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~What's the Best Way to Save for Retirement?~

 

When saving for retirement, a lot of people wonder if they should contribute to a 401k, 403b, a Roth IRA, or to a traditional IRA.

 

An IRA is a tax-advantaged account that you can open up yourself with almost any brokerage firm and contribute to on your terms (subject to federal rules).  

 

A 401k, a 403b, and a 457 plan are pretty much the same things.  The difference lies in whether or not you work for a private company or a public entity.  In each of these accounts, you can only contribute through payroll deductions via your employer.  Due to the way the federal law is written, there are fewer limitations on contributing to a 401k/403b/457 than to an IRA.

 

 

While the details differ (like contribution limits) the traditional IRA is essentially the same as the traditional 403b (which is what many school employees contribute to through payroll deductions).

 

Likewise the Roth IRA is essentially the same as the relatively new Roth 403b.

 

People are often unsure whether they should contribute to the traditional 403b/IRA or to the Roth 403b/IRA.  The answer to this question largely hinges on two factors:  1) whether one's tax rate will be higher or lower in retirement compared to one's working years; and 2) whether one takes advantage of the immediate tax break of the traditional IRA/403b.

 

With a Roth, you get paid from your job, you pay taxes on the income, and then you put some of that money into the Roth IRA or Roth 403b account.  Since you already paid taxes on the income, the government allows this money to grow tax free for life (you choose what to invest it in); so you will never pay any taxes on this money, even when you take the money out in retirement.

 

On the other hand, when you contribute to a traditional IRA or a traditional 403b, you get a tax break immediately.  In other words, you don't pay any taxes on the income that you contribute.  For example, if you are in the 22% tax bracket and you contribute $100 to a traditional 403b, you will effectively have $122 to invest immediately because your taxes will go down by $22 when you contribute the $100.  Then it grows (hopefully) until you retire and you start taking money out of the account.  At that point you have to pay taxes on every penny that you withdraw (not just the gains), because you never paid any taxes on the original income.  The government actually requires you to start taking minimum distributions from these accounts each year in retirement, because the government wants to start collecting the taxes that were never paid on this income.

 

So which one is better?  Is it better to pay the taxes up front when you're working (Roth) or is it better to wait and pay the taxes in retirement (traditional)?  

 

Mathematically it depends on when your tax rate is lower.  For most people (depending on the size of your pension and the size of your retirement savings) that may be in retirement, making the traditional IRA/403b potentially more advantageous.  However, there is an important factor that may turn the tables on this result.  What many people probably overlook is that if you don't invest the tax break that you get when you contribute to the traditional IRA/403b, you aren't getting the full benefit of this account.  This makes the tax benefit of the traditional over the Roth less certain.  

 

The reason is due to the fact that when a person contributes $100 to their traditional 403b, most people probably spend the $22 tax break because the $22 just ends up as "extra" money in their paycheck.  My guess is that this is a much overlooked aspect of the traditional IRA/403b.  If you don't invest the tax break, you will likely end up with significantly less money in retirement than if you had invested initially through a Roth 403b/IRA, even if you end up in a lower tax bracket in retirement.

 

So, if one's goal is to maximize one's retirement savings, it may actually be beneficial to choose the Roth because it essentially forces you to pay all of the taxes up front.  Then you'll never pay a dime in taxes on this money, regardless of how large it (hopefully) grows.  On the other hand, if your goal is to lower your current tax bill in order to have more money in your paycheck to meet your current expenses, the traditional 403b or IRA could be the way to go.  Or, if you think your tax rate will be lower in retirement and your goal is to maximize your retirement savings, then be sure to invest the tax break if you contribute to the traditional 403b/IRA.

 

And like many things when it comes to investing, it might be a good idea to diversify.  In other words, it might be beneficial to have some of your retirement funds in a traditional IRA/403b and some of your retirement funds in a Roth IRA/403b.  If you're already contributing to a traditional IRA or 403b, when you increase your contributions, you may want to consider putting those additional contributions into a Roth IRA /403b (this is my plan).

 

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March 1, 2023