It seems many professionals, including some financial advisors, assume a teacher’s pension will be sufficient to meet retirement spending goals. After all, some retired teachers may receive a pension that’s comparable to the salary they received while working. So why should a teacher be concerned with his or her investment options?
Well, what if it’s not fair to assume pension income is enough? What if a teacher needs more retirement income than his or her STRS Ohio pension provides? For many teachers I work with, this is the case. And while a pension may provide a significant portion of their retirement income, they also rely upon investment accounts to generate additional income.
So let’s review the basic investment options available to most members of STRS Ohio while working. In this discussion, we’ll look 403(b), 457(b), and Individual Retirement Accounts (IRA).
A traditional 403(b) is a tax-deferred retirement savings account available through nearly all school districts. Under this type of plan, contributions reduce taxable income today and participants pay taxes on distributions later in life. Throughout that time though, you pay no taxes on the earnings, which gives the account its “tax-deferred” status.
An alternative to the traditional 403(b) is the “Roth” version of the 403(b). When investing in a Roth 403(b), you pay income taxes on contributions today, but future distributions may be received tax-free, provided certain criteria are met. Only some 403(b) providers offer a “Roth” version, so you’ll have to do a bit of homework to see what’s available in your district.
403(b) plans may provide excellent tax-planning opportunities, but there are a couple limitations to mention. First, you are limited to the investment options available in the plan. A 403(b) may offer a menu of 10-20 mutual funds, for example, for you to select. Beyond that, however, you have no investment flexibility. Second, your account must typically remain part of the 403(b) plan until you leave the district. At that time, you may rollover the account to another retirement plan such as an IRA, but prior to that point you’re usually locked into the plan.
If you elect to contribute to a 403(b), you must also decide what type of 403(b) you wish to invest in…an Annuity 403(b) or an Investment 403(b). Most districts offer plans that fit both molds and it’s sometimes not obvious which plans are which. You may have to perform some in-depth research to find out what product you are buying. However, if you’re buying it from an insurance company, chances are it’s an annuity plan.
So what does that mean? If you buy an Annuity 403(b), you will be locked into a contract. For example, if you’re in an Annuity 403(b) and decide, “This isn’t right for me,” you’re not likely going to be able to move your money without incurring significant expenses, typically known as surrender charges. I’ve seen surrender charges as high as 7% of the account value (and I’m sure some plans are higher!) that exist the first 7 years the account is open (some plans may have a longer time period!).
If you determine an annuity plan isn’t right for you, your district may offer an Investment 403(b) plan, which is typically provided through an investment company. The investment company establishes a 403(b) account for you, and they will likely assess some type of management fee. The management fee may be 1% of the account value per year, but they’ll likely make investment decisions and help you through the process of opening the account, without subjecting you to surrender charges should you decide to change plans. In other words, you aren’t locked into a contract like you are within the Annuity 403(b). You are purely just investing money and having someone manage it for you.
If available through your district, careful consideration should be given to a 457(b) plan. A common 457(b) provider for Ohio’s teachers is the Ohio Deferred Compensation plan.
Similar to 403(b) accounts, a 457(b) may offer traditional or Roth contributions, which provide tax-deferred or tax-free distributions, respectively. Contributions to a 457(b) may be made in lieu of or in addition to 403(b) contributions. Should you retire or terminate employment prior to age 59.5, a 457(b) may prove more beneficial than a 403(b) as you may access funds from the account without paying a 10% early withdrawal penalty. However, should you become disabled or experience financial hardship while working, a 403(b) may provide benefits that a 457(b) does not. In addition, when comparing a 457(b) to a 403(b), it’s important to analyze plan expenses as the Ohio Deferred Compensation investment options may be less expensive than that of an available 403(b) plan.
Individual Retirement Accounts (IRAs) may be another investment option for teachers. Like a 403(b) and 457(b), participants may be eligible for a traditional or Roth IRA, which provides tax-deferred or tax-free treatment of distributions, respectively.
An IRA is not tied to a school district so you may choose any custodian or provider of the account you wish. In addition, an IRA provides greater investment flexibility than the previously mentioned options as you determine what stocks, bonds, and/or mutual funds you wish to invest in.
Two disadvantages of an IRA are the contribution and income limitations placed on such accounts. In 2016, the maximum permissible contribution to an IRA is $5,500 ($6,500 if age 50 or older). This is much less than the contribution limits of a 403(b) or 457(b) account. Also, if your income exceeds certain levels, you may not be eligible for the tax-deduction typically provided for traditional IRA contributions, or you may not be eligible to contribute to a Roth IRA at all.
Clearly, as a teacher, you have many options when it comes to investing. Regardless of which you decide is best for you, it’s important to consider your long-term financial planning goals and opportunities prior to investing!