The Roth 403b
“Roth” refers to the ability to withdraw earnings tax-free for qualified contributions. 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/year. With the traditional 403b plan offered at your school, you decide to do an automatic salary deferral of $15,000 in 2006. As a result, your only taxed on $85,000 worth of income in 2006 and the $15,000 grows on a tax-deferred basis until you reach age 59 ½. If you invested that $15,000 in an aggressive mutual fund which grew to $25,000- there is no capital gains tax for that growth. When you retire in 2018, you decide to take a withdrawal of $5,000 from your 403b account. In 2018, you’d pay tax on that $5,000 as if you’d earned it that year.
If you had contributed $15,000 into a Roth 403b in 2006 instead, you’d be taxed based on $100,000 rather than $85,000, but wouldn’t have any tax penalty in 2018 when you took out the $5,000. You pass up the current year tax deduction for the benefit of withdrawing the money later on in life without having to pay 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 20 years from now, because of how radically different the tax code is now from how it was 20 years ago, in 1986. Even if Congress changed the tax code and, in the worst case scenario, did away with Roth provisions, it would probably add some wording to protect the millions of people already invested in Roth IRA’s. Keep things 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 personality. 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 will probably 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 would 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 are technically supposed to expire in 2010. I’m 90% sure Congress will continue those provisions since more traditional forms of tax savings and income (such as social security) just may not be as readily available as they were in the past.
I hope this article is more helpful than 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.
Russell Bailyn
(212)752-4343 *31
