Each winter, when my staff and I meet with our clients to review their tax information, we get this question a lot, “Should I go with the Roth version of my employer’s 401(k) or 403(b) plan, or should I stick with the traditional version?”
Taxpayers first had the option of contributing money to a Roth account back in 1998. Remember, when you contribute money to a Roth account, you elect to forego a current year tax break in exchange for a promise from the government that distributions taken from the Roth account down the road won’t ever be taxed.
Through 2005, the only access you had to these tax-free accounts was to contribute to a Roth IRA. Many middle-income and high-income taxpayers never had the opportunity to contribute to a Roth IRA, however, since their incomes exceeded the relatively modest threshold based on their filing status. (The Roth IRA threshold for 2012 is $125k for single individuals and $183k for married couples.)
Congress liked that people were giving up a current year tax break by opting to go with a Roth IRA instead of to a Traditional IRA, so decided to expand this opportunity to 401(k) plans and 403(b) plans. As we wrote in our October 2005 Newsletter in an article called The New Roth 401k and 403b, employers could begin to offer the Roth version of these plans as of January 1, 2006.
What’s the difference between the Traditional and Roth versions of these popular retirement savings plans? With the traditional 401(k) or 403(b) plan, the salary deferrals you make reduce your taxable salary and grow tax deferred. You will then owe income taxes on distributions taken from these accounts when you retire.
Let’s say you earn $200k, and you max out your 403(b) salary deferrals for $17k during the year. In this case, your W-2 will report taxable wages of $183k in Box 1. Assuming you are in the 33% federal tax bracket, the $17k you contribute into your 403(b) plan saves you $6,667 in federal income taxes. That’s a pretty good tax break I would say.
What happens if you instead decide to go with the Roth version of the 403(b) plan for your salary deferrals? When you contribute money to a Roth account, you forego a current year tax-break. Your W-2, therefore, will report the full $200k as taxable wages in Box 1, instead of $183k that would be reported had you gone with the Traditional 403b. The benefit of giving up this tax break is the tax-free treatment of the compounded growth on the $17k of salary deferrals. In other words, you won’t owe any federal income taxes on the distributions taken from this account when you retire.
In Part 2, I’ll give you advice about the amounts you should be savings.