“Roth” is a provision which allows earnings from qualified plans to be withdrawn free of income tax. What you sacrifice with any Roth plan is the ability to take a tax deduction in the year the contributions were made. Take the following example: you’re a teacher who earns $100,000 per year. With the traditional 403b plan offered at your school, you decide to do a total salary deferral of $15,000 for 2006. As a result, your only taxed on $85,000 worth of income. The $15,000 grows on a tax-deferred basis until you reach age 59 ½. If you invested that $15,000 in an aggressive fund which grew to $25,000, there is no capital gains tax owed on that investment when sold. When you eventually retire in 2018, you decide to take a withdrawal from your 403b account. In 2018, you’d pay tax on your withdrawals at your income tax bracket for that year. Whether marginal tax brackets are higher or lower in 2018 than they were in 2006 is anybody’s guess. Most financial planning scenarios assume a lower tax bracket during retirement because, well, you’re retired!
If you had contributed $15,000 into a Roth 403b in 2006 instead, your tax would be based on $100,000 rather than $85,000. 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 love Roth plans because I don’t trust Congress or the IRS to leave the tax code alone long enough for me to appreciate the benefits. I’d be worried about passing up a current tax deduction for the opportunity to have one thirty years from now. Just think about where taxes where 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 personal preferences. 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 may 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 might 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 403b’s. 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 with your individual situation or for other advice.
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