401ks and 403bs and 457bs, Oh My!

The Individual Retirement Account (IRA) is well-named. (Technically, the ‘A’ actually stands for “arrangement”, not account, but everyone just says account.) It describes really well what the account is for (although the details around it can still be confusing), and people quickly grasp the concept. The same can’t be said, unfortunately, about employer-sponsored retirement plans. In the United States’ continuing effort to make things needlessly complicated, employer-based retirement plans are named things like 401k, 403b and 457b. And then they each come in two flavors, “Traditional” and “Roth” which are also remarkably unhelpful names. The names are not descriptive at all and, when you combine it with many folks’ fears about investing and thinking they don’t enough to do it well, it results in them being used less than optimally (or not at all). Instead of helping with retirement security, the naming (along with sometimes complicated rules) actually contributes to retirement insecurity.

You can find many great resources online (and in books!) that explain these types of plans in great detail, but I’m going to try to summarize them in a fairly “shallow” way, with a particular eye on public employees (since that’s mainly who I’m writing for). (Really, I’m writing this so I have a link to send people when they ask me questions.)

The 401k

The most familiar of these plans is the 401k. Named after the section of the tax code that governs their properties and use, the 401k is a tax-advantaged account that employers can offer to their employees. (It’s a surprise to most folks that the 401k provision was never intended to be the primary retirement plan for workers.) The idea is that the government (actually “we” as a country) want to incentivize people to save for their retirement, so we do that by offering tax breaks for special retirement accounts. The original flavor, knows as “Traditional“, allows you make contributions pre-tax (meaning you don’t pay tax on those earnings now) and as your investments grow in value over time, those earnings aren’t taxed (immediately) either. Then, when you start withdrawing from these accounts in retirement, your withdrawals are taxed at that point like ordinary income. A newer flavor is the “Roth” 401k, which allows you to make after-tax contributions now (meaning you do pay taxes like normal on those earnings now), but then the earnings from your investments are not taxed and when you withdraw the money it is not taxed either. (A key point to understand is that, mathematically, Traditional and Roth 401ks get you exactly the same result over time if you are in the same tax bracket when you contribute as when you withdraw.)

401ks are offered primarily by private employers (although we’ll talk about how it’s not always private employers, including for Colorado folks), and they have become much more important in the last few decades as private employer pension plans have become much less common. Since the 1930’s, retirement security has been thought of as a “three-legged stool”, with the three legs being Social Security, employer pension, and personal savings. While it used to be that many private-sector employees had an employer-sponsored pension plan, now the vast majority of private employers don’t offer that. So employees have to rely on only two of those legs – Social Security and their personal savings. Employers have moved to 401ks instead of pensions, with many private employers offering a partial match of contributions as an incentive (and to compete in hiring). This ends up being much less expensive for the employers, but also much more problematic for employees.

A positive thing about 401ks is that they are often (although not always) chosen carefully and offer great investment choices at low cost. A big reason for this is that they are covered by ERISA, which means that employers, among other things, have a fiduciary duty to provide good plans. Employers also have an incentive to provide good plans because it helps them attract talent (and, of course, the folks who work for the employer to help choose the plan also get to participate in it). This means that most employers put their 401k plans out to bid, forcing companies to compete for their business which lowers fees. They then choose one, very good, low-cost plan for their employees. Very few private employers offer more than one 401k vendor, and that’s a good thing, because as long as the plan is a good one, you don’t want multiple choices to complicate things. (We’ll talk more about the tyranny of choice below). In general, while I think a 401k is not the best approach we should take as a society toward retirement security, they are at least well constructed plans and work well for what the way they are being used.

The 403b

A 403b plan is the public employer “equivalent” of the 401k. Note that “equivalent” is in quotation marks for a reason, because while 403bs and 401ks have similar purposes, they unfortunately are not equivalent in terms of cost and quality. (I highly recommend the five-part podcast series Learned by Being Burned to hear about how truly bad most 403bs are and what can be done about that.) Interestingly enough, 403bs (created in 1961) actually predate 401ks (created in 1978, but not really used until several years after that) but, unfortunately, being older in this case has not made them better.

On the surface, 403bs and 401ks appear to be nearly identical, other than the name and the fact that 403bs are for public employers. Just like 401ks, 403bs are employer-sponsored and allow you to invest money in tax-advantaged accounts, in both the “Traditional” (pre-tax) and “Roth” (post-tax) flavors. They even have the same basic contribution limits as a 401k (up to $20,500 per year in 2022 if you are under 50, up to $27,000 per year if you are over 50). But, unfortunately, unlike most 401ks, most 403bs are really, really bad. A major reason for this is that 403bs do not fall under ERISA, so the employer does not have a fiduciary duty to pick a good plan. In addition, many public employers don’t have the capacity (or at least haven’t developed the capacity) to choose a good plan by putting it out to competitive bid. Most public employers also don’t match contributions like in the private sector and, because most public employers (and employees) think of their pension plan as being their retirement, they don’t see the 403b as being very “important” so there isn’t much incentive to make it better. Unfortunately, this can end up costing an employee tens of thousand, hundreds of thousand, or even millions of dollars compared to what they would’ve earned in a 403b that was as good as most 401ks. When you add up the total cost to all public employees, the cost is likely in the billions (yes, billions with a ‘b’).

Because public employers don’t have a fiduciary duty, and because many of them don’t see it as important (and, frankly, don’t understand the impact of fees), they typically don’t put out their 403b plans to bid. Instead, they often will allow any 403b vendor who wants to to offer their plans to their employees. (Or, at best, they might limit the number of plans to some arbitrary number, but still not really vet them). In some California school districts, employees have a choice of over 100 403b vendors. In America, we tend to view more choices as a good thing. But when it comes to 403b plans, it’s actually almost always a bad thing, for two reasons.

First, the tyranny of choice. With so many plans to choose from, it’s confusing to employees, which results in them either making a less-than-optimal choice or, often, making no choice at all. Second, when you have a lot of choices, but almost all of them (or sometimes actually all of them) are bad, then it’s not really a “choice”, it’s a system designed to produce bad outcomes. In fact, if you were to grade the 403b plans offered by most school districts, the majority of them would get a C or lower. And even the ‘C’ grades are generous, because all it means is that they offer at least one good vendor, but often it’s mixed in with five or more other really bad vendors, and employees don’t know enough to make the good choice.

So exactly how are so many of these 403b plans bad? In a word, fees. To borrow a phrase from Barb Besal (one of my co-authors in the TL;DR Financial Literacy series of books), it’s the “Secret Life of Fees.” When 403bs were first created (remember, before 401ks existed), they were primarily offered by insurance companies in the form of an annuity. An annuity is not necessarily bad in and of itself (a pension is basically an annuity), but it is bad if it’s not appropriate for the individual’s needs or – in the case of most 403bs – the fees are outrageously high. Those fees actively fight against the compound interest that is the powerhouse of long-term investment gains. What do I mean by high fees? Fees in 403bs are often 10 to 20 times higher than in a 401k (administrative fees, mortality expense fees, investment fees; and they often make it very difficult to determine what the fees are). To make matters worse, many of the 403b vendors have “surrender charges“, which means that if you try to move your money to a different vendor, they will charge you (often 5%, sometimes even more) to move your money. This is a concept that would be unbelievable except for the fact that it exists.

So how do employees learn about the 403b options their employer offers in order to make a good choice? Well, more bad news. Most public employers won’t provide any “advice” to their employees because they don’t want the liability. Compare this to a private employer, who has a fiduciary responsibility to only provide a good plan, and therefore typically only offers one good 401k choice (and wouldn’t dream of offering 5 or 10 or – shudder – 100 choices). Most public employers provide a list of vendors and contact information, and that’s it. To make it even worse, however, many employers then allow salespeople from those 403b vendors to come into their workplaces and actually try to sign up employees as customers. (Again, listen to the Learned by Being Burned podcast for much more on this.)

In a typical school setting, this might be a sales rep bringing “free” donuts to the staff lounge (often the most expensive donut people have ever eaten), or offering an “educational” session after school (it’s not really “educational” when the one doing the educating is incentivized to sell their employer’s high-fee products). Most employees think that these vendors are “endorsed” by their school district and must have their best interests at heart, when in reality they are often salespeople who earn higher commissions by selling high-fee products. (Note that not all of the sales people are on commission, and many of those who are are nice people who don’t realize what a disservice they are providing.) And, ironically, if there is a good 403b vendor in the school district, they most likely don’t send salespeople into the buildings because there isn’t the high-fee, commission-based incentive structure that’s necessary to pay those salespeople.

A quick note: While 401ks and 403bs are different, they do use the same “bucket” of available contributions. So, someone under the age of 50 in 2022 can contribute up to $20,500 total between a 401k and 403b. That could be the full amount in the 401k, the full amount in the 403b, or split between the two, but the total contributed can’t exceed $20,500 for the year. For those over 50, it’s currently $27,000.

The 457b

The one piece of good news for public employees is that they may have an alternative to the 403b. Public employers (as well as non-profits) can choose to offer a 457b plan, which is also very similar to a 401k and 403b, although with a few important advantages. The 457 is a separate “bucket” from the 401k/403b, so employees can shelter an additional $20,500 ($27,000 if over the age of 50) above and beyond (or instead of) what they invest in the 401k/403b bucket.

Since the 403b is usually so bad, and since I’ve said that more choice is often an (unintuitively) bad thing, why is having an additional choice a good thing? Again, in a word, fees. 457 plans typically have a much better fee structure than a 403b, on par with – and often even better than – 401ks. This is because many 457 plans are statewide plans, where every public employee (or at least many public employees, unfortunately some state plans exclude public school employees) can contribute. Because of this massive scale, and because the states put these out to bid, the fees are usually very, very good.

Another advantage of the 457 is it has more liberal catch-up contributions than a 401k or 403b. Depending on the plan provisions, and depending on your previous contributions to the 457, you can often contribute double the annual amount (so $41,000 in 2022) during your last three years of employment.

One more very important advantage of the 457 is the ability to access your money earlier without penalty. For both 401ks and 403bs, if you withdraw any money before age 59.5 you are hit with a 10% penalty (in addition to the taxes you owe). (Note that are some exceptions to this, but in general this is the case.) With a 457 however, you can withdraw money at any time without penalty (although you still owe taxes) as long as you have left that employer. Your age doesn’t matter at all, as long as you’ve left that employer you can access the money without penalty. While ideally you are saving for retirement so don’t want to access the money “early”, it still provides some nice flexibility. For example, some folks may want to retire earlier than their pension kicks in, and a 457 allows them to access their retirement savings without penalty to “bridge the gap” between retiring and drawing their pension. Or some folks might want to do a career change, maybe even start their own business. The 457 funds can allow them to supplement their income as they get their new career up and running and/or provide some startup money for their business. This flexibility is why, all things (fees, investment choices) being equal, folks should probably fund a 457 first before a 401k or 403b.

Very Important Note: While many 457’s are great, particularly the state-run choices, those same 403b vendors may also offer 457s. The 457s from those vendors usually have the same very bad fee structure as the 403bs. Stay away from them.

I mentioned previously that while 401ks are typically offered by private employers and 403bs and 457s by public employers, there are some exceptions. For example, all public employees in Colorado have access to a 401k through PERA, our pension plan. All public employers in Colorado are required to offer PERA’s 401k and they can choose to also offer PERA’s 457. (While many do offer the 457, unfortunately not all have opted in). Since many public employers offer 403b vendor choices, that means that many Colorado public employees can choose from a 401k, a 403b and a 457. (Again, remember the 401k and 403b use the same “bucket” for contributions, while the 457 is a separate “bucket”.)

Because the fees for PERA’s 401k and 457 are very, very good, almost all public employees in Colorado should choose to invest in the PERA 401k over any of the 403b choices their employer may offer. And, if their employer has opted into the PERA 457, they should probably fund that first, even before the PERA 401k (and then if they can contribute even more than the $20,500/$27,000 yearly limit, the additional amount should go to the PERA 401k, not any of the 403b vendors).

Summary

Okay, so this is very, very long, so let me try to sum it up: Fees Matter.

  • 401k: Usually Good
  • 403b: Usually Bad
  • 457b: Usually Good

What “order” should you typically fund your various tax-advantaged accounts?

  1. Any type of plan that provides a match, up to that match.
  2. 457 (for pre-tax contributions, before a traditional IRA, if it’s a good, low-cost plan, like PERA’s 457)
  3. IRA (choose a good, low-cost custodian like Vanguard)
  4. 401k (if you have the option, like Colorado public employees do with PERA’s 401k)
  5. 403b (if and only if it’s one of the “good” 403b vendors). In general, the following vendors are likely to be the only good employer-level 403b/457 choices with relatively low fees and good investment choices: Aspire (direct, without an advisor), Fidelity Investments, Mission Square (ICMA-RC), TIAA, T. Rowe Price, and Vanguard. (There can be other good vendors, particularly if an employer has put the plan out to bid and negotiated better fees.)

Again, despite the length of this post, it still doesn’t cover all the details of these various plans or all the nuances. But hopefully it gets the basics across in a way that his helpful. If you have further questions, please leave a comment or contact me directly.

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