Q: I am 41 years old, and my wife and I are both public school teachers. We’ve been contributing to our 403(b) accounts in order to supplement our pensions, and we’ve each accumulated about $100,000. Because we are in a position to save more, we’re wondering if we should increase our contributions to our 403(b)s, save in Roth 403(b)s, or save in Roth IRAs. What is your opinion?
A: That’s a tricky question, because the answer is based entirely upon future tax laws, which are next to impossible to predict. Your current retirement savings into 403(b)s provides tax benefits to you now, but may or may not be the best for you in the long term. As with 401(k) plans, you receive a tax deduction for any contributions you make to a 403(b), which reduces your current income-tax bill, but, although your account grows tax-deferred, all withdrawals will be taxable when you are retired and pulling income from the account.
If we could know for certain that you are in a higher tax bracket today than you will be in retirement, there would be no question you should keep funding your 403(b)s and ignore the Roth options.
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The problem is, of course, that we don’t know what your future tax situation will look like.
A Roth option, whether it be a Roth 403(b), or a Roth IRA, will not provide you with any current tax savings, but your account will grow tax-deferred and your withdrawals will NOT be subject to income taxes when you are retired and withdrawing the funds.
The challenge for those people who are still decades away from retirement is that we have no idea what the tax code will look like in the 20 or 30 years. The tax code, as complex as it is, hasn’t really changed that much in the past three decades. Tax rates are progressive, meaning the higher your income, the larger the percentage of your income that will be taken out for taxes.
What might the tax code look like in another 20 or 30 years? What if the progressive income tax system that we currently have is eventually replaced with a flat tax? Or a national sales tax? It would be a real bummer to use a Roth 403(b) or a Roth IRA for your retirement savings, only to have our tax system get replaced by a national value added tax (VAT) and a relatively low flat income tax.
Another factor to consider is the state in which you are working versus the state in which you plan to spend your retirement years. For example, if you are working in New York, with a high state income-tax structure, yet plan to retire in Florida, one of nine states with no income taxes, a Roth IRA or a 403(b) might not be helpful at all. In a situation like this, a traditional 403(b) (or an IRA) would be much more beneficial, at least as far as state income taxes are concerned.
Because it’s anyone’s guess as to what the tax structure will look like in the future, it’s probably best to have a diversified approach to your tax planning in the same manner you would have a diversified approach to your investments. Odds are, you don’t have your entire 403(b) plan balance in just one type of investment. Why? Because you know that having your investments spread around will provide you with the highest degree of certainty with your retirement savings.
You should have a similar approach with your income tax strategy. Ideally, you reach retirement with a number of different types of retirement plans. In a perfect situation, you’d have your 403(b) plans, some money in Roth IRAs (or 403(b)s), some investments held outside of your retirement plans, perhaps some income-producing real estate, etc.
If I were in your shoes, I’d contribute about 80% of my retirement savings to a traditional 403(b), and the remaining 20% to a Roth IRA. This would enable you to take advantage of the current tax savings that your 403(b) provides, while also allowing you to accumulate a nice chunk of cash that will not be subject to income taxes once you retire.
In regard to whether you should contribute to a Roth 403(b), or a Roth IRA, from an income standpoint, it really doesn’t matter that much, as both plans allow for tax-free retirement income. There are a few minor nuances between the two, but what I prefer with the Roth IRA is the investment flexibility. With a 403(b), your employer dictates which providers you can work with, whereas you have full discretion over a Roth IRA.
By the way, you are wise to be thinking about your retirement savings at such a young age. Far too many people wait until late in life to get serious about their savings, and the longer you wait, the tougher it is.
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.
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