Recently, a physician asked me whether it is better to put retirement savings in a regular 403(b) or a Roth 403(b). My answer was… do both. The strongest retirement portfolios are diversified portfolios that allow you to strategically withdraw from different retirement “buckets” in different years in order to keep taxes as low as possible. This means having both Roth and non-Roth deferred income accounts.
What is a Roth 403(b)?
A regular 403(b) is a deferred income retirement account that you pay local income tax, Medicare tax, and Social Security tax the year that you earn the money but you do not pay federal income tax or state income tax until the year that you take the money out in retirement. With a Roth 403(b), you pay federal and state income tax the year you earn the money and then you pay no income taxes the year that you take the money out in retirement. In other words, with a Roth 403(b), you pay income taxes now and with a regular 403(b), you pay income taxes later, when you are retired.
The 403(b) is a deferred income savings program used by non-profit organizations. Similar deferred income retirement savings programs include the 401(k) which is used by for-profit companies, the 457 which is used by government institutions, and the IRA which is used by anyone with a taxable income. Each of these deferred income programs can be offered as either a regular 401(k)/403(b)/457 or as a Roth 401(k)/403(b)/457. Some employers will offer both a Roth and regular option and other employers will only offer a regular 401(k)/403(b)/457.
This post will address what you should do if your employer offers both a regular 401(k)/403(b)/457 and a Roth 401(k)/403(b)/457 as well as the factors that affect your choice of one versus the other. Although I will be discussing the Roth 403(b), the information is also applicable to the Roth 401(k) and Roth 457.
What is the difference between a Roth IRA and a Roth 403(b)?
Most people are familiar with the Roth IRA and as I’ve posted before, I think everyone should have a Roth IRA as part of a diversified retirement portfolio. If your income is too high to contribute directly to a Roth IRA, then you can do a “backdoor Roth IRA” by first contributing post-tax dollars into a traditional IRA and then promptly converting that traditional IRA into a Roth IRA. The Roth IRA and the Roth 403(b) are similar in that with both, you pay income taxes now and then the distributions are tax-are in retirement. However, there are some important differences between them:
- Contribution limits. In 2022, the contribution limit for a Roth IRA is $6,000 ($7,000 if over age 50). The contribution limit for a Roth 403(b) is $20,500 ($27,000 if over age 50).
- Investment options. With a Roth 403(b) account, you can only put money in specific investment options chosen by your employer. These are typically mutual funds or annuities offered by 403(b) administrators such as TIAA or Fidelity. With a Roth IRA, you can put the money in a much wider variety of investments, chosen by you.
- Employer matching. Some employers will match a portion of your contributions to a 403(b). This is more common with 401(k)s than 403(b)s and rarely if ever found with 457s. These matching contributions are free money that you should never turn down. There is no matching contribution options to a Roth IRA.
- Early retirement. If you retire before age 59 1/2, you cannot take money out of your Roth IRA without incurring a large tax penalty. However, you can withdraw money from a Roth 403(b) before age 59 1/2 without a penalty if you separated from your employer before age 55.
- Required minimum distributions. The IRS requires you to take a minimum amount out of Roth 403(b) accounts starting at age 72 years old. Roth 401(k) and Roth 457 accounts are also subject to these required minimum distributions. Unlike Roth 403(b)s, Roth IRAs are not subject to required minimum distributions.
It’s all about tax rates
The main determinate of whether to contribute to a regular 403(b) or a Roth 403(b) is whether your income tax rate will be higher or lower when you are retired than your income tax rate today.
If your taxes are higher today than they will be in retirement, then you should contribute to a regular 403(b). If your taxes are lower today than they will be in retirement, then you should contribute to a Roth 403(b). If your taxes are the same today as they will be in retirement, then there is no difference between contributing to a regular 403(b) or a Roth 403(b). The problem is knowing if your taxes today will be higher or lower than your taxes in retirement. There are three factors that will influence this.
- Tax brackets. In a previous post, I showed how everyone pays an effective federal income tax rate that is less than the income tax bracket that they are in. However, the federal income tax brackets do determine your effective income tax rates. Congress changes the tax brackets and therefore the effective tax rates every few years and it is impossible to predict what those tax brackets will be in your retirement years. Currently, Americans have been enjoying relatively low federal income taxes since the 2017 tax cuts making this a good time to contribute to Roth accounts. However, these tax cuts are set to expire in 2025 and then federal income tax rates will rise back up to 2016 levels (unless congress passes new legislation otherwise) at which time it will be more advantageous to contribute to a regular 403(b). Tax rates will also fluctuate during your retirement years so that there will be some years in retirement that your tax rates will be higher (favoring taking distributions from a Roth 403(b) and some years that your tax rates will be lower (favoring taking distributions from a regular 403(b).
- Income level. Most people start off their career with lower incomes and their income gradually increases as they get promotions and greater experience on the job. As income goes up, tax rates also go ups. Therefore, it is generally favorable to contribute to a Roth 403(b) early in your career, when your tax rates are lower. It is generally favorable to contribute to a regular 403(b) later in your career, when your tax rates are higher. In addition, there will be some years during your career that your income will be lower for a variety of reasons: going part-time, being laid off, not getting an annual bonus, etc. In these years, it is more favorable to contribute to a Roth 403(b).
- Retirement spending. The amount of money that you withdraw from your retirement savings will vary from year to year, depending on your spending. On retirement years that you do a lot of traveling, buy a vacation home, or buy a new car, you will need to take larger distributions from your retirement accounts. These larger distributions mean a higher income in those years and with higher income comes a higher income tax rate. Therefore, in those retirement years that you have a lot of expenses, it is better to take distributions from a Roth 403(b) and in retirement years that you have fewer expenses, it is better to take distributions from a regular 403(b).
Summarizing these factors, we can see that there are times during your career that contributing to a Roth 403(b) is more favorable than contributing to a regular 403(b). Similarly, there are years in your retirement when withdrawing distributions from a Roth 403(b) is more favorable than withdrawing distributions from a regular 403(b):
You should have BOTH a regular 403(b) and a Roth 403(b)
If you have access to a Roth 403(b) (or a Roth 401(k) or a Roth 457), then you should contribute to it in years when congressionally-determined tax rates are low and in years when you have a lower income (such as early in your career). You should contribute to a regular 403(b) in years that income tax rates are high and in years when you have a high income (such as late in your career). This will result in you having both a regular 403(b) and a Roth 403(b) so that when you are retired, you can withdraw distributions from one or the other, depending on whichever is more favorable from a tax standpoint on any given year.
The result of paying less in taxes is that you have more in disposable income. In order to maximize that disposable income in both your working years and your retirement years you need a diversified retirement portfolio. This allows for a tax-advantaged withdrawal strategy of withdrawing from regular deferred income accounts some years and Roth deferred income accounts other years. Thoughtful retirement saving today will pay off in a healthy finances when you use those savings once retired.
March 31, 2022