Which Is Better – 403b or IRA?

A reader was thinking about her retirement income planning and needed to decide between contributing to a 403b versus an IRA.

First, what is a 403b?

These are retirement accounts available to certain employees. Basically, if you work for an educational institution, civil government or certain nonprofit organizations, your employer probably offers a 403b plan. These plans are pretty similar to 401k plans. You can put money aside for your retirement on a pretax basis and the money grows tax-deferred. When you take money out of the account, you’ll have to pay your income tax.

Early withdrawals (generally speaking, prior to age 59 ½) are subject to the 10% penalty, but there are a number of ways you can withdraw money penalty-free:

· You reach the age of 59½.

· You retire from service at the age of 55 or older.

· You become disabled.

· You die.

What are the benefits of a 403b over an IRA?

1. If you participate in a 403b, you can defer up to $16,500 (2010). If you are over age 50, you can contribute an additional $5,500 (2010). Some employers will make matching contributions to a 403b. IRA contribution limits are much lower: $5,000 for those under 50 and $6,000 for those over 50; and nobody matches your IRA contributions no matter what your age is.

2. You can borrow money from a 403b plan but not from an IRA. If you do take a loan you must pay it back with interest. Having said that, sometimes being able to borrow money from your retirement plan isn’t such a blessing.

3. If you retire at 55 or older, you can access your 403b money penalty-free. If you have an IRA, you have to wait until you are 59 ½ to access the money penalty free.

What are the disadvantages of a 403b plan?

1. Investment choices in 403b are limited and they are often expensive. It’s also very difficult to even know what the real costs are of the choices provided. To make matters worse, many plans only offer fixed and variable annuities. This is a very expensive proposition because on top of the plan expenses, the annuities have their own costs. Also, annuities often have ridiculously long surrender periods. It almost never makes sense to buy annuities within any retirement account but the 403b plans often leave you no choice.

2. IRAs offer a lot more investment flexibility. You can invest your IRA just about any way you want and usually much less expensively. You can change your investments whenever you like and you can even hire a financial adviser to manage your IRA for you. The 403b plans are limited in the choices you have and the frequency with which you can make changes.

3. IRAs offer a lot more flexibility with respect to beneficiary planning. For example, if Mary dies and she names a non-spouse beneficiary, that person could take advantage of Inherited IRA rules that provide much greater deferral than the 403b offers.

Now that I’ve convinced you that the IRA is a better choice, I have some bad news. None of this may matter.

Why? There are a number of IRA restrictions and you may not have any choice.

If your joint income exceeds $89,000, your ability to make deductible contributions to an IRA is phased out since you have the option to participate in a 403b plan. That’s right…even if you chose not to participate in the 403b, your deductible contributions to an IRA are restricted.

If you have limited resources and are interested in getting the best immediate tax break, you should first maximize your contributions to the 403b if your joint income is over $89,000.

(If you go this route, you should call the administrator and ask for the booklet that describes ALL the investment options. I know from firsthand experience how difficult it is to get information from employers and there are many reasons for this. Without going into a very long story, suffice it to say that the investments that teachers and other participants in the 403b plan are approached with are rarely the best deals. In fact, they usually stink.)

If your joint income is below $89,000, you will have the option of putting your money into the 403b or a deductible IRA. If that’s the case, go with the IRA. This will give you the most flexibility and lowest cost.

What advice would you give? Do you think the 403b is better? Should you skip both the 403b and IRA and opt for a ROTH?