Tuesday, July 2, 2019

How To Decide Between A 403b or a 457b?

What's up everyone!  I got an interesting email this morning directly from my Kindle eBook: CommonCoreMoney: Financial Literacy for Educators and Other Professionals.  The person, a 16-year veteran teacher of the San Diego Unified School District, wanted help figuring out if he should open a 457b account with Valic, AIG Retirement Services.  Already putting some of his money in a 403b, Steve (not his real name), needed help sizing up the 457b offering as a potential replacement for the 403b.  He wrote:

"Looking into getting a Roth IRA started up and switching out my 403b with a new vendor the district is working on adding by summer's end...I keep reading a 457 is better than a 403b..."

He then included the link to the San Diego Unified 457 highlights PDF for me to look at and give him feedback on.

To keep this part of the story short, I told him that the 457b by Valic has as one of its "pros" the fact that admin fees are waived by his district.  As a "con," I wrote to Steve that I didn't like the limited offerings in terms of the mutual funds available to invest in.  Specifically, I didn't like that there weren't any Vanguard Funds to select from.  Vanguard is the low cost/fee leader in the industry!

However, I couldn't give him a definitive decision as to whether or not he should choose the 457b in favor of the 403b because I didn't have any info on how he is positioned in the 403b.  Here's what all of you need to understand about these very similar retirement investing products.

457b and 403b Similarities:

Both the 457b and 403b are annuity entities that allow you to build a retirement fund outside of your State Teacher (Educator) Retirement pension tax free.  You make set amount (you choose the amount) and direct contributions pre-tax from your gross pay into the annuity.  In doing so, you lower your taxable income, and in many cases, get paid a little more each month than you would normally if you had nothing else to offset your taxable income.  Of course there is a catch!

Just because you have the option of building a secondary retirement fund outside of your state teacher pension, it doesn't mean you should do it using either a 457b or a 403b.  You could open up a Roth IRA and build your second stream of retirement income with after tax contributions.  You can withdraw contributions from your Roth IRA tax free anytime if you follow all the rules!  (Look these up).

The unknown known about 403b/457b investing is the future of your tax situation.  Namely, will you be in a higher tax bracket when you retire or in a lower one?  If you don't intend on buying assets that allow you to deduct and lower your effective tax rates (like rental property) and you will be simply climbing the pay ladder of your career, then you will undoubtedly be in a higher tax bracket when you retire.  This means that once you're allowed to withdraw from your 403b/457b funds in retirement, you will be taxed more on this income than you are today.  Yikes!  So think long and hard about this before you open a tax sheltered account like a 403b/457b.  

In my eBook, I recommend you do like me, and Steve, and put a little away each month using either a 403b/457b AND a Roth IRA.  Annuities have their perks, but they're not the end all, be all.  I have, for example, a 403b, and two Roth IRAs in addition to my CA state teacher's retirement pension.  (I also own several rental properties and this helps tremendously with taxes).  But I'm not maximizing my 403b.  Some money into a 403b/457b is better than no money.

And now I go to the question serving as the title of this post: How to decide between a 403b or a 457b?

Below are the things you should consider listed in order of importance!

1.  Admin fees.  It doesn't matter if it's a 403b or a 457b, can you get enrolled in one that takes the least amount from you each year.  Does your district allow you to shop around for a 403b /457b vendor or are you stuck with only one?  CalSTRS provides members with a webpage that allows them to 403bcompare.  Not all vendors are the same so if your district allows you to choose from more than one, select the one that charges the least admin fees!! I can't stress this enough people.

2.  Mutual Fund fees.  This is where educators and basically most people (401k, 403b, 457b, etc.) get in trouble.  They select mutual funds to invest in within their tax-sheltered retirement account not knowing how much they're paying in mutual fund expenses.  If you have no idea how mutual funds work, you are most likely letting the vendor sway you into mutual funds that are expensive.  These will sap away your investment gains over time.  The least you can do is look up the "Annual Fund Expense Ratio (%)" of the mutual funds you intend on selecting or are already invested in.  Fintech companies like Wealthfront make their money helping people sort this stuff out...for a fee, of course!    

3.  Choice of mutual funds.  You have a pool of choices whether you do a 403b or 457b.  What matters is the choices you have to invest in Index Funds!  Yet another crucial mistake people make when selecting mutual funds to allocate their money into each month in their 403b/457b/401k is too many funds.  They look at it like a menu at a restaurant and pick funds that sound juicy.

"Ooooh, I think I'll have the Growth Small Cap, and the International Large Cap, with the Value Midcap, please.  Oh and can you please add a little Muni Bonds on the side?"

LOL!  As funny as this scenario is, it's happening all the time.  I took a look at my older sister's 401k and she had a ton of overlap. Just paying more fees unnecessarily!

Let me help you make this extremely easy.  Do like Warren Buffett, Jim Cramer, and Jack Bogle have all recommended: invest in index funds.  For example, in my 403b 58% of my current monthly contribution is used to buy shares of Vanguards Total Stock Market Index Fund, Ticker: VTSMX.  Expense ratio: 0.14%!!  The remaining 42% of my contribution is used to buy shares in Vanguard's Total Bond Market Index Fund, Ticker: VBMFX.  Expense ratio: 0.15%.  You're fully exposed to both markets this way so don't let vendors try to trick you into buying other types of mutual funds.  By the way, I don't work for Vanguard and no, they're not paying me any money to recommend their funds...though I wish they were.

The last thing you have to decide on when setting up a 403b/457b are your allocations, i.e., what percentage of your monthly contribution do you want to be used to buy your stock index fund versus your bond index fund.  If you're young, obviously you want a high percent of your money going into the stock fund, and little into the bond fund 90:10, e.g.  Some people use the 100 Rule to decide.  I use it myself actually.  Every year of teaching I adjust my allocations online at the 403b vendor's website.

Okay, I hope this has helped all of you understand the 403b/457b and even 401k investing mystery.  Thanks for being here!

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