Author: Natalie Pine
As a professor or university administrator, you can probably contribute to a 403(b) plan and/or 457 plan one of two ways: with a traditional before-tax contribution, or with a Roth contribution.
Roth and Traditional 403(b) or 457 - What's the Difference?
The difference between the two contribution methods essentially boils down to tax treatment:
- Traditional. When you make a traditional contribution, your taxable
income is reduced by the amount of that contribution. So, you get an upfront reduction in your taxes. But, those contributions grow tax-deferred not tax-free. So, when you start withdrawals at retirement or when required at age 72, all distributions are included in taxable income. In essence, for every $1 of return made in your Traditional 403b or 457, the US Treasury is owed a piece. - Roth. With a Roth contribution, you contribute after-tax dollars, so there is no immediate tax benefit. But, the US Treasury does not benefit from any of the earnings in that account. Everything you withdraw after 59 ½, including all earnings, are tax-free. In addition, any Roth amounts inherited by someone else will also be tax-free to the recipient.
Pay Now or Pay Later?
So deciding between the two depends upon your age, your outlook for taxes, and your asset mix expected in retirement. So, why would age matter?
Age
In most cases, someone young should contribute to a Roth vs. a Traditional 403b or 457. This is due to two factors. First, earning power tends to grow with age leading to higher taxes paid as you get older. Second, younger professionals have a longer time horizon to allow a Roth to grow tax-free.
Outlook for Taxes
In the past, most people just assumed they would be in a lower tax bracket in retirement so it wouldn’t make sense to contribute to Roth. But today, you can’t necessarily make that assumption. Why? We’re now paying historically low tax rates.¹ And with talk of higher taxation in the future, there is a possibility you may be subject to higher tax rates later, even if you earn less.
Asset Mix in Retirement: Most Provided University Retirement Income is Taxable
For university faculty, most of the retirement benefits provided to you, including any pension or optional/alternative retirement plan, will likely be taxed as regular income. This is where a Roth can be invaluable: you can create a source of tax-free income. In retirement, this can help you manage your annual tax liability since having this tax-free income bucket could help you avoid moving into a higher tax bracket in certain years.
So having the Roth account provides considerable tax planning flexibility.
No Income Limitations for 403(b) Roth Contributions
One other important point is that with your 403(b), you have the flexibility to make Roth contributions no matter how much you earn. This is an opportunity since the Roth IRA has strict limitations, and high earners usually can’t contribute to one.
Bottom line? If you can work it into your retirement plan, a Roth 403(b) or Roth 457 may be a valuable tool to help you lower and manage your taxes in the future.
¹ https://www.washingtonpost.com/news/wonk/wp/2014/04/11/your-taxes-are-really-low-in-one-chart/
