“Roth” is a provision which allows distributions from qualified plans to be withdrawn free of income tax forever. What you sacrifice with a Roth plan is the ability to take a tax deduction in the amount of your contribution. However, you gain the comfort of knowing that money won’t be subject to tax ever again. Take the following example: you’re a teacher who earns $100,000 per year. With a traditional 403b, a salary deferral of $15,000 would result in taxable income of $85,000. The $15,000 contribution would grow on a tax-deferred basis. At age 59 ½, you’d be able to withdraw money from the plan without penalty. When you eventually decide to retire and take distributions from your account, they would be taxed at your income bracket for that year. The big question is whether marginal tax brackets will be higher or lower when you retire than they are today. The answer to that is obviously a pure guess. However, for the purposes of financial planning, we generally assume our personal tax brackets will be lower during retirement because, well, you’re retired!
If you had contributed $15,000 into a Roth 403b instead, your taxes for that year would be based on the full $100,000–no tax deduction is taken. However, you wouldn’t owe any tax on your withdrawals. You pass up the current year tax deduction for the benefit of withdrawing the money later on in life free of income tax.
So which one is better? Personally, I don’t fully embrace Roth plans because I don’t trust Congress or the IRS to leave the tax code or legislation alone long enough for me to appreciate the benefits. I’d be cautious about passing up a tax deduction now because thirty years from now I’ll have a lower taxable income. Just think about where tax brackets were 30 years ago, in 1977. The highest marginal tax bracket was 70%. Would a Roth have been better back then? The argument would have been exactly the same. Do we take a tax benefit today to reduce the amount of our earnings taxed at 70%, or do we wait until we’re 59.5 and see how things look then? Nobody knows. I like to keep the equation simple and take a tax deduction when and if one is available.
The theoretical answer to “which one is better” is that it depends on your personality. If one person invested in a pre-tax 403b, and the other in a Roth 403b, they would both end up with the exact same amount of money in the end, assuming they stayed in the same tax bracket. In life, people generally earn more money as they increase in age and then earn less (enter a lower tax bracket) when they retire. This isn’t the case for everybody, but for the overwhelming majority. If you fall into this scenario, a traditional 403b will probably offer better tax protection for you.
Another factor is the performance of the market. If you knew the market was going to average a 20% annual return for 10 years, you’d want to be in a Roth because paying income tax on all that growth is going to sting. If the market was going to average a 2% annual return, it would be better to take the tax deduction and avoid the Roth since you aren’t really going to have such a huge tax problem anyway.
Roth fans generally do point out one factor which gives them an edge. Regular IRA accounts require you to take distributions starting at age 70 ½. With a Roth 403b, you can roll your money into a Roth IRA and keep the money growing tax-free until death. If you are wealthy enough to not need the distributions and are looking for a tax shelter, a Roth product might add some value to your portfolio.
Most importantly, Roth 403b accounts are still not an option at most organizations that offer traditional 403bs. The reason is that it costs money to make an option like this available and companies don’t want to offer it until they are sure the tax code will continue to support it. The provisions which allow Roth 403b plans to exist were technically supposed to expire in 2010. The Pension Protection Act extended them indefinitely. I think we’ll continue to see a pattern of tax-friendly government while the problems regarding Social Security and pensions seem to get worse, not better.
I hope this article is helpful and not confusing. Understanding 403b’s is challenging even for financial professionals because of how new and constantly changing the rules about them are. Please feel free to e-mail me about your situation or for any other advice.
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