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Course 203
403(b) Plans

Introduction

We covered the basics of the 401(k) plan in Portfolio 202. Now it's time to explore the cousin of the 401(k) plan: the 403(b) plan.

403(b)s versus 401(k)s

Not-for-profit organizations, such as schools and hospitals, generally offer 403(b) plans rather than 401(k) plans to their employees. Both plans allow participants to save dollars direct from their paychecks into retirement accounts and both defer taxes on any investment gains. That's where the similarities end.

403(b) plans can differ significantly from the better-known 401(k) plans, and not in good ways. For instance, employers offering a 403(b) plan rarely match their employees' contributions, which is a common practice among 401(k) plans. Employers offering 403(b) plans aren't responsible for running the plans, either.

Handling the Shortcomings

Do those shortcomings make 403(b) plans worthless? Not necessarily. But if your company offers a 403(b) plan, consider the following.

Investigate the Options
As with any investment plan, you should learn what you can about your plan options. 403(b) plan participants often find a lot of annuities and very few mutual funds on their list of options. That's because annuities were the only choices the law allowed until the early 1970s. As a result, insurance companies selling annuities established a stranglehold on the 403(b) market.

Here's how an annuity works. A variable annuity ties its returns to the performance of a mutual fund, while a fixed annuity delivers fixed returns. With either, you sign a contract to make regular contributions for a period of time, and the annuity will provide regular payouts when it comes due. The annuity also carries insurance so that you or your beneficiaries won't receive less than what you contributed.

That guarantee might seem compelling, but it hardly makes annuities no-brainers. In fact, most 403(b) participants would be better served by mutual funds.

Funds benefit more than annuities do from the main advantage of 403(b) plans: Gains aren't taxed until participants start drawing money from the plan. Even outside 403(b) plans, annuities avoid taxes. There's no extra benefit in keeping them in a tax-deferred account. What's more, mutual funds often offer higher returns than annuities do. You'll find out why inPortfolio 401, which focuses exclusively on these investments.

Check the Fees
There's a simple reason why funds often perform better than annuities: They cost less.

For example,an annuitymay charge twice as much in percentage terms as the underlying fund. Over long time periods, these higher expenses have a dramatic effect on returns.

Let's assume you contribute $5,000 a year to an annuity that charges 1.77% annually. Let's also assume that its average annual return will be 12%. After 30 years, you'll have $947,018.87.

That's not chump change, to be sure. But if you instead put the same amount each year directly into the underlying mutual fund--which charges, say, 0.66%--via a tax-deferred account, you will walk away with $1,182,720.99. By choosing the variable annuity, you will have paid $235,000 extra for guarantee that you'll get your $150,000 contribution back.

Try to Make Your Plan Better
A little cajoling from a determined group of employees can make a weak 403(b) plan much better.

When you approach your company's higher-ups, have a list of mutual funds you'd like to see included in your plan in hand. In particular, look for funds with low annual expenses, good performance, and experienced management teams. You should also pick funds that invest in different parts of the market so that you can build a diversified portfolio. Those who are Morningstar.com Premium Members can get some ideas from our list of Fund Analyst Picks. (Nonmembers can sign up for a free trial to our Premium Service.)

Alternatives to the 403(b) Plan

If you can't improve the options in your 403(b) plan, look for a way to get out. That can be difficult, because many annuities will charge you to leave. That's called a surrender fee, and it can lop as much as 7% off your investment. Surrender fees usually vanish after you've been investing in the annuity for seven years, though.

If you can avoid the fee or if you have passed the seven-year mark, consider transferring your money into a 403(b)(7) account. That plan will allow you to invest directly in mutual funds. You can set up a 403(b)(7) account with fund companies, such as Vanguard and Fidelity, and your employer can send your contributions directly to your account.

Maybe you don't want to deal with the hassle of setting up a 403(b)(7) account. If your employer doesn't match your regular contributions, it might make sense to skip the plan entirely.

Individual Retirement Accounts (IRAs) and Roth IRAs offer tax advantages similar to 403(b) plans, and you can pick from practically the entire universe of mutual funds. Their only shortcoming is a lower ceiling for annual contributions.

It might be to your advantage to make the maximum annual IRA contribution, then put the rest of your annual savings in a taxable account. You'd forgo the tax advantages of the 403(b) plan, but a host of tax-managed funds do their best to keep their tax burdens low. If you're restricted to low-return, high-cost annuities in your 403(b) plan, you may do better after taxes with many of these tax-efficient mutual funds.

Quiz 203
There is only one correct answer to each question.

1 Which statement is false?
a. Both 401(k) plans and 403(b) plans allow participants to set aside as much as $15,500 per year (the limit in 2007-2008)
b. Both 401(k) plans and 403(b) plans defer taxes on any investment gains
c. Employers offering both types of plans usually match their employees' contributions
2 What's the difference between a variable annuity and a mutual fund?
a. A variable annuity offers insurance so that you or your beneficiaries won't receive less than what you contributed
b. A variable annuity delivers fixed returns
c. There isn't any difference
3 Why do mutual funds often make better investments in 403(b) plans than variable annuities?
a. Mutual funds benefit more from the tax-deferral that a 403(b) offers
b. Mutual funds cost less and therefore usually perform better
c. Both A and B
4 If you want to get out of an annuity, what do you need to watch out for?
a. Surrender fees
b. Insurance fees
c. Both A and B
5 What is a 403(b)(7) account?
a. A plan that includes variable annuities
b. A plan that includes fixed annuities
c. A plan that allows you to invest directly in mutual funds
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