As employees, we have the ability to save for our retirement in a few different ways through the cash flow of our wages. The most common method of accumulating wealth for those in education is the deferment of earnings in the 403(b) plan provided by the educational institution. There can be however, an option within the 403(b) plan that can go unnoticed, and that option is the Roth 403(b). Today I’ll center on the Roth option and what to look for as an employee.
What is a Roth 403(b)?
A Roth 403(b) plan is a part of your qualified plan that designates itself to act just like a Roth IRA. A Roth 403(b) isn’t subject to the same income restrictions or contribution limits as its Roth IRA counterpart, which makes the Roth 403(b) an attractive offering inside the qualified plan. The biggest issue with individuals contributing to a Roth IRA is the income restriction attached (updated annually). Because a Roth 403(b) is tied to the qualified plan, there are no income restrictions causing you to miss out on the ability to contribute. The qualified plan contribution restrictions1 ($22,500 annually plus a $7,500 catch-up if you’re 50 years old or older)2 still apply, however.
What makes a Roth 403(b) attractive?
In financial planning, nearly everything with the term Roth is attractive. A Roth 403(b) is funded with after-tax money from your paycheck, meaning money that is taxed immediately and then tax-exempt. Contributions grow inside the Roth 403(b) tax-deferred, and when it’s distributed to you later in life, it leaves the Roth 403(b) without any taxes due (as long as you meet the standard Roth IRA distribution rules).3 The tax-sheltered nature of the Roth 403(b) makes it attractive for long-term accumulation.
How is this better than just a regular 403(b) contribution?
Whether or not it’s “better” needs to be determined between you, your tax advisor and your financial planner, but it’s definitely an option that needs to be considered. The benefits of your traditional 403(b) contribution include the fact each dollar you contribute decreases your taxable income for the year. If you make $115,000 per year and contribute $15,000 into your 403(b), your taxable earnings will be $100,000 and you just saved $15,000 into a long-term account. The traditional 403(b) does grow tax-deferred, just like the Roth 403(b). Where the Roth portion can benefit you is the distribution phase. It’s very possible when you enter the distribution phase in retirement that you actually increase your tax bracket. This becomes a reality for many people as they start to receive social security, pensions and distributions from traditional plans. Because non-Roth money was tax-sheltered as it went into the plan, it’s taxed as you distribute it out of the plan. If you withdraw $100,000 out of your traditional 403(b) or IRA (treated the same way) in retirement, the IRS is going to show you have ordinary income of $100,000, and they’ll tax it that way. Now if you add a $25,000 Social Security benefit and a $50,000 pension to that $100,000 distribution, there’s a fair chance you’re being taxed at a higher rate in retirement than you were as an employee. You can avoid jumping tax brackets in retirement if you have the ability to pull money from your Roth accounts (which aren’t taxed on the way out).4
How do I start saving in my Roth 403(b), and how do I know how much to save?
It’s important to note not every plan offers the Roth option, so checking with your benefits department is step one. If you come to realize your plan does have a Roth option, it’s important to work with your wealth manager to understand how much of your salary you can defer to the Roth and how much you can defer to the traditional portion so that your income tax situation in the present day is manageable and efficient. It’s common to defer a percentage to the Roth along with a percentage to the traditional. Your advisor can help you balance out the method that’s best for you, both now and in the future. Contact your wealth manager or request a meeting for more information on starting a Roth 403(b) plan.