Welcome everyone. I’m Glenn Downing with CameronDowning, a registered investment advisory firm in Miami, FL.
Today’s topic in our continuing video series is 403b accounts.
What are they? How do they work? How do they work for you?
A 403b is sort of like a 401K for a non-profit, and there are many similarities. But basically a 403b is a retirement plan that is sponsored by a 501c3 organization, meaning a non-profit employer. A local school board or hospital are good examples. The employee invests in mutual funds or annuity contracts. If annuity contracts are the only investment choice, the plan is likely sponsored by an insurance company, and can also be known as TSA, or tax-sheltered annuity.
Money can go into your account from two sources: deferrals from your paycheck (money that you could have taken in cash) and your employer can also make contributions. The employer’s contributions can be discretionary or according to a match formula. Say the employer will offer you 50 cents on the dollar of whatever you contribute, up to 6% of your earnings. That’s a fairly typical formula. We’ve seen some out there more generous, and some not quite as generous. But generally a 403b is going to be driven by your deferrals rather than the employer kicking in. 403bs are sponsored by non-profits, remember.
There are several deferral limits, all of which work together. You may defer 100% of your salary If you are a participant in a 403b plan, up to a maximum of $18000 per year. The overall limit is $53,000 in 2016. That means that if you defer your maximum of $18,000, your employer may contribute $35,000. Furthermore, if you are age 50 or above, you may defer an additional $6000.
What are the advantages to you? number one, automatic savings. It happens every pay cycle without you even thinking about it. You don’t have to write a check. You’re not having to make a conscious decision as to whether you’re going to save this money or spend it on something that gives me more immediate gratification.
Another big advantage to you is tax savings. As you defer money into the 401k you are not taxed on it for federal income tax purposes. You do pay payroll taxes – that is FICA, but not federal income tax.
Some 403b plans may offer a Roth option. In this option you are deferring on an after-tax basis. Much like a Roth IRA, the account grows without taxation, and come retirement you can distribute your funds with no taxable event. Many taxpayers are income – phased out of contributing directly to a Roth IRA. With a Roth option in a 403b or 401k account, there is no income phase-out, nor is there the $5500 annual contribution limit. A Roth option should be considered carefully, as there is a little pain now in the loss of an immediate tax deduction, but a potentially huge gain, in gaining a large retirement account with no taxes on distribution nor any required minimum distributions.
What happens to the account at retirement? Over the years it is going to grow, and grow without federal taxation. You’re going to have compounding -earnings upon earnings – and the effect can be enormous. So if you do it purposefully, with a good serious deferral, and your employer throws in some money too, you can end up with hundreds of thousands of dollars in a retirement account – or into seven figures even – if you’re very disciplined about it.
Now what happens with the taxes at the other end? When you retire and you take money out of this account it will be taxable to you then, at ordinary income tax rates. There’s your tradeoff: you’re trading off the benefit of tax deductibility and tax deferral now on your contributions for what will probably be higher ordinary income tax rates in the future. That’s another topic, and we’ll cover that a little later.
Now there’s another option that your employer may offer you, and that is the ROTH 401K option. It’s going to work the same way except that in the ROTH you are not going to take a deduction for the money going in. You will pay both Federal and payroll tax. BUT when you take the money out at the other end, it does not come out taxable! That’s really, really something to consider, because if you have access to an account that approaches 7 figures, or even exceeds $1 million, in your retirement years, without any taxation – that’s huge! This is really something to consider and to get some professional advice on.
Now, how do you invest the money once it’s there? Your employer will have a plan sponsor and that plan sponsor will give you a universe of investment choices. You’ll have pretty much everything in there – you’ll have government and corporate bonds funds, you’ll have US common stock funds, and you’ll have international stock funds. You might have foreign bond, and emerging markets funds, and you might have a target date fund which is sort of a default that people choose when they don’t know what to do. A target date fund targets the date of my retirement. That account will start out aggressively invested and become more conservative as the years go by.
If you are in a TSP, or a plan with an annuity option, we would steer you away from any variable annuity allocation. There is nothing inherently wrong with a variable annuity – it has its uses, primarily with non-tax qualified dollars. Basically it gives non-retirement dollars tax deferral, and there is an underlying contract fee. Since in your 403b account you already by definition have tax deferral, there is no reason to pay variable annuity fees.
The investment allocation you choose is a very important consideration for you. Your allocation should reflect how you feel about investing and what type of volatility you can take in the markets. If you are launching your career, or in the early stages of your career, and have a long working life ahead of you, we’ll generally tell you: Go aggressive. Markets will always have their ups and downs. That can work for you actually. When you have down months or down years you’re going to be buying in every month at bargain prices. When the market recovers those dollars are the ones that will work for you the hardest.
Now the main thing – the main takeway here- is to invest – defer – up to the employer match. Otherwise you’re just leaving money on the table that you could’ve had in your account. This is the best beginning place to start your long term retirement savings. So: participate! Get started! Take your employer’s match. Don’t leave money on the table. And let the time value of money work for you.
I hope we’ve provided good information for you here. If you have any questions, by all means get in touch: firstname.lastname@example.org. Visit our website at www.cameron-downing.com, where you’ll see all of our blog entries and be able to book an appointment to come see us.