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Traditional vs. Roth 403b, 457b, 401k Contributions

| May 01, 2018
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While many people are familiar with differences between Traditional and Roth IRAs, many work-related retirement plans (i.e 403b, 457b, 401k, etc.) now offer investors the option of making either Traditional or Roth contributions as well. Read on the see which option might be right for you.

Traditional IRA vs. Roth IRA

With Traditional IRAs, eligible contributions are tax-deductible, and taxes on investment gains are deferred until withdrawals are made in retirement. Withdrawals that are taken after age 59 1/2 are 100% taxable (since you never paid tax on the contributions in the first place or on the investment gains over the life of the IRA.)

With Roth IRAs, on the other hand, eligible contributions are not tax-deductible. However, investment gains are deferred until withdrawals are made in retirement, as with Traditional IRAs. More importantly, withdrawals that are taken after age 59 1/2 are 100% tax-free (since you made your contributions with after-tax money).

(See the Tax Update 2016 on the Resources page for more information about Traditional and Roth IRA eligibility.)

Traditional vs. Roth Contributions In Your 403b, 457b, and 401k Plan

Many work-related retirement plans now offer the option of making either or both Traditional or Roth contributions to your 403b, 457b, and 401k plans and those contributions are treated in a similar manner as Traditional or Roth IRAs, in terms of the tax-deductibility of contributions, the deferment of taxes on investment gains, and the taxability of withdrawals.

In general, with Traditional 403b/457b/401k contributions, eligible contributions are tax-deductible, and taxes on investment gains are deferred until withdrawals are made in retirement. Withdrawals that are taken after age 59 1/2 are 100% taxable (since you never paid tax on the contributions in the first place or on the investment gains over the life of the plan.)

In general, with Roth 403b/457b/401k contributions, eligible contributions are not tax-deductible. However, investment gains are deferred until withdrawals are made in retirement, as with Traditional contributions. More importantly, withdrawals that are taken after age 59 1/2 are 100% tax-free (since you made your contributions with after-tax money).

Contribution Limits

For Traditional or Roth IRAs, the 2018 contribution limits are $5,500 per person, across all IRAs ($6,500 for those age 50+). So, you can put $5,500 in a Traditional IRA… or $5,500 in a Roth IRA… or some into one and some into the other… Just make sure you don’t go over the maximum annual contribution limit of $5,500 ($6,500 for those age 50+) across all of your IRAs.

For 403b, 457b, and 401k plans, the 2018 contribution limits are $18,500 per person ($24,500 for those age 50+). However, unlike Traditional & Roth IRAs, you can double your maximum contributions to $37,000 ($49,000 for those age 50+) if you utilize certain combinations of retirement plans (i.e 403b and 457b or a 403b and 401k). See The UNC 457b Retirement Plan… 4 Things To Know for more information.

Pay Your Taxes Now Or Later?

A major consideration in choosing between Traditional vs. Roth contributions comes down to, “Do you want to pay your taxes now or later?”

In a vacuum, all things being equal, after taxes are paid either on the front end or back end, it shouldn’t matter which option you choose… it should be a wash. To use a simple example, let’s say you are in the 25% tax bracket and put $1000/month into Traditional contributions and another $1000/month into Roth contributions. After all taxes are paid, either on the front end or back end, you will end up with the same amount in both plans:

Now, since we do not live in a vacuum, and all things are not equal, it actually does make a difference which plan you choose, particularly in regards to whether you believe you will be paying a lower or higher effective tax rate in retirement than you are paying now.

If you think you’ll be paying a lower effective tax rate in retirement than you are paying now, then you’ll want to pay your taxes in retirement, and put as much into Traditional contributions as you can now (this is the situation that most people will find themselves in).

If you think you’ll be paying a higher effective tax rate in retirement than you are in now, then you’ll want to pay your taxes now, and put as much into Roth contributions as you can now.

That said, it’s impossible to know what is going to happen with your tax rate over your lifetime. Although you may be planning on retiring on the equivalent of 90% of your current income, the political winds of change may cause your lower income to be taxed at a higher amount. Who knows what are wise politicians will come up with in the future?

If you are not sure either way, you can split up your contributions between the Traditional and Roth contributions, thereby giving yourself some future tax diversification in addition to your investment diversification.

Which to Choose?

These are just some of the considerations to be taken into account when choosing between Traditional and Roth contributions. Other considerations include your income, tax filing status, required minimum distributions, etc.

Ultimately, choose the contribution type that will make it easier for you to save more today, which is really much more important towards building wealth than whether you pay a little more or a little less in taxes. And for most people, that will be the Traditional contribution. (Remember, it’ll take $24,000 in pre-tax income to be able to save $24,000 in Traditional contributions, whereas, if you’re in a 25% effective tax bracket, it’ll take $32,000 in pre-tax income to be able to save $24,000 in Roth contributions, because you’ll have to pay $6,000 in taxes first. That makes the Traditional contribution psychologically easier to commit to for most people.)

Let me know what you think. Feel free to offer comments or ask questions about any of the points made in this article.

PJH


*This article was originally published 05/01/16 and was revised 05/01/2018.

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