Properly managing your 403b account to maximize its value long-term can help you ensure financial security through retirement. 403b Accounts with nearly $1.3 trillion in assets reported in 2023 are a popular way for not-for-profit organization employees to save for retirement and rank second in size only to 401k accounts.
Using strategic financial planning and consistent contributions to your 403b account can be a way to generate a sizable source of income to help you live comfortably in retirement.
What Is a 403b Account and How Does It Work?
A 403b plan generally uses a tax-sheltered annuity as a retirement savings vehicle for employees in education, healthcare, and tax-exempt 501(c)(3) organizations. Similar to a 401(k), the plan allows you to deduct part of your paycheck as a contribution to your 403b account, investing in mutual funds offered by the annuity provider.
Federal income taxes are deferred until you withdraw money after age 59 ½ from the 403b account, unless you choose the Roth 403b option which has you pay that tax up front.
What are the key benefits of a 403b Account?
With this type of retirement savings account, you can invest in your retirement with automated deductions from every paycheck. You don’t pay tax on your contributions until you withdraw the money from the plan, generally when you’re retired and use it for income. 403b accounts feature higher contribution limits (up to $23,000 in 2024) than traditional IRA or Roth accounts with the potential for employer matching contributions.
Selecting the Right Investment Options
With a 403b account your investment choices are designed to match your tolerance for investment risk. Within your risk profile you can generally choose various types of investments to suit your preferences. You choose the funds that comprise your account portfolio and a professional asset manager manages the individual investments within each fund based on economic, industry, and company performance data.
How can I choose the right investment options for my 403b account? Employer-sponsored retirement plans do not provide employees with a dedicated financial advisor. In fact, the first and last time you see the financial advisor of record on the plan may be when you enroll in the plan. The advisor is responsible to your employer, not to you. That’s why it’s important to understand how to use the employer’s plan for your retirement needs and not ignore it.
Generally, participation in the plan is an easy decision, especially if the employer offers a matching contribution. But that means participation is not enough: you need to contribute and probably should contribute to maximize the employer match. Beyond the matching contribution, you can decide how much to contribute to your employer’s plan or to use another strategy toward your retirement. But, you should have a strategy to invest toward your retirement, regardless. That may require you to hire a financial advisor—someone accountable to you alone—to design a financial strategy that’s customized to your needs and goals.
Minimizing Fees and Expenses
A U.S. Government Accountability Office study found that fees for 403b investment options varied from 0.01% to as much as 2.37%. Surrender fees, a separate fee which is applied if you cash out, sell, or cancel an annuity investment before the surrender period is over, can be comparatively high.
Fees and expenses like these reduce your total payout for retirement, so it’s important to know how to minimize them to help maximize your return. The first rule: retirement funds are meant for retirement so don’t use them before retirement or you may pay a penalty. You should plan to reach age 59.5 (unless your employer’s plan allows fund distributions beginning at age 55) before withdrawing funds from your plan to avoid the IRS’s 10% penalty tax on top of income tax you would normally pay.
Diversifying Your 403b Portfolio
Diversifying your 403b portfolio, or asset allocation, is always recommended because it helps insulate you from investment risk and market fluctuations. The old saying applies—don’t place your eggs in one basket. For more consistent, long-term growth, you should strategically diversify your 403b portfolio, which means including various types of assets that adhere to your risk tolerance.
No one knows which asset class will perform best this year, next year, and so on. Having a diversified investment portfolio can help ensure you participate in whichever asset class performs well that year. Diversifying also helps to provide stability to your portfolio, preventing the performance of any one investment fund from overwhelming the others positions.
Some suggestions include:
- Split your investments (i.e., 70% stocks, 25% bonds, 5% short-term investments) wisely.
- Invest with risk tolerance in mind. Stocks may have higher growth potential that comes with higher risk, while money market funds have lower returns with lower risk.
- Diversify by investing in multiple types of funds (domestic, international, large, mid, small, different sectors, etc.)
- Review your account at least annually or after major financial changes, like a job loss or large bonuses, and determine which funds perform well, which may not. Ask for help if you have questions.
Tax Implications of 403b Accounts
With a traditional 403b, you get a tax break now—your contributions reduce your taxable income dollar-for-dollar as reported on your income tax return (IRS Form 1040). As a result of that reduced taxable income you pay reduced income tax today. The funds in your 403b grow sheltered from income tax until your age 59.5 when you may withdraw funds for use as income. In the calendar year in which those withdrawn funds are used as income you would report that income on your tax return, including the original contribution and any gains you realized, and pay tax by April 15th of the following year (the tax filing deadline).
Is the 403b available as an after-tax Roth option? Generally, yes.
If you’d prefer paying taxes on your contributions when you earn money rather than when you withdraw them for retirement, choose the Roth 403b option. Paying tax on your contributions as you make them means you won’t have to pay taxes on withdrawals later. This can help keep your reported income lower when you’re in retirement, reducing your concerns of not knowing what the tax rate may be when you retire.
Roth-type plans have restrictions like many other popular retirement plans. This includes a 5-year holding requirement (you cannot access gains in the plan until they are held in the Roth for 5 years) and you must be at least age 59.5, or have a qualifying disability, or pass away and leave the money to heirs. However, one benefit of a Roth account is you can access your cost basis money—any money on which you’ve already paid tax—at any time.
Best Practices for Contributions and Management
Contribute to your 403b account regularly, consistently building your funds so your investments can grow with interest over time. The earlier you start habitually contributing to your 403b for retirement planning, the more you can earn as you build your retirement “nest egg”.
Minimize fees and expenses by researching your investment options, diversifying your investment choices, and making adjustments over time, especially after significant changes in your financial circumstances.
Early age, habitual contributions to your retirement financial well-being making the most of your 403b account. Contact MyStages® retirement consultant.
