Q&A - Tax Shelter Plan


Topic:  Employee Benefit Planning, Retirement Planning

Q:  I recently graduated from college and just got my first real job working for a hospital in southeast Wisconsin.  A representative from an investment firm has been after me to enroll in a tax shelter plan sponsored by my employer.  Is this a good idea?  

What you're talking about is technically known as a 403(b) plan.  Like its better-known and popular cousin, the 401(k), it's a good way for employees to build a tax-deferred nest egg. Yet millions eligible to join 403(b)s fail to do so. Here's how to make the most of your 403(b) plan.

Participate. A 403(b) plan is designed for employees of certain, but not all, nonprofit organizations, including public educational institutions, churches, hospitals and social welfare agencies. Government organizations, credit unions and civic leagues, among others, are not included. Participation is fairly good in the better 403(b) plans, more typically universities and hospitals, but it is dismally low in the one arena involving the most employees: school systems. According to the research firm of Spectrem Group/Access Research, only two in five public school teachers have 403(b) accounts.

Although 403(b) plans generally aren't considered as attractive as 401(k) plans for employees, they still provide the benefit of allowing employees to divert some of their salary before taxes into an account whose earnings grow tax-deferred until withdrawal. This typically is the best way for most people to build a retirement nest egg.

Invest wisely. When 403(b)s were first formed, before 401(k)s, they offered only tax-deferred annuities. Annuities are investment programs offered by insurance companies. The annuities may either offer a fixed return guaranteed by the insurer, or a variable return that depends on the performance of the investments you choose. Contributions to 403(b) annuities, unlike investments in non-403(b) annuities, are tax deferred, which helps your retirement account grow faster.

Today, 403(b) plans, although still often referred to as tax-sheltered annuity plans, allow you to invest in mutual funds. Yet roughly half of the money invested in 403(b) accounts is invested in fixed annuities, according to Spectrem, compared with a heavier weighting in stocks and stock mutual funds in 401(k) plans. Many Certified Financial PlannerTM practitioners feel that the returns of fixed annuities generally are too low for people trying to build for retirement, averaging around six percent, and they would do better over the long run to beef up their stock side. In addition, critics point out that it generally doesn't make sense to invest in annuities inside a tax-deferred 403(b) because the earnings of annuities are already tax-deferred, anyway.

Watch out for high fees. This is the most controversial aspect of 403(b) plans. The annuity options inside a 403(b) generally have higher fees than no-load mutual funds offered through the same accounts. These include charges for switching out of an annuity within a certain number of years after buying it, and the fee you pay for the insurance component attached to an annuity. Some employees have had to fight to get no-load mutual funds offered in their plans.

Take advantage of matches. Compared with 401(k) plans, far fewer 403(b) plans match employer contributions to a percentage of employee contributions. This is often because these plans are offered by nonprofit organizations. However, if your employer does offer a match, it becomes even more important to contribute to the plan.

Another advantage of 403(b) plans is that any employer match is usually automatically vested. In a 401(k), you might have to wait two to five years before the employer's matching funds become your money.

Play catch-up.  A unique feature of 403(b) plans is that sometimes you can contribute more to the plan than the normal annual contribution limits (a maximum of $11,000 in 2002). You can use this feature to catch-up in the event you contributed less than the maximum in previous years.   Generally-speaking you can contribute an additional $3,000 under the catch-up rules.  Beginning in 2002, employees age 50 and older can take advantage of a special catch-up that allows them to contribute an additional $1,000 to their 403(b) plan.  That means that in 2002 they can potentially contribute $11,000 (basic limit) + $3,000 (basic catch-up) + $1,000 (special catch-up) for a total of $15,000.  Eligibility and contribution rules are complex here, so you'll need to run it by the benefits department at work or a Certified Financial PlannerTM.

Despite some drawbacks compared with 401(k) plans, 403(b) plans offer a good way to build a nest egg. Consider seriously joining such a plan if you have one available at work.