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Barbara O'Neill: 403(b) Plan Foundations — The Six Ds

December 20, 2022

By Barbara O'Neill, CFP®, AFC®

There are several foundational concepts that 403(b) plan participants need to understand and key decisions they need to make to become successful long-term investors. Taken together, these 403(b) foundations can be described as the Six Ds: Defined Contribution, Decisions, Deductions, Deposits, Diversification (investment, tax, and time), and Dollar-Cost Averaging.

All six Ds are interrelated. For example, if someone decides to participate in a traditional 403(b) defined contribution plan via payroll withholding, they practice dollar-cost averaging and must decide how much money to deposit and how to diversify their investments. In turn, they receive a valuable tax deduction.

This post briefly describes each of the six Ds that underlie 403(b) plan participation. Research results, three “need to know” facts, and six take-away action steps conclude this discussion.

Defined Contribution

Defined contribution (DC) refers to the retirement plan category to which 403(bs) belong, along with 401(k)s and other tax-deferred employer retirement savings plans. The other category is defined benefit (DB), which describes pensions that guarantee a formula-based monthly income based on income and years of service. Some government and non-profit employees have both types of plans (i.e., a pension and a 403(b) plan).

With DC plans, employees voluntarily decide the percentage of their pay (e.g., 6%) to contribute (exception: workers who are automatically enrolled by employers) and this money is deposited into a personally earmarked account. Pre-tax dollars (money not yet taxed) are invested in traditional 403(b)s and after-tax dollars (money that has been taxed) in Roth 403(bs). This money grows tax-deferred until retirement.

Some employers match a portion of worker 403(b) contributions, but this is rare in publicly funded educational settings. DC plans are self-directed and a worker’s account value at retirement reflects how much money was saved, investment asset allocation decisions, and market performance. There are no guarantees that a DC plan account balance will last a worker’s lifetime.

Decisions

403(b) plan participants must make several key decisions:

  • Whether to Contribute (or Not)- Workers with access to 403(b)s must generally initiate the enrollment process themselves by contacting their HR office and completing necessary online or print forms.
  • How Much to Contribute- This generally involves workers “doing the math” to calculate different percentages of their pay and deciding how much less they can live on to set money aside for the future.
  • Where and How to Invest- These two decisions are inter-related: 1. Choosing a (ideally low-expense, A rated) vendor on an employer’s list and 2. Selecting investments from that vendor that are consistent with age, risk tolerance, and other factors (e.g., access to a DB pension and prior investing experience).

Deductions

Major advantages of traditional 403(b) plans are a federal tax deduction (state tax regulations vary) for plan contributions and tax-deferred investment earnings for as long as 50 years (e.g., a 22-year old first-year teacher with an account that keeps growing until required minimum distributions (RMDs) begin at age 72)!

Example: a plan participant who earns $50,000 and contributes $5,000 is only taxed on $45,000.

There is also a tax deduction for traditional IRAs, although income limits apply for tax deductions when someone is covered by a retirement plan at work, such as a 403(b).

Roth 403(b) contributions, like Roth IRAs, do not provide a current-year tax deduction because after-tax dollars are deposited. However, unlike Roth IRAs, there are no income-based restrictions to participate in Roth 403(b)s. Tax-free withdrawal of Roth contributions and earnings is available if an account is open at least five years and the account owner is age 59½ or older or when disability or death occurs.

Deposits

A key decision is how much money to put into a 403(b). On the high end, the IRS determines the maximum annual contribution amount. In 2023, the most that workers can contribute to a 403(b) plan is $22,500 (~$865 bi-weekly) under age 50 and $30,000 (~ $1,153 bi-weekly) at age 50 and over with an additional $7,500 catch-up contribution. Minimum deposits are generally set by employers as either a flat amount (e.g., $10) per pay period or a low percentage (e.g., 1% to 3%) of gross pay.

As noted above, plan participants must select asset allocation weightings and deposits are pro-rated among these selections accordingly (e.g., 60% growth stock, 10% international stock, and 30% fixed income). Quarterly statements typically provide detailed reports of how deposited amounts are invested.

Diversification

Diversification means spreading your money among different investments to reduce the risk of loss from a decline in any one investment. This includes money invested for retirement in 403(b) plans and elsewhere. By diversifying, investors reduce the risk of loss from a decline in value in any one investment.

There are three types of diversification that 403(b) plan participants should consider: investment diversification, tax diversification, and time diversification.

Investment Diversification

Investment diversification can be achieved in a number of ways: selecting different asset classes (e.g., stocks, bonds, cash, and real estate), selecting different investment styles (e.g., value and growth), selecting mutual funds and exchange-traded funds that contain diversified portfolios, selecting stock and bond index funds that track broad market indices, and selecting target date funds that include several asset classes combined.

Tax Diversification

This means selecting different types of investments that are taxed in different ways. Specifically, taxable investments (e.g., a regular bank or brokerage account) where earnings are taxed in the year they are received, tax-deferred investments (e.g., traditional IRAs and 403(b) plans) where earnings are taxed at a future date, and tax-free investments where taxes are not due on earnings (e.g., Roth IRAs and 403(b)s).

Time Diversification

Historical data indicate that volatility (i.e., ups and downs of values) of investments, especially stocks, decreases as the holding period increases. In short time frames, stock market performance is often like a roller coaster. Think 2022, for example. This speaks to the need to match investment choices to financial goals. Since 403(b) assets are typically held for decades, they are a great vehicle for time diversification.

Dollar-Cost Averaging

Dollar-cost averaging is the practice of investing equal amounts of money at regular time intervals, regardless of whether the value of investments is moving up or down.  A common example is the amount contributed to a 403(b) plan each pay period.

Plan participants acquire more shares in periods of declining share prices and fewer shares in periods of higher prices. A simple illustration of dollar-cost averaging can be found in the table below. The average cost per share is $7.06 ($600 divided by 85 shares).

 
   
Illustration of Dollar Cost Averaging
Time Period Regular Investment Share Price Shares Aquired
Month 1 $100 $10 10.00
Month 2 $100 $8 12.50
Month 3 $100 $5 20.00
Month 4 $100 $5 20.00
Month 5 $100 $8 12.50
Month 6 $100 $10 10.00
TOTAL $600   85.00

 

Research Results

A 2020 study by Lu et al. compared dollar-cost averaging (DCA) and lump-sum (LS) investing when financial markets are trending upward. They found that DCA outperforms LS in uptrend markets and less uptrend markets, especially when markets are volatile and investment time horizons are long. An implication is that investors should consider DCA as a trading strategy, which 403(b) participants already do.

Another study by Toolson & Craig explored the composition of tax-efficient portfolios with comparisons made under various rate-of-return and marginal tax rate scenarios. They concluded that future retirees may want to reduce contributions to tax-deferred retirement plans to lower subsequent RMD payments.

Three (More) Things

Many workers with DC plans, including 403(b)s, roll over their accounts to individual retirement accounts (IRAs) when they leave their job or retire. Reasons include more control over investment options, lower fees, and account consolidation.

Dollar-cost averaging is done automatically in 403(b) plans, regardless of market conditions. As a result, some investments will be purchased “on sale” following a sharp market decline.

Good candidates for non-deductible Roth 403(b)s that lack an up-front tax deduction include younger workers with a long investment time horizon and high-income workers who are ineligible for Roth IRAs.

Six Smart Strategies

No. 1: Practice Tax Diversification — It is difficult for workers in their 20s to 50s to predict their income, assets, and federal/state tax rates in their 60s and beyond. Hedge this risk by saving money for retirement in all three “buckets”: taxable, tax-free, and tax-deferred investments. Future tax rates are expected to rise due to the size of the federal deficit.

No. 2: Diversify for Protection — The primary purpose of investment diversification is protection against severe market losses resulting from concentrated asset holdings in just a few stocks or industry sectors. Diversified investors receive neither the highest, nor the lowest, market returns.

No. 3: Avoid Recency Bias — People have a tendency to overweight recent events and irrationally believe they will occur again in the future. In investing, market returns can vary widely from one year to another and recent performance is no guarantee of future results. Hence, the need for investment diversification.

No. 4: Dollar-Cost Average Beyond a 403(b) — For tax diversification, a mutual fund automatic investment plan or company stock dividend reinvestment plan can be established as a taxable account that debits an investor’s checking account on a regular basis to fund deposits. Roth IRA contributions can also be made through a series of regular deposits.

No. 5: Regularly Review Tax Withholding — Tax deductions on traditional 403(b) deposits reduce taxable income and this needs to be incorporated into tax withholding estimates each time contribution amounts change. A good resource for tax withholding calculations is the IRS Tax Estimator.

No. 6: Get Help When Needed — 403(b) plan investing involves a myriad of decisions and some participants need help. Employer HR personnel can assist with enrollment, 403bwise with answers to plan-specific questions, and fiduciary financial advisors with a comprehensive overview of plan participants’ finances.

In Summary

Before investing in a 403(b) plan, take time to understand the six Ds. Decisions to make tax-advantaged contributions and diversify invested assets will greatly impact subsequent wealth accumulation and help achieve financial independence in later life.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.