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The Roth 403(b) option

Chris Farrell Jan 17, 2012

Question: My wife and I both work for a state university that recently began offering a Roth 403(b) option. I am 52 and she is 47. We both contribute the maximum to the traditional retirement plan and to a traditional 403(b), as well as making the maximum contribution to Roth IRAs. I’ve used various online calculators to try to determine if we should switch new 403(b) contributions to the Roth option, but the result always comes out to just a couple hundred dollars or less monthly income difference one way or the other. I wonder if I’m missing some significant considerations or if the decision really is just a toss-up for people our age. I’d greatly appreciate some insight on how best to weight this decision. Thanks! Jerry, Hillsborough, NC

Answer: I think the major reason for you and your wife to consider the Roth 403(b) is tax diversification.

As you know, the big difference between a traditional 403(b) and a Roth 403(b) is taxes. Contributions to a 403(b) are made with pretax dollars. It’s a nice upfront tax break. You’ll pay your ordinary income tax rate on the savings when it’s withdrawn during retirement. People often see their tax rate fall during retirement.

With a Roth 403(b), contributions are made with after-tax dollars. The earnings on your contributions come out tax-free at withdrawal. The tax-free withdrawal of money during retirement is especially valuable if you anticipate that your tax rate will be higher than it is now when you’re elderly.

By the way, the employer match is made with pretax dollars in a Roth 403(b). It grows in a segregated account and the match will be taxed at your ordinary income tax rate when it’s taken out in retirement.

Here’s the thing: Who knows what tax brackets will be 10 to 15 years from now when you and your wife might be contemplating retirement or down-shifting to a reduced work schedule. Many people reasonably expect that taxes will be higher to pay for entitlements such as Social Security and Medicare and government services. I’m in that camp, although I think it’s very possible overall tax rates will be lower with comprehensive tax reform. (We can always hope, right?)

What’s more, whether it’s better to invest in a traditional pretax retirement savings accounts versus the various after-tax Roth retirement savings accounts depends on whether your income during your elder years is higher or lower than it is during your main work years. You can make an educated guess, but you can’t get rid of the uncertainty. Again, who knows?

These are two reasons why I favor tax diversification. Another is that it adds to your financial options when it does come time to take money out in retirement. For instance, you might want to tap into the Roth early in the traditional retirement years because you’re still earning an income and tap into the traditional 403(b) later on when you aren’t getting a paycheck.

The benefits of the Roth 403(b) might not be large for you and your wife since you’re already funding Roth IRAs. The effect of tax-free withdrawals could be bigger for other savers, however, especially for younger workers with a longer period of time for their retirement money to compound (hopefully).

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