A "4-0-Something"
It’s not uncommon for me to hear, “I know I have a 4-0-something, but I’m not sure what it is.” That’s typically a sign they don’t know the opportunity they have and how it could help them create long-term wealth.
If you’re an employee of a non-profit health care group, you likely have a 403(b) available for you to participate in. 403(b)s like 401(k)s get their name from the tax code. Though similar they do have differences. While some elements about them might seem complex or at least take a much longer article to explain, I want to provide a few key ideas so that you can be more familiar with the opportunity you have with a 403(b).
Tax-deferred Investments. Taking advantage of your 403(b) can be a great opportunity to build long-term wealth. A 403(b) plan allows you to invest in the market while deferring taxes like capital gains tax. This can be a very effective way to invest since it offers the potential of compounding growth without the erosion of capital gains taxes.
Your Contributions. For 2022, you can contribute up to $20,500 of your earned income and an additional $6,500 if you’re age 50 or older (a total of $27,000). Making consistent contributions could have a sizeable impact over time. How you choose to make those contributions can also have an exponential impact. You may be eligible to contribute two different ways; traditional or Roth.
Making traditional contributions allows you to receive an income tax deduction for the amount of your contributions so when you file your taxes for the year of your contribution you’ll have less taxable income. Then when you retire after the age of 59 ½, withdrawals will be taxed as income. If you’re in a smaller tax bracket when you retire this could be very beneficial.
Making Roth contributions is a little different. Rather than taking a deduction from your income in the year of your contribution you tell Uncle Sam to tax you on the amount of your Roth contribution as income for that tax year. Then it grows tax-deferred (without capital gains). After age 59 ½ when you make a withdrawal, since you already paid income tax on the money, your withdrawal would be income tax free. If you’re younger and want tax-free income in the future this could be very beneficial.
Employer Contributions. Depending on your employer they may even match your contributions. If so, it’s an opportunity you likely don’t want to miss out on. Some companies match dollar for dollar up to a certain percentage of your contributions. Not participating can feel like missing out on an employee bonus that’s offered. Sometimes employers have a timeline for when their contributions are fully credited to the employee, called a vesting schedule. For example, it could be 20% of the employer’s contributions in the first year, 40% the second, 60% the third, etc. Typically, if an employer has a vesting schedule for employer contributions employees are fully vested after 5 years.
Investment Selection. One frequent limitation of 403(b)s can be their investment selection. The plan may have limited options. Some plans do offer a process for greater additional flexibility and greater access to a wider array of investments. Depending on the plan’s offerings this may be an option worth investigating. Whatever the mix it’s important to vet the investments and understand how they fit in your overall financial picture and investment strategy.
Transferability. Your 403(b) is transferable even if you leave your employer. If you leave your employer or retire you may choose to keep your 403(b) account, or you could transfer your money to an Individual Retirement Account (IRA) by a direct rollover. Any traditional 403(b) contributions could be transferred to a Traditional IRA and any Roth 403(b) contributions could be transferred to a Roth IRA.
Not all 403(b)s are created equal. You’ll want to be aware of your investment options, vesting schedule of employer contributions, and potential tax consequences of any premature withdrawals. Because 403(b)s may be more limited or complicated than traditional 401(k)s, some employers may offer additional supplemental retirement plans such as a 401(a).
It’s always helpful to consider the 403(b) in the context of your specific situation and the opportunities before you. In future articles I hope to cover some of the key ideas above to further illustrate how they may help create wealth over the long-term. Of course, if you have a question about your 403(b) or finances don’t hesitate to reach out.
Sojourn well,
Sean M. Williams, CFP®