A 403(b) Plan, done right, can help you reach this date. Photo: American Advisors Group, via Flickr.
It seems like almost everyone has heard of a 401(k) Plan, but very few know of its closely related cousin: the 403(b). The key difference is that the 401(k) is used by employees of for-profit companies, while the 403(b) is for government employees, public school teachers, and those who work at nonprofit or other tax-exempt organizations.
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Understanding the pros and cons of a 403(b) Plan is crucial, especially for employees of nonprofit organizations -- who often have lower salaries than their peers in the private sector. To help you navigate this retirement vehicle, we asked three of our retirement experts what everyone needs to know about the 403(b). Read below to find out more about the tax advantages of the 403(b), how your money can be invested, and dangers that can secretly lurk inside your plan.
One of the biggest advantages of a 403(b) is that it reduces your taxable income. In 2015, you can put up to $17,500 into your plan; if you are 50 or older, that limits extends to $23,500. While not many people are able to fully max out their plans, the benefits begin with the first dollar that you put in.
Let's say you are a single filer earning $90,000. After your standard deduction and personal exemption, you have taxable income of $79,700. At that level you would owe approximately $15,720 in federal income taxes.
But if you put the maximum into your 403(b), your taxable income would be reduced all the way to $62,200. At this new level, you would owe $11,340 in federal income taxes -- or a whopping $4,380 less than if you had not contributed at all.
Of course, the government will eventually get a piece of this money. With 403(b) plans, that comes when you take withdrawals to help cover retirement expenses. However, by that time, if you have learned to live frugally, you will likely be in a lower tax bracket than you are right now, meaning you'll owe significantly less than you do now.
One of the drawbacks of 403(b) plans -- and 401(k) plans, too, for that matter -- is that they tend to offer plan participants limited choices when it comes to what they can invest their moola in.
If you open an IRA at your favorite brokerage, you can fill it with almost any stock or exchange-traded fund (ETF) and, typically, any of hundreds or thousands of mutual funds offered by the brokerage. That gives you alotof flexibility and a lot of control over your retirement account and how it might grow.
But 403(b) plans often feature a more limited menu of choices, often a dozen or fewer. The Securities and Exchange Commission (SEC) notes that "403(b) plans typically offer fixed annuities, variable annuities, and mutual funds." Read up on any kind of investment you consider, because each has some drawbacks. Many mutual funds have high fees, for example, especially if they're not index funds. Annuities can be especially problematic, as Dan explains below.
Fortunately, you can work around this limitation a bit. For example, you can max out your IRA contributions first each year, contributing as much additional money as you can to your 403(b). If you change jobs, as many of us do every few years, you can roll over your 403(b) account into an IRA -- where you'll be far less fettered in regard to investment choices.
And even while you're actively using your 403(b) account, you can do very well if it offers you a low-cost index fund that tracks the stock market, such as one based on the S&P 500. Many investors don't have the time or skill to choose individual stocks and funds, and index funds tend to outperform most managed mutual funds over the long run, anyway.
Dan CaplingerOne thing that 403(b) participants really need to watch out for is what type of investments they have available to them. Currently, 403(b) plans are allowed to offer the same mutual funds that 401(k) plans have, but historically, 403(b) plans focused exclusively on annuity products because the law that initially created them required the plans to own annuities.
Annuities have a lot in common with mutual funds, but they can also carry higher fees that go not only to pay for some of the beneficial features of annuities but also toward some of their unique expenses. In addition, surrender fees can make it difficult to move in and out of certain annuity investments for years after purchase, with many companies limiting exchanges to other annuities within the same firm.
Most 403(b) plans have come a long way since annuities dominated the industry; so you should generally seek out cheaper mutual funds to compare with annuities. Occasionally, the guarantees that you can get with certain annuities might make them worthwhile in a retirement account. More often, though, you'll probably find that despite some of the features that annuities offer, a simple mutual fund will be more in line with your current financial goals for retirement.
The article The Pros and Cons of a 403(b) Plan originally appeared on Fool.com.
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