Fifteen 403(b) Plan Errors
June 14, 2022
Guest post by Dr. Barbara O’Neill, CFP®, AFC®
It is rare to find 403(b) plan participants who do everything right from their first payroll deduction. In real life, mistakes happen. Whether it is saving late in one’s career, emotionally reacting to market downturns with panic-induced moves, or selecting a high-cost 403(b) plan vendor with a low 403bwise rating, plan participants often become successful 403(b) investors through trial and error.
What are the most common errors made by 403(b) plan participants? A quick Google search yielded few useful results. Most links that popped up were about errors made by 403(b) plan providers — not plan participants themselves. This post fills a void by compiling a comprehensive list of mistakes to avoid.
It is not enough to simply know about these errors, however. 403(b) plan investors also need strategies and tools to avoid making them. This post describes fifteen common 403(b) mistakes (in no particular order) and, more importantly, workarounds, action steps, and resources to address each one. It concludes with three “need-to-knows” and six take-away action steps.
Fifteen 403(b) Flubs and Fixes
Failure to Do a Retirement Savings Calculation
Not calculating how much 403(b) plan savings is needed to supplement a pension and/or Social Security and other income sources like aiming a bow and arrow at a target while blindfolded. Chances are extremely high you will miss the mark. A useful tool to develop a 403(b) savings plan is the FINRA Retirement Calculator. Users input data about key variables (e.g., current savings, age, retirement age, annual income needed) and receive an estimate of the amount of money they need to invest annually until they retire.
Getting a Late Start (Procrastination)
Early 403(b) plan savings is better than late savings, but late savings is better than none! The point is that late savers can still accumulate significant amounts throughout the remainder of their teaching career. I was a late saver and am living proof. Sign up to save today if you haven’t already. To increase your motivation to save, see what you could accumulate with this 403(b) Savings Calculator from Bankrate.
Not Using Catch-Up Savings Opportunities
Older 403(b) participants have, not one, but two opportunities to invest additional money later in their careers. First, like all workers age 50+, they can contribute an additional $6,500 to a 403(b) for a maximum of $27,000 in 2022. In addition, under the “15-Year Rule,” participants who work for the same employer for at least 15 years can contribute up to $3,000 more per year, up to $15,000, if their plan permits.
Inadequate Tax Diversification
This error is often not apparent until older adults face taxable required minimum distributions (RMDs). If all of their savings from age 22 to 72 (50 years of earnings!) is in traditional 457(b)s, 403(b)s, and IRAs, there could be quite a tax bite! This speaks to the need for tax diversification, which is ownership of assets in a combination of taxable, tax-deferred, and tax-free accounts that are taxed in different ways. Example: qualified Roth IRA and Roth 403(b) withdrawals are tax-free and taxable accounts have no RMDs.
Investing Too Conservatively
Some investors are unnecessarily conservative in their asset allocation (i.e., percentage of contributions in stock, bond, cash equivalent, and real estate-related investments). They may be afraid to lose money or be paralyzed by the number of plan choices. The downside of risk avoidance is that low-risk investments usually produce low returns, often below the inflation rate. In other words, money grows very slowly. Start addressing this with a personal analysis using an empirically tested Investment Risk Tolerance Assessment.
Inadequate Investment Diversification
Diversification means having an investment portfolio with different asset classes (see above) and different types of investments within each one (e.g., large, medium, and small company stocks and bonds issued by governments and corporations). It reduces the risk of loss from a decline in value of any one investment. The easiest way to assess personal portfolio diversification is to complete a net worth calculation (assets minus debts), review the asset side of the ledger, and consider buying securities in “missing” asset classes.
Staying in a High-Cost 403(b)
As 403bwise notes, a bad 403(b) plan is expensive because most financial vendors sell expensive, commission-based products. In their illustration of $250 contributed monthly with a 6% average return, there was a difference of almost $160,000 in end value between an average variable annuity and an index fund. Many plan participants are unaware of this or, if they are, don’t know what to do about it. Not to worry! 403bwise has your back with step-by-step instructions for how to get money out of a bad 403(b).
Cashing Out Before Retirement
There are significant tax consequences when cashing out a 403(b) before retirement (e.g., changing jobs). Withdrawals are fully taxable and there is an additional 10% penalty before age 59½. Worse yet is the loss of tax-deferred compounding. Better options are to borrow from a plan (emergencies only) or, if changing employers, leave 403(b) assets where they are or roll them over to an IRA or new employer’s plan.
Not Rebalancing 403(b) Investments
Over time, asset class values shift due to market fluctuations. Example: if the stock market does well, stock weightings will rise. It is important to periodically recalculate asset allocation percentages and rebalance, if necessary. Rebalancing back to target weights can be done by reallocating securities in an over-weighted asset class (e.g., stocks to bonds) or placing new deposits into an under-weighted asset class. Some 403(b) vendors rebalance portfolios on a regular basis (e.g., annually, on a birthday) if you request this service.
Underestimating a High-Tax Future
When teaching personal finance classes for older adults, I meet many who tell me they never realized their assets would grow as much as they did over 30-40+ years of work and that they would be in a higher tax bracket in later life than when they were working. Some are educators with pensions, Social Security, RMDs, dividends/capital gains on larger taxable accounts (vs. balances at younger ages), and/or job earnings. This calculator can estimate what current investments could be worth in the future. To hedge the risk of higher taxes, consider dividing 403(b) savings between a traditional and Roth account (if available)
Market Timing
Some 403(b) investors try to “time” the stock market’s highs and lows in an effort to score big gains and avoid big losses. They often do this by changing the stock allocation weight of previously invested money. Market timing is generally futile because investors have to be right twice- on the upside and the downside. A much better strategy is to stay invested in both up and down markets to avoid missing market gains.
1/n Investing
1/n means allocating 403(b) deposits equally among the number of available plan investments (n). For example, if there are ten plan choices, each would get 10%. While this approach seems simple, it is rarely ideal. First, there is no consideration of an investor’s age, goals, other retirement savings, or risk tolerance. In addition, some investment options might hold the same assets as others, which reduces diversification.
Poor Record-Keeping
Organized records (paper or electronic) make it easier to monitor a 403(b). Files should include quarterly and annual statements showing account balances and asset allocation weights and vendor correspondence regarding fees, tax forms, portfolio rebalancing, annuity contracts, investment prospectuses, and more.
No Tax-Deferred Savings
Some teachers forgo 403(b)s, as well as 457(b)s, Roth or traditional IRAs, and other retirement savings, figuring their pension will be sufficient. This could be a big mistake. In recent years, some cash-strapped state governments with underfunded pensions have reduced retiree benefits and/or COLAs. In addition, new hires in some locations are placed into defined contribution plans in lieu of a defined benefit pension.
Three (More) Things
- Be smart about 403(b) rollovers. Account balances should be transferred directly from one plan custodian to another. Participants need to arrange transfers but should not take possession of the money.
- Plan ahead for RMDs. 403(b) participants who are “super savers” may want to begin making 403(b) plan withdrawals after age 59 ½ but before age 72 to avoid higher taxes later on larger balances.
- Get help when needed. If you have made one or more of the fifteen errors, reach out for help from a low-cost 403(b) plan vendor, a certified financial planner®, and/or 403bwise office hours.
Six Smart Strategies
No. 1: Aim High and Multi-Task
Invest as much as you can as early as you can. Financial goals do not have to be accomplished in a series of steps. Rather, you can “multi-task” and concurrently fund several financial goals (e.g., repay student loans, save for a house, and start making 403(b) deposits).
No. 2: Select Some Stock
Consider some stock in 403(b) plan asset allocations to increase the potential for inflation-adjusted long-term growth. Market history tells us that stock assets have outperformed other asset classes over time.
No. 3: Diversify
Diversify your 403(b) in three ways: selecting different asset classes, selecting different securities within each asset class, and investing for the long term (i.e., time diversification). Also consider asset classes that investors tend to overlook (e.g., international investments and small cap stocks).
No. 4: Monitor and Modify
Review 403(b) plan statements regularly to monitor account performance and rebalance as needed. As you get older, consider modifying the portfolio mix (i.e., less stock) to reduce investment risk.
No. 5: Don’t Go Overboard
Consider downstream impacts of multiple tax-deferred plans. While some educators with access to both a 403(b) and a 457(b) have the ability to contribute to both at the same time, doing so could bring big RMD tax bills in later life. It might be better to put “excess” savings in a Roth IRA and/or taxable account.
No. 6: Borrow Only in an Emergency
Treat a 403(b) as a long-term savings vehicle, not a short-term savings account. Establish an emergency fund in a money market or bank account so 403(b) assets can remain intact when quick cash is needed.
In Summary
Learning about common 403(b) plan errors can make help plan participants avoid making costly mistakes. Four keys to 403(b) success are: invest as much as you can, diversify across asset classes, avoid market timing, and choose low-expense investments with good historical performance.
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.