Barbara O'Neill: The 403(b) Lifecycle 403(b)s, 457(b)s, 401(k)s, IRAs, and More
July 26, 2022
When it comes to retirement income sources, 403(b)s are not the only game in town. Plan participants have access to other savings options including Roth and traditional individual retirement accounts (IRAs), 457(b) and- in limited cases- 401(k) plans, and SEPs (if self-employed). In addition, 89% of public-school teachers participate in a defined benefit (DB) pension and about 60% are covered under Social Security. Both DB pensions and Social Security are structured to provide monthly lifetime income.
This post describes voluntary retirement savings accounts that education and non-profit sector employees may consider instead of, or in addition to, 403(b)s. It compares and contrasts 403(b)s with other tax-deferred employer plans, as well as IRAs and other savings vehicles, and discusses their key characteristics. It also explains two key concepts related to retirement plan selection: tax diversification and asset location. Research results, three “need to know” facts, and six take-away action steps conclude this discussion.
Employer Retirement Savings Accounts
Some 403(b) participants also have access to 457(b) deferred compensation plans and grandfathered (pre-1986) 401(k) plans. In 2022, the maximum employee contribution for all three plan types is $20,500 and the maximum catch-up contribution for workers age 50+ is $6,500 (total of $27,000). Minimum savings amounts are determined by employers as either a flat amount (e.g., $10) or percentage of pay per paycheck.
Deposits are made via payroll deduction (salary reduction) “paperwork” through employers, who may offer more than one plan type (e.g., both 403(b) and 457(b) plans) and pre-tax (i.e., deposits not yet taxed) and after-tax (Roth) account options. Traditional plan deposits lower current taxable income but are taxed (along with earnings) upon withdrawal. Qualifying Roth deposits do not lower income, but withdrawals are tax-free. For 403(b) and 401(k) plans, early withdrawals made before age 59½ are subject to a 10% penalty.
Required minimum distributions (RMDs) from non-Roth, tax-deferred accounts must begin no later than April 1 of the year after taxpayers reach age 72. Exception: the current employer plan of someone who is still working. That RMD must start no later than April 1 of the year following a worker’s retirement.
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.
403(b) Plans
403(b)s are a retirement savings plan for school and non-profit sector employees. A unique characteristic of 403(b) plan plans is that, after 15 years of service, special catch-up rules allow participants with at least 15 years of eligible service with their current employer to increase their maximum annual contribution by $3,000, with a lifetime limit of $15,000 of extra deferral. Participants should check their eligibility with a plan administrator before authorizing this additional payroll deduction.
A major disadvantage of 403(b)s is that many offer only poor investment choices. Specifically, a large portion of available plan investments are made through vendors that sell high-cost, commission-based variable annuities. Compared to low-cost index funds, these 403(b) accounts perform poorly as earnings are eroded by fees. Over a 35-year teaching career, over $100,00 of investment earnings could be wiped out. Use the 403bwise Vendor Search tool to check if an employer is offering at least one quality 403(b) vendor.
457(b) Plans
457(b) plans are a retirement savings plan for state and local government and public-school employees. They are often called deferred compensation plans. A unique “last 3-year catch-up” rule allows employees to contribute up to $41,000 more (2022 figure) within their last three taxable years before attaining normal retirement age under the plan, if their employer allows this option. Another difference from 403(b)s is that 457(b)s do not charge a 10% early withdrawal penalty if someone withdraws money when leaving a job. 457(b)s may offer fewer investing options than 403(b)s, but they may also include more lower-fee vendors.
401(k) Plans
401(k) plans are generally offered by for-profit businesses but are available to public employees in several states (e.g., Colorado and North Carolina), where they were established before the Tax Reform Act of 1986 and became grandfathered. There are no special catch-up provisions beyond the IRS catch-up provision for all workers and, like 403(b) and 457(b) plans, governmental 401(k)s are not subject to standards set by the Employee Retirement Income Security Act (ERISA); e.g., reporting and fiduciary responsibility.
Individual Retirement Accounts (IRAs)
IRAs are personal retirement savings accounts for anyone with earned income (i.e., salary/wages or self-employment earnings). They are not an investment product per se but, rather, an account to hold retirement savings. Common IRA custodians are banks, brokerage firms, and mutual fund companies. In 2022, the maximum contribution for IRAs is $6,000 and the maximum catch-up contribution for workers age 50+ is $1,000 ($7,000 total). Minimum savings amounts are determined by account custodians. IRAs can be funded until the tax filing deadline of the year following each tax year (e.g., April 15, 2023 for 2022 taxes).
Traditional IRAs
Traditional IRAs are tax-deductible for taxpayers who do not participate in an employer retirement plan or plan participants with income below annually adjusted levels ($78,000 AGI for singles and $129,000 for married couples filing jointly in 2022). A spouse without an employer plan married to someone who has a plan can make a tax-deductible IRA contribution provided the couple’s AGI is less than $214,000. Non-deductible traditional IRAs can be funded by taxpayers who do not qualify for a deductible IRA.
With the exception of non-deductible IRA contributions, which should be tracked using IRS form 8606, required withdrawals from a traditional IRA are taxed as ordinary income. Like tax-deferred employer plans, RMDs must begin no later than April 1 of the year following the year someone turns 72. There is no still-working exception. Traditional IRAs can be converted to Roth IRAs with taxes due accordingly.
Roth IRAs
All Roth IRA contributions are non-deductible and are made with after-tax income. Qualified withdrawals are tax-free if an account has been established for at least five years and a taxpayer has reached age 59½. Unlike traditional IRAs, Roth IRA owners are not subject to RMD rules. Account owners can also withdraw their own deposits at any age tax-free and penalty-free because that money was already taxed.
Not everyone can qualify for a Roth IRA, however. Eligibility to contribute to a Roth IRA begins to phase out for individuals with an AGI over $129,000 and ends when it exceeds $144,000 (2022). For joint filers, the phase out range is $204,000 to $214,000.
Other Retirement Income Sources
Ten other retirement income sources that 403(b) participants may have available include:
- Taxable investments (money not held in retirement accounts)
- Tax-free investments (e.g., municipal bonds)
- Health savings accounts (HSAs)
- Simplified employee pension (SEP) and Keogh plans (if self-employed)
- Annuities purchased from insurance companies
- Rental real estate
- Home equity (e.g., reverse mortgages and downsized housing)
- Sale of collectibles or business assets
- Continued employment or self-employment
- Gifts and inheritances
Tax Diversification
Tax diversification is a retirement planning strategy that considers the taxation of different sources of retirement income in later life. Ideally, retirees should have savings in each of three “buckets” that are taxed in different ways:
- Taxable “Tax Now” Accounts- Qualified dividends and long-term capital gains are taxed annually at preferential tax rates. Examples: stocks, exchange-traded funds (ETFs), and growth mutual funds.
- Tax-Deferred “Tax Later” Accounts- Deposits are made with pre-tax dollars and withdrawals are taxed as ordinary income with required RMDs. Examples: 403(b)s, traditional IRAs, and SEPs.
- Tax-Free “Tax Never” Accounts- Deposits are made with after-tax dollars and earnings are tax-free. Examples: municipal bonds and bond funds and qualified Roth IRA and HSA withdrawals.
Asset Location
A previous post discussed asset allocation, which is spreading investment dollars among different investment types (e.g., 60% stocks, 30% bonds, and 10% cash equivalent assets). Asset location is the strategy of maximizing after-tax returns by determining which investments should be placed in taxable, tax-deferred, and tax-free accounts.
Stocks and stock funds are typically recommended for taxable accounts because of lower dividend and capital gains tax rates and the ability to defer capital gains and recognize losses. Municipal bonds and bond funds are other good candidates for taxable accounts because earnings are generally tax-free.
Good candidates for tax-deferred accounts are investments that are taxed at ordinary income rates such as taxable bonds and bond funds and real estate investment trusts.
For tax-free accounts, taxable bonds and bond funds, high turnover stock mutual funds, and long-term growth funds and stock index funds or ETFs, are appropriate.
Research Results
Elective retirement savings plans are extremely important because more than half of teachers leave the profession without a pension. Just one in five stays on the job long enough to receive full benefits, which are based on length of service, earnings, and other plan-specific factors. Worse yet, many pension benefits have eroded in recent years with increased contribution rates, reduced benefits for new teachers, raised retirement ages, and modified benefit formulas.
One study found that pensions provide adequate income for only a small group of long-serving veteran teachers. New, young teachers must work at least 28 years before qualifying for adequate benefits. To afford a comfortable retirement, teachers with limited pension benefits must work longer, save more in personal accounts (e.g., IRAs and 403(b)s), and/or rely on other sources of income or family members.
Three (More) Things
- In addition to inadequate pensions, some teachers have spousal Social Security benefits reduced or eliminated by the Government Pension Offset (GPO) and/or personal Social Security benefits reduced by the Windfall Elimination Provision (WEP). Personal savings accounts can help plug income gaps.
- It is possible to “double dip” and fund two elective retirement savings plans simultaneously: i.e., a 403(b) and a 457(b) or a 403(b) and a 401(k), if an employer allows it. Plan participants can contribute up to the maximum limit allowed for both plans (i.e., $41,000 if under age 50 and $54,000 if age 50+).
- “Super Savers” in tax-deferred accounts need to be wary of higher taxes in later life. Tax diversification can help mitigate future bills. For example, instead of funding two different tax-deferred accounts, consider funding one and putting the remainder of savings into taxable accounts and a Roth IRA.
Six Smart Strategies
No. 1: Go “All In” — Save early and often. The earlier you begin contributing to retirement savings plans, the longer your money will benefit from the magic of compound interest. Borrow from savings only in a true emergency.
No. 2: Know Your Pension — Get familiar with pension rules (e.g., vesting requirements) and expected future benefits to inform retirement savings calculations using online tools such as the FINRA Retirement Calculator.
No. 3: Be Fee Wise — Investigate vendors and vendor products offered by your employer and review the grades assigned to school district vendor lists by 403bwise. Lobby your employer for low fee vendors, if needed.
No. 4: Hedge Your Bets — Face it: nobody knows what tax rates- or their net worth- will be when they retire. You can hedge your bets by dividing your retirement savings between pre-tax and after-tax (Roth) accounts for tax diversification.
No. 5: Minimize Taxes — Consider strategies such as Roth IRA conversions and qualified charitable distributions (QCDs) from traditional IRAs to reduce taxable income in retirement.
No. 6: Consider Early Withdrawals — Consult a tax advisor for assistance if income will increase in later life. Some teacher couples, for example, could have two pensions, Social Security checks, and RMDs, plus other income. It may save money to start withdrawals from tax-deferred accounts starting at age 60 to spread smaller tax bills over more years.
In Summary
403(b)s are just one retirement income source for school and non-profit employees. Take the time to thoroughly explore available savings options and consider the future tax consequences of your decisions.
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.