
When you reach age 72 you are required to start withdrawing funds from your account.
Your 403b plan can be chosen from a group of vendors provided by your employer.
Deciding which vendor you choose for your 403b plan will be determined by the type of investment product you want.
Different vendors offer an array of different investment products.
Typically, the types of investment products offered within 403b’s are mutual funds and annuities.
A mutual fund is an investment vehicle that pools money from investors and invests in a grouping of stocks, bonds, or other assets.
There are two types of mutual funds: load mutual funds and no-load mutual funds. Loads are a commission or sales charge that is paid by you to the fund manager for their services.
Additionally, mutual funds can be actively managed or passively managed. Actively managed mutual funds have the goal of attempting to outperform the returns of the market but come with higher costs to the investor. Passively managed funds, such as index funds, simply try to generate the same returns of a given market index (such as the S&P 500). Passively managed funds have very low costs and fees because there is very little management involved.
Annuities are a contract between the employee and an insurance company where the employee makes regular payments to the insurance company in return for a lump-sum or series of disbursements immediately, or at time of retirement.
The most common types of annuities are fixed annuities and variable annuities. A fixed annuity is an insurance contract that promises a specific interest payment on contributions to the buyer. A variable annuity is an insurance contract that pays interest dependent on the performance of assets within the account. Most annuity products have very high fees.
What to be careful of?
Poor Vendor/Product Selection
Where you invest your 403b money is not entirely up to you. Employers provide a list of vendor options, from which you can see each vendors list of investment products, and thus make a decision on where to invest.
For many teachers, the list of vendors and investment products is limited and contains poor options.
Why? Well without going into too much detail, 401ks in the private sector are subject to a law called “ERISA 1978”, which in general means employers must have the employee’s best interest in mind when offering their retirement plans. 403bs do not have that protection.
What that means for educators is that there are many poor products and vendors that make there way onto school district 403b lists. So it’s very important for educators to do their homework before choosing a particular vendor and product.
When I mention poor products and vendors, I am talking about products and vendors that have very high fee’s.
Fee’s are the operating and administrative costs associated with a particular investment product and vendor. The fee’s from one product/vendor to another can vary greatly, and understanding the role that fee’s play is important. Fees, although they may appear small and insignificant, can have a MAJOR impact on your investment returns.
Don’t be fooled by vendors that purposefully lack transparency about their fee’s.
Mutual fund products and variable annuities are required to outline their fee’s in a document called a prospectus. Fixed annuities do not have a prospectus, but rather a sales contract that outlines the fee’s associated with the product. Asking for these documents and reviewing them is important before investing your money. In my opinion, I consider anything above .5%/year to be high fees.
The total amount of fees you pay is denoted as a percentage taken out annually. On average, the fees associated with a variable annuity are 2.25%; actively managed mutual funds are 1.4%; and index funds are .18%.
The following chart demonstrates the impact that fees have on the total value of an investment after 35 years, considering $250 contributed monthly and an 8% annual return.
Source: Meridian Wealth Management
The difference between an annuity and index fund is over $200,000!
So it’s not an exaggeration that fees can cost you HUNDREDS OF THOUSANDS of dollars over the course of your working career.
Most 403b investment products being offered to educators are sold through salespeople, NOT fiduciaries. What’s the difference? A fiduciary is a financial advisor that is legally required to act in the clients best interest. A salesperson is trying to make a sale and has no legal obligation to do right by you.
Many salespeople are financially motivated to push poor products on unsuspecting educators because they get a nice commission on the backend of you signing up. Many times educators think that the person signing them up for their 403b has their best interest in mind, but in reality, they don’t. Don’t be afraid to ask “Are you a fiduciary?” If the answer is no, you know you’re working with a salesperson. My advice is to do your homework, ask questions, and know what you’re buying before agreeing to anything.
Contact your employers payroll office to inquire about which 403b options are available to you.
I suggest going with a vendor that offers passively managed low-fee, no-load mutual funds such as an index fund.
Their performance is consistent over the long term and their costs are extremely low.
The Bottom Line
Contributing to a 403b can be a great primary or supplemental resource for retirement saving.
Avoid vendors and investment product with high fees and poor product selection.
Do your own homework and ask questions before choosing a particular vendor and product.
Do you recommend allocating funds to fixed return fund or Equity index fund?
Since I am not a financial professional and not knowing your personal situation, I can’t recommend where you should allocate your funds. I can tell you though that a fixed return fund will have much higher fees than an equity index fund. I always choose an equity index fund for myself.