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June 28, 2020 • 5 minutes
If you are an employee at a school, church, hospital, or other non-profit, then you are eligible for a “tax-sheltered annuity,” also known as a 403(b) plan. Don’t work for a nonprofit? Learn more about annuities and how to invest in them in a tax-advantaged way.
The precursor to the 403(b) plan was simply a tax-exempt employer (usually a school) putting money aside into an annuity contract for an employee. These contracts were typically individual annuities, owned by the employees. In essence, they were fully portable pensions.
In 1958, section 403(b) of the Internal Revenue Code was put in place to limit the amount that could be contributed to such annuities. At the time, the only investment options available for 403(b) participants were insurance-based annuity products. Thus, the names 403(b) plan and tax-sheltered annuity became synonymous.
In 1974, Congress added paragraph 7 to section 403(b) of the Internal Revenue Code, which allowed participants to invest directly into mutual funds in addition to annuities.
So while the name tax-sheltered annuity lingers, it’s a bit of a misnomer.
403(b) plans are similar to 401(k)s in that they allow employees at eligible institutions to make pre-tax contributions into a retirement plan. Contributions to the plan are not taxed until the employee starts taking distributions in retirement. Employers can also make contributions to the plan, so the employee gains the benefit of having additional tax-free funds invested.
Like a 401(k), elective deferrals to 403(b) plans are limited. For 2020, the most an employee can contribute to a 403(b) account out of salary is $19,500. Employees aged 50 or over at the end of the calendar year can also make catch-up contributions of $6,500.
The limit on annual additions (the combination of all employer contributions and employee deferrals to all 403(b) accounts) is generally $57,000 or 100% of the taxable wages the employee received in their most recent full year of service. Some plans allow additional catch-up contributions for employees with at least 15 years of service.
The main difference between a 401(k) and a 403(b) plan is the menu of investment choices available to employees. 401(k) plans can choose from a wider range of investments, including mutual funds, exchange-traded funds, and sometimes individual securities. 403(b) plans can only invest in mutual funds and annuities.
The bad news is that your options for investing with a 403(b) are fairly limited. However, research shows that having too many options can be paralyzing, so perhaps the limitations of the 403(b) can actually be an advantage.
You basically have two options:
Annuities typically come in two forms: fixed or variable annuities. A fixed annuity offers a guaranteed payout, similar to a pension. A variable annuity functions more like a mutual fund. Your income in retirement depends on how well the investments in the annuity have performed.
Whether an annuity is fixed or variable, one trait remains the same: in most cases, the fees associated with annuities are higher than those of other investment products. However, the returns can be more stable. For example, lifetime annuities guarantee income for life – no matter how long you or your spouse live.
When selecting how to invest your money, consider fees, annual charges associated with the investment, investment returns, the types of mutual fund and the types of annuities. You may also want to understand the cashing out policies.
Your 403(b) plan is an important part of your retirement plan, but it is probably not everything. Retirement planning involves many different elements that must all fit together. You need to figure out when to retire, whether or not you are eligible for Social Security and when to start that benefit, how much income will you need to support your desired lifestyle and much more.
One of the easiest ways to get your hands around your overall retirement plan is to use a reliable retirement calculator. The trick is to make sure you find one that includes the ability to document pensions and variable start dates for different benefits and income sources.
The Boldin retirement calculator is an easy to use tool that gives you really great information. This tool was recently named a best retirement calculator by the American Association of Individual Investors (AAII).
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