403(b) Plans

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 403(b) plans.

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 situation.

ATPE: What is a 403(b) plan?
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 for you.

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 for retirement.”

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.

How much 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, etc.

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 spouse.

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 percent.

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.

What 403(b) 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.

What distinguishes a 403(b) product from other products?
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.

Who evaluates 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 best interest.