403(b) plans offer employees of public schools a way to save money
for retirement tax free.
In October 2002, ATPE asked Michael Muth, a senior principal in Rudd
and Wisdom Inc. Consulting Actuaries, the following questions regarding
Muth has worked since 1979 as an actuarial and employee benefit
consultant, designing and administering 401(k) and 403(b) plans.
The following information should in no way serve as a definitive
retirement planning guide. You should use the information as a
foundation to pursue additional resources pertinent to your particular
ATPE: What is a 403(b)
Muth: 403(b) is a section of the Internal Revenue Code that
authorizes certain types of tax-deferred compensation for employees of
schools and certain other tax-exempt entities.
Why are 403(b)s
available primarily for educators?
When section 403(b) was drafted, educators and employees of tax-exempt
entities generally had no employer-sponsored retirement plans. So the
403(b) might have been the only way such employees had to prepare for
retirement. There are now variations on the concept available to private
sector employees who have 401(k) plans.
What are the
benefits of a 403(b) for educators?
403(b) plans allow employees to elect to reduce their taxable
compensation so they can put the money into the retirement investment
vehicle before they pay taxes on it. For example, if your salary is
$30,000, you might instruct your employer to pay you $29,000, and put
the other $1,000 into a 403(b) on your behalf. You don’t presently have
to pay taxes on that $1,000, and whatever income that $1,000 generates
is not presently taxed.
You could accomplish a similar goal by putting
after-tax dollars out of your income into a mutual fund, savings account
or CD, but those would be after-tax dollars. If you are in a 28 percent
marginal tax bracket, an after-tax investment of $1,000 is immediately
reduced to $720. Then any income the $720 generates is also immediately
taxable. The 403(b), on the other hand, keeps all those dollars working
Are 403(b)s taxed?
Not when the money is deducted from the paycheck; it’s taxed only when
participants begin to draw money from that plan, usually when they
retire. But in retirement, their income is usually lower, so their taxes
are lower. Another benefit is that the dollars have been earning
tax-deferred investment returns in the interim.
Why do I need a
403(b)? Isn’t the TRS a good plan?
The TRS is an excellent, fiscally sound retirement system. For the
full-career educator, it provides a substantial benefit and a very good
retirement. But for people who leave teaching prior to retiring, TRS may
not be sufficient. They may need to supplement their TRS pensions
because the inflation that occurs after leaving TRS will not be
reflected in their pensions. And anyone can benefit from supplemental
retirement income. It’s not common for people to say, “I saved too much
How much can I
contribute to a 403(b)?
The maximum you can contribute out of your own dollars, on a pre-tax
basis, is $11,000 in 2002, unless you are age 50 or older as of Dec. 31,
2002, in which case you may contribute $12,000 in 2002, provided your
plan has been amended to permit the extra contribution. (Both the
$11,000 and $12,000 limits are scheduled to increase over the next five
years, reaching $15,000 and $20,000, respectively, in 2006.)
Some employers also make their own contributions to
their employees’ plans, either on a matching basis or an
across-the-board basis, where everybody may get, for example, 1 or 2
percent of pay. The $11,000 and $12,000 limits are not affected by
employer contributions. The sum of employee and employer contributions
may not exceed the lesser of 100 percent of pay or $40,000.
should I contribute to a 403(b)?
If you start when you’re young, you might only need to contribute 3, 4
or 5 percent of pay for 40 years to accumulate an amount sufficient for
a good retirement. If you start at age 30, 40 or 50, you’re going to
need to set aside a larger share of your pay. So start early, even if
you have competition for your financial resources, such as a house, car,
AGE WHEN SAVINGS
These are general recommendations based on these assumptions:
- 45 percent of pay will fill the
gap between your TRS pension and the amount needed to maintain
your pre-retirement living standard.
- Your investment garners a 7
percent annual return (and 6.5 percent post retirement earnings),
you receive an annual salary increase of 3 percent, and you make
disciplined annual contributions with no withdrawals.
- Your mortality is in accordance
with UP 1994 Female Mortality Table projected to 2002, providing 2
percent annual cost-of-living increases after retirement.
What if I start
saving late? Can I catch up?
The law allows for additional amounts to be saved if you are over age
50. However, you can’t make up for a lifetime of not saving in the last
15 years of your career. If you have the available cash flow, and your
tax situation warrants, it makes sense to take advantage of this
“catch-up” provision, but you certainly shouldn’t rely on it.
Can my spouse
contribute to my 403(b)?
No. Only the employee or her employer can contribute, but the
distribution can be payable for the joint lifetime of employee and
If I move, can I
continue my former plan?
If you remain in Texas, you can continue to use the certified vendors’
products. If you move out of state, rollovers are permitted to another
403(b), a qualified plan, a Section 457 plan or an IRA.
If the rollover is done directly, no withholding
occurs, but if the distribution check is paid to the employee, 20
percent must be withheld for taxes, even if the employee intends to roll
it all over. Such a rollover must be completed within 60 days of
receipt, but watch out for the 20 percent amount. It’s taxable, even
though it went to the IRS and even if you rolled over the remaining 80
Can I start drawing
money from my 403(b) when I’m 59 and a half?
You can actually start earlier in certain circumstances, but unless you
structure the distributions properly, if you are under 59 and a half,
you’ll be charged a 10 percent excise tax in addition to the income tax
you will be charged on that money.
Distribution of your retirement funds must commence by
age 70 and a half. Congress’ perspective is that they’ve offered these
403(b) tax benefits for retirement savings, not to save to transfer to
an heir. So they require you to start paying taxes on it at age 70 and a
half. You should seek tax counsel prior to receiving the distribution.
investment options are available to educators?
TRS maintains a
list of certified products from which you can choose. If you’re
already contributing to a plan, you can continue to use it even if it
isn’t on the list, as it has been grandfathered. However, you may want
to investigate why it isn’t on the list.
distinguishes a 403(b) product from
There are restrictions on the availability of funds. Once the dollars go
into the fund, they can only be taken out under certain circumstances.
With the 403(b) rules, Congress is basically saying, “In exchange for
the tax-preference, we’re going to restrict the assets of the fund to
retirement purposes. We’re not going to let it be a piggy bank.” Once
the dollars are in, they generally cannot be accessed until the account
holder turns 59 and a half, is disabled or has a financial hardship,
which unfortunately is not clearly defined.
It’s important when comparing 403(b) products to keep
in mind what the product is designed to do. There are product names that
have developed (such as growth funds, growth and income funds, small cap
funds, etc.) that don’t always mean the same thing. The growth fund of
company A may have a different twist to it than the growth fund of
company B. Unfortunately, you really need to get into the fine print to
discern what the product does.
403(b) investment performance?
It’s left up to you. And people who promote their own products define
the market. So, when you sit down with your expert, she has the most
interest in selling you her product, which may not always be in your
should I take with 403(b)s?
It’s your responsibility to learn about products before you buy them and
to monitor their ongoing performance after you invest. Make certain you
understand how your money will be invested, the fees that will be
assessed and the risks attendant to the product.
Regulations adopted in 2002 provide a limited level of
screening of investment options. They provide a certification process
for companies selling 403(b)s. However, just because a vendor is on the
TRS certification list, does not mean TRS endorses that vendor or
its products. It means solely that the vendor has certified to TRS that
it meets the criteria established in the regulation.
With this regulation, TRS can be credited with creating
a convenient clearinghouse for educators to identify vendors that meet
the minimum standards set forth in the regulations, but educators should
not view this as a seal of approval or guarantee of desirable investment
results. Educators still need to do their homework on these products.
Also, existing products are grandfathered, meaning a
current contract need not be compliant if it is a continuation of a
contract that was in place prior to the regulation’s effective date. So
even if your vendor is on the certification list, you should get into a
new contract with the vendor to get the benefits of the regulatory
structure. The bottom line? Caveat emptor. Buyer beware.
Back to top