403(b) or Deferred Compensation?
Due to recent changes in legislation, as of October 2023, teachers and all state workers will now have an option to do Roth contributions for Deferred Compensation Retirement Savings, making the need to utilize or open a 403(b) account only relevant for teachers if they are already maxing out the contribution they are making to a 457(b) DCP Account.
Which is better for Washington Teachers when saving for retirement?
K-12 Public School Teachers in our state fund some of their retirement with a pension, but for many, a pension alone won’t be enough to fund a comfortable retirement. So how do we make up the difference in what our pensions provide and what we’ll need to retire comfortably?
Most teachers have two options for additional savings outside of the TRS 2 or TRS 3 Plan:
What’s the difference?
Both 403(b) and DCP accounts allow teachers to contribute up to $19,500 per year (in 2021) with additional catch-up contributions of $6500 per year for employees age 50 and up. They are both voluntary programs, and you can change your contribution amounts at any time. But there are a number of important differences:
In the state of Washington, K-12 public school teachers who sign up for a 403(b) plan typically do so through private investment or insurance companies. The list of companies a teacher can use is provided by the school district, and often includes a lot of companies who charge teachers high fees while delivering products that are not necessarily in their best interest. (You can read more about that here.) Mounting pressure has forced many, but not all districts to add at least one low-cost investment provider to their list, but many teachers still sign up for a 403(b) through a sales rep sitting in the staff lounge and end up tied into high-fee investment or annuity contracts that are sometimes difficult to get out of.
For most school districts in the state, 457(b) accounts are now exclusively run by the Department of Retirement Systems (DRS) Deferred Compensation Program – the same folks who manage the TRS 2 and 3 Plans. In the Deferred Compensation Program, teachers can build their own portfolios using available funds, or choose a target date retirement plan which matches their retirement goal. There are fewer choices in the investment lineup than you might get at a private investment company, but compared to most 403(b) accounts, fees related to investment management are low, and typically run between 0.13% and 0.3% annually.
Most districts in the state of Washington offer both a traditional and Roth 403(b) option, but because 403(b) options vary from district to district, you’ll have to check your benefits and payroll website, or contact the folks in the payroll office to determine whether your district offers both options, and to find out who your providers are.
A traditional contribution to 403(b) account is a pre-tax contribution. The money is taken directly from your paycheck, before taxes, and it reduces the total taxable income on your W2. When you take distributions from this account in retirement they will be taxed as income.
A Roth contribution to a 403(b) account is an after-tax contribution. Money is still taken directly from your paycheck and sent to your Roth 403(b), but it does not reduce the taxable income shown on your W2. When you take distributions from this account in retirement they will not be taxed since you already paid the taxes on the contributions upfront.
Currently, the Deferred Compensation Program only offers a traditional, pre-tax, retirement savings option, there is no Roth contribution option. So, whatever you contribute to your Deferred Compensation account reduces your current taxable income and is taxed as income when you distribute funds from the account in retirement, just like the traditional 403(b) account.
Though there are a few exceptions to the rules below that might allow you to qualify for a penalty-free distribution earlier in life in the event of unforeseen circumstances, we’ll focus on eligibility to access these funds in retirement.
If you have a traditional 403(b) account, you can access the funds without incurring an additional 10% penalty
You will owe income tax on any distributions you take from the account in retirement.
If you have a Roth 403(b) account, you can access the funds without having to pay any income taxes or pay any penalty on the distributions
In a Deferred Compensation account, you can access your funds penalty free at any age, as long as you have separated from service.
The traditional 403(b) and the Deferred Compensation account are also both subject to required minimum distributions (RMDs) at Age 72, but the Roth 403(b) is not
Which one is better?
In any situation, it’s important to do your research and select the right option for your needs, so the following should not be considered financial advice specific to your situation, but rather, a guide to some of the factors that may lead you to choose one of these account types over the other.
For teachers looking for a straight-forward, low-cost investment option to make pre-tax contributions, the Deferred Compensation Program is often a good place to start. It’s user friendly for a beginning investor, easy to set up, and the costs related to the program are low. The fact that the account’s funds are available at any age once you’ve separated from service also makes this a good option for those considering early retirement.
On the other hand, if you are looking to make after-tax Roth contributions, a 403(b) is most-likely your only work-based option if you work for a K-12 public school district in our state. So, if a Roth contribution makes sense for your long-term financial plans, set aside enough time to carefully vet the list of providers your school district works with, and look for one with low fees that offers the investment products that best suit your long-term investing needs.
Every district has a different list of 403(b) providers that it works with and typically the ones with sales reps that make the rounds through staff lounges, ready to offer you a slice of pizza for lunch and sign you up on the spot, are not the ones that have your best interest or long-term goals in mind. Take the time to do your homework upfront before choosing a 403(b) provider.
Is it possible to change from one to the other?
You can change the amount you are contributing to these accounts at any time. So, if you’re putting $200 a month into a 403(b) and you’ve decided that Deferred Compensation is a better option for you, you can reduce the 403(b) contribution to $0, and start a Deferred Compensation contribution of $200, or vice versa.
In many cases, it may also be possible to do a contract exchange, where you transfer what’s in a 403(b) account into a Deferred Compensation account, as long as both of the accounts are funded with pre-tax dollars. It’s also possible to change providers for your 403(b) if your current provider is no longer meeting your investment needs, as long as the new provider is also on your district’s approved list of vendors.
If you are thinking about doing a contract exchange or switching providers for your 403(b) and you’ve got an account that’s being managed with an annuity, there may be penalties imposed if you transfer the account without waiting a certain amount of time (which can be as long as 8 years for some annuity contracts). So, you’ll need to do a little research to make sure your transfer won’t be costing you a lot of money. If it will, the way to get around this is simply stop making contributions to that 403(b) account (and start one at the provider you want to work with or open up a Deferred Compensation account), wait the required amount of time to avoid the penalty, and then start the transfer or contract exchange process.
Can I contribute to both?
You can make up to the maximum contribution to both types of plans if you’re looking to accelerate your retirement savings. By opening both types of accounts, you can contribute up to $39,000 (or $52,000 is you are age 50 or older) to supplemental retirement savings each year.
How can I get started?
No matter which account type is the right one for you, choosing one and getting started with regular monthly retirement savings is an important part of retirement planning for most teachers. So, after deciding which account type is right for you, here’s how to get started:
For a 403(b) account, work with your payroll office and the private service provider you choose from your district’s approved list to set up a 403(b) account and start regular contributions. Many districts have teacher access portals where teachers can access all of the information and forms needed to get started, as well as a list of 403(b) providers that the district works with.