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Plan Well, Retire Well

Saving and investing your money

To Roth or Not: Deciding between Traditional and Roth Contributions to 403(b) and 401(k) Plans

My Human Resources Office just informed me that I now have the option of designating some or all of my 403(b) plan contributions as Roth contributions. Your employer may be offering you the same choice for your 401(k) or 403(b) plan. So how do we decide--To Roth or Not?

But before I go on, here's my bottom line: Most of us should be putting aside as much as we can for retirement. Just making some kind of contribution to your retirement plan or IRA is the important thing. Whether you can save only $50 month or you want to do the max ($15,500, or $20,500 if you're 50 or over), just sign up and do it. Now, on to the Roth decision.

Here's the choice:

  1. Roth: Would I rather pay taxes now on my contribution, and never owe tax on any dividends or gains?
  2. Tax deferred: Would I rather reduce my taxes now, deferring the tax on my contributions until I take the money out? But then I'll owe tax on all the money--contributions, dividends, and gains.

I also have the option of splitting my contribution - designating some as Roth, and the remainder as tax-deferred.

If my tax rate stays the same, the tax-deferred and Roth options are mathematically equivalent. That means that I would end up with the same amount of money whichever I choose. (This assumes that I keep my take-home pay the same, and reduce my contribution in by the amount of taxes I would pay on my contribution if I choose Roth.)

So what should I do? Here are the things I will consider in making my decision.

  • Many working people expect that their income will be lower in retirement, putting them in a lower tax bracket than they are in now. That makes tax-deferred plans very attractive. But income taxes are at historically low rates right now. While I don't believe anyone can predict the future, my guess is that income tax rates will be higher by the time I retire. If I think those across-the-board increases in tax rates will be bigger than any reductions I get from having a lower income, it's Advantage: Roth.
  • Other taxable income in retirement could cause up to 85% of Social Security benefits to be taxed. My Social Security benefits will be very small since I don't pay into Social Security as a University employee, but my husband will get a more typical Social Security benefit. Distributions from a tax-deferred plan could cause those Social Security benefits to be taxed, but Roth distributions will not. Advantage: Roth.
  • Illinois does not tax distributions from tax-deferred retirement plans, so my tax-deferred contributions are completely free of Illinois income tax forever. But I will pay Illinois tax on my Roth contributions. Advantage: Tax deferred.
  • What benefits could I get now by making tax-deferred contributions and having less taxable income ? A lower income could let me claim the Child Tax Credit, the Saver's Credit for contributions to retirement plans, education tax breaks like the Hope Credit or Student Loan Interest Deduction, or, if I'm a higher income household, prevent adjustments to my itemized deductions or exemptions. Since I have no kids or education expenses, and my income wouldn't be low enough to claim the Saver's Credit, I wouldn't get any additional benefits from reducing my income now. For me, it's a wash. But depending on your individual situation, it's very possible that it's Advantage: Tax-deferred.
  • Will a tax-deferred contribution actually reduce my taxes? As a widow with dependents and education expenses, my sister doesn't end up owing any income tax. She would get no tax benefit from a tax-deferred contribution and it's clearly Advantage: Roth. But I do pay income tax each year, so for me, It's a draw.
  • Maybe I can convince myself to contribute the same amount as a Roth contribution that I've been making as a tax-deferred contribution. I'd have to survive on less take-home pay. I'll end up with the same amount in my retirement account as I would with the tax-deferred contribution--but I'll owe no income tax on Roth distributions! This would be especially appealing if I'm already contributing the maximum to my plan. I can keep contributing the maximum, paying the taxes out of my take-home pay, and essentially sheltering even more of my income from taxes than if I were making tax-deferred contributions. If you will contribute the same amount as Roth as you have been with tax-deferred contributions, it's Advantage: Roth.
  • To avoid the 10% early distribution penalty in tax-deferred plan, I must be age 59-1/2 before taking distributions unless I qualify for an exception. For a Roth 403(b) or 401(k), I must meet an additional requirement: I must have participated in the Roth option for 5 years. If not, I will owe taxes (and maybe penalties), but only on the part of the distribution that is coming from the growth in the account, not from my contributions. If I were planning to retire in less than 5 years and needed to start taking distributions then, I would lose some of the tax benefits. So if you're retiring soon, it might be Advantage: Tax-deferred.
  • If there's still money in my account when I die, my heirs will have to pay tax when they take money out of my tax-deferred account, but the money in a Roth is tax-free. Advantage: Roth.

I want to point out two differences between Roth 401(k)/Roth403(b) plans and Roth IRAs. With Roth IRAs, you don't have to take distributions beginning at age 70-1/2, and distributions are deemed to come first from your contributions. But Roth 403(b) and Roth 401(k) plans will require you to take distributions beginning at age 70-1/2, and distributions are considered to be a pro-rata mix of your contributions and the earnings in the account. However, you may be able to roll over a Roth 401(k) or 403(b) to a Roth IRA and get those added benefits.

If the decision between tax-deferred and Roth is not clear-cut for you, maybe you'll do what I will probably choose. I will probably split my contributions between Roth and tax-deferred. Some financial planners describe that as "diversifying tax risk." I'll pay some tax now, some later. If my taxes end up being higher in retirement, I'll be glad I used the Roth option for some of my contributions. If I'm in a lower tax bracket, I'll be happy that I chose tax-deferred for the rest.

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