(b)lines Ask the Experts – Roth Accounts and Participant Post-Retirement Benefits

“I have heard that a Roth 403(b) can actually help participants maximize their after-tax retirement benefit. If this is true, can the Experts assist me with the math as to why?”
By PS

It can be true, depending on several factors, including your accumulated contributions under both types of deferrals, your applicable effective tax rate when you contribute and when you retire, and the investment earnings in your accounts, the economic value of prepaid taxes adjusted for the time value of money versus investing that money on an after-tax basis, etc. However, the much simplified example below shows how Roth contributions could be more advantageous, but that there are so many variables involved is a major caveat, which the math will demonstrate.

 

Let’s say I wish to contribute the current pre-tax, younger than age-50 maximum of $18,500, and I am in a combined tax bracket (state + local) of 50% (we are using 50% just to make the math a bit easier to follow, but it works for any tax bracket) both at time of contribution and at the time of withdrawal in retirement. Furthermore, for the sake of simplicity let’s just look at that one year of contributions rather than the accumulated contributions from each year. Finally, let’s assume that the funds were in the account for a sufficiently long period of time that they quadrupled in value. Here is how one year’s worth of maximum Roth 403(b) contributions would compare at retirement to a traditional tax-deferred contribution of the same amount:

 

 

Pre-tax 403(b)

Roth 403(b)

Deferral/Roth contribution

$18,500

$18,500

Taxes (50%)

$0

$9,250 (tax on income does not reduce the contribution amount)

Contribution to account

$18,500

$18,500

Balance at Retirement

$74,000

$74,000

Tax on Distribution (50%)

$37,000

$0

After tax Retirement Benefit

$37,000

$74,000

 

 

So, as you can see, the same Roth 403(b) contribution of $18,500 can yield a much larger after-tax benefit at retirement than the equivalent pre-tax deferral. However, the caveat is that, to max out on a Roth 403(b) contribution reduces one’s net take-home gross pay by both the contribution and the applicable income tax withholding, since the Roth contributions are taxable, and additional funds are needed to cover the tax. However, leaving aside the income tax analysis, assuming the individual in question has these funds available, the Roth contribution would provide an after-tax retirement benefit that the pre-tax 403(b) deferral could not. In the above example, in order to provide the same benefit with a 403(b) pre-tax deferral, he/she I would need to double the amount of that deferral to $37,000 to produce the same after-tax benefit, which is an impossibility due to the annual statutory limit on deferrals. To fully evaluate the difference, you would also need to take into account the potential economic impact of investing the taxes not paid on a pre-tax deferral outside of the plan until retirement.

 

This is a very complicated topic and much has been written about it. There are also online calculators available to show participants the difference the two types of contributions can make in their retirement income, but we cannot recommend one over another. Regardless, whether Roth 403(b) contributions are advantageous for participants depends on their unique circumstances and should be reviewed carefully.

 

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

 

Do YOU have a question for the Experts? If so, we would love to hear from you! Simply forward your question to Rebecca.Moore@strategic-i.com with Subject: Ask the Experts, and the Experts will do their best to answer your question in a future Ask the Experts column.

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