Pre- and Post-tax ratio of contributions in 403b?

[StepRightUp]

Hi guys,

Before my current job, my retirement savings were strictly limited to a Roth IRA because that's all I could afford. Now, thankfully, in my new job I can contribute to a 403b in addition to a Roth IRA. Not only that, within my 403b, I'm able to make pre-tax and post-tax contributions.

I know the concepts behind the benefits of choosing a pre-tax or post-tax contributions to retirement. But with that in mind, I still can't predict the future. I don't really know what my tax bracket will be at retirement or what tax rates will be.

Given this uncertainty, I've defaulted to using my new 403b for pre-tax contributions, and my Roth IRA for all post-tax contributions. I'm looking to save 15% of gross income through both vehicles and the current ratio is 2:1. (10% is pre-tax to 403b/5% is post-tax through IRA).

Should I adjust this at all? Or should I max out as much post-tax contributions as I can now that I have that option through my 403b?

Thanks!

[jpg7n16]

What I normally recommend is the following 3 steps:

1) Take any employer match available
2) Max your Roth IRA
3) Increase 401k/403b contribution until you're at 15-20% of pretax income

Keep in mind too, that next year the Roth limit bumps up to $5,500

Retirement Topics - IRA Contribution Limits


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Example: Say you make $70,000 in 2012 and your employer matches 50 cents on the dollar for your first 6%.

$70,000 * (15-20%) = $10,500 - 14,000

Step 1) Set 403b to 6% : 70,000 * .06 = $4,200 (6,300-9,800 to go)
Step 2) Max Roth IRA: 5,000 (1,300-4,800 to go)
Step 3) Increase 403b to 15-20% overall: 1,300/70,000 = 1.8% ; 4,800/70,000 = 6.8% --- so add say 2-7% to your 403b contribution rate

Therefore making new 403b 8-13% and maxing the Roth IRA.


Example 2) Say you make $45,000 in 2012 and your employer matches 50 cents on the dollar for your first 6%.

$45,000 * (15-20%) = $6,750 - 9,000

Step 1) Set 403b to 6% : 45,000 * .06 = $2,700 (4,050-6300 to go)
Step 2) Roth IRA: $4050-5000 (you've already hit your goal and can stop or)
Step 3) Increase 403b to 20% overall: 1,300/45,000 = 2.9%

Therefore making new 403b 6-9% and putting $4,050-5,000 in the Roth IRA.

[StepRightUp]

Thanks, JPG. I do max the Roth and have upped my 403b contribution to total 15% between it and the Roth.

But the 403b has the option of being pre- and post-tax.

So if I wanted, I could contribute 15% of my income entirely post-tax. It made me think that because it's so important to max a Roth at my age, should I extend that same benefit using the 403b. In 2013, I could technically contribute $5,500 (Roth) plus $17,500 (403b) all post-tax. (I don't think I can afford to do that, but you get the idea.)

Does a general rule exist that recommends people below X years of age to contribute as much as they can to retirement post-tax?

At what age, on the whole, might a switch to pre-tax contributions be advised over post-tax?

I'm 35, 30+ years away from retirement. If I can contribute 15% of my gross income post-tax, is that the way to go? Or do I split it between pre- and post-tax as I'm doing now in a 2:1 ratio?

[Petunia 100]

My opinion is it is good to have both.

[jpg7n16]

Thanks, JPG. I do max the Roth and have upped my 403b contribution to total 15% between it and the Roth.

But the 403b has the option of being pre- and post-tax.

Yes, I saw that. The strategy outlined above gives you 1 part pre-tax and 1 part post-tax. The thing is, when you use the 3 step strategy, as your income gets progressively higher, so does your tax rate (in general) -- which means that it is more beneficial to take the deduction today, as opposed to paying the taxes today.

So if I wanted, I could contribute 15% of my income entirely post-tax. It made me think that because it's so important to max a Roth at my age, should I extend that same benefit using the 403b. In 2013, I could technically contribute $5,500 (Roth) plus $17,500 (403b) all post-tax. (I don't think I can afford to do that, but you get the idea.)

I would not do that. And here's why:

There are a number of tax benefits to standard (not Roth) 401k/403b contributions. Primarily in that you are pulling money out of your top bracket today, to withdraw into your bottom tax bracket in retirement. And if you've truly retired, you probably won't be earning a lot at that time, so your rates will be on the lower side of the tax rate at that time.

Federal Income Tax Brackets for 2012

If you are single, and maxing your Roth is 5%, then you make $100k. That puts you most likely in the 28% bracket. So every dollar you put into your 401k saves you 28% on taxes today (plus any state tax). But what rate will you draw it out in retirement?

If all your money is in Roth IRAs, then you paid 28% already, and get to withdraw tax free. If it's in pre-tax money, a portion will be tax free as well.

How? Deductions. Everybody gets at least the standard deduction plus personal exemptions. In 2012, Many Tax Benefits Increase Due to Inflation Adjustments - for a single individual today, that's nearly $6k + $4k -- nearly $10k of deductions automatically applied to your income. In retirement, when you withdraw from your 403b, that counts as income which can be offset by those deductions - making that portion of your withdrawals tax free. (If you don't need the income at that time, you can convert that portion to a Roth "tax-free")

Roth IRAs do not benefit from deductions as they're tax free already, so essentially you miss out.

Assuming you retire at 65 and live to 90 (the way healthcare is advancing, we could all live much longer), that's 25 years of deductions you'd miss out on. And at $10k/year, that's $250k. (Not even factoring in that the deduction amounts increase each year)

So you get to save 28% on taxes today, and withdraw a portion tax free tomorrow. The remainder will start in the lowest bracket at that time, and work upwards. If you understand the marginal tax bracket system, the 1st portion of your money is taxed at one rate (10% at today's rates), while the next at a slightly higher, the next portion at a slightly higher, etc. -- until all your income is accounted for. You don't just read a chart and say "I'm 28% bracket, so 28% times $100k = $28k of taxes due." That's not how it works now, and not how it'll work in retirement.

If you structure it right, and plan appropriately, you stand to significantly reduce the taxes on your income using the standard pre-tax 403b.

Does a general rule exist that recommends people below X years of age to contribute as much as they can to retirement post-tax?

No. It's based on taxes, not on age.

At what age, on the whole, might a switch to pre-tax contributions be advised over post-tax?

Again it's not based on age, it's based on tax rates. Someone in an incredibly low bracket today could consider a Roth 401k, but I'd still do the above strategy for the benefits already mentioned.

I'm 35, 30+ years away from retirement. If I can contribute 15% of my gross income post-tax, is that the way to go? Or do I split it between pre- and post-tax as I'm doing now in a 2:1 ratio?

I would do the strategy I outlined above. Max your Roth and do the rest in pre-tax 403b.

[jpg7n16]

Just as an example of what I’m talking about. Say over a period of years you have $100k that you want to contribute the 403b. And say you’ll withdraw it all in 1 year at retirement (just to show you what the tax situation will look like). For ease of calculations, I’ll assume you’re in Texas (no state tax) and that there’s 0% growth to factor in. The point on this post is to show the tax benefit, not investment gains.

Scenario 1: You want to make all $100k into post-tax (Roth 403b). Because you only have $100k to work with, and are in the 28% bracket each year, you would owe $28k in taxes. Letting you contribute $72k to the Roth 403b.
At retirement, you can withdraw all $72k tax free as your only income.
So you started with $100k, paid $28k taxes, and have $72k to live on.

Scenario 2: You make all $100k in pre-tax (standard 403b) contributions. Because it was pre-tax, there was no tax due yet.
At retirement, you withdraw all $100k as your only income. Here’s the tax calculation:
100,000 income
-5950 standard deduction
-3800 personal exemption
90250 taxable income

http://www.taxbrackets2012.com/

10% on the first 8700 = 870
15% on the next 26650 = 3997.5
25% on the next 50300 = 12575
28% on the next 4600 = 1288
Total taxes due: $18,730.50

So you withdraw $100k and get to keep $81,269.50

That's $9,269.50 more to live on in retirement (based on today's rates)


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Same income. Same tax bracket. But significantly less taxes due because of the 403b. That's a pretty good deal.

[StepRightUp]

Thanks, JPG. As always, clear and insightful.

[Like2Plan]

StepRightUp,
Will you also be eligible for a pension when you retire?

[StepRightUp]

Yes, there is a defined benefit plan too that contributes roughly 6% of my income. That began after a year. I think it's half vested after 3 years and fully vested after 6.

[Like2Plan]

Yes, there is a defined benefit plan too that contributes roughly 6% of my income. That began after a year. I think it's half vested after 3 years and fully vested after 6.

If your pension is like most, the majority of your pension benefit will be taxable (and filling in the lower tax brackets and standard deduction).

I think age and current tax bracket do matter, especially in your case. Why?

In 30 years, in a Roth type account your earnings will continue to grow untaxed. Suppose you contribute 1,000. If you achieve a 7% rate of return, that money will double approx 3.3 times. So, over 8,000. If you are in the 28% bracket, you end up paying taxes of $280 in the year you make the contribution and that's it.
And, you don't pull all of your money out on the day you retire, you pull it out gradually over your retirement years, so the money left in your account will continue to grow untaxed.

On the other side of the equation, you have to consider your current tax bracket. As you earn more, you may have no choice but to contribute pre-tax as you may find some tax breaks get phased out.

[jpg7n16]

If your pension is like most, the majority of your pension benefit will be taxable (and filling in the lower tax brackets and standard deduction).

Certainly a possibility. I don't view that as a certainty though. Many times people with pensions take a lump sum option for estate reasons, and roll that to an IRA along with the 401k/403b balance. I don't believe that having a pension guarantees you'll burn through all the low brackets and deductions.

It is a possibility though.

I think age and current tax bracket do matter, especially in your case. Why?

In 30 years, in a Roth type account your earnings will continue to grow untaxed. Suppose you contribute 1,000. If you achieve a 7% rate of return, that money will double approx 3.3 times. So, over 8,000. If you are in the 28% bracket, you end up paying taxes of $280 in the year you make the contribution and that's it.

At the 28% bracket, to have $1,000 on hand you actually paid $388.89 of taxes.

$1388.89 * (1-.28) = $1000.00

@ 7% for 30 years, that 1,000 would grow to $7,612.26 tax free

If you instead put that $1388.89 into your 403b, it would have grown to $10,572.58. Which if you have to pay 28% at time of withdrawal would leave you with? The same $7,612.26.

The timeframe doesn't matter, because both accounts get to grow. So back to my original statement, it's based on taxes, not age.

And, you don't pull all of your money out on the day you retire, you pull it out gradually over your retirement years, so the money left in your account will continue to grow untaxed.

Technically, the money in the 403b grows untaxed as well. It's only taxed at withdrawal.


With the traditional 403b money, you have more flexibility. Pension doesn't start until 65, and you want to retire at 60? Great. Withdraw/convert some/all into low brackets during those years. Left the company before accruing full pension benefit, so it's payout only has you in the 15% bracket? Withdraw/convert as you see fit. Started single today, and are withdrawing into married brackets in retirement? Great, you have that option. Pension is more than you expected? Not ideal, but you can choose to postpone until RMDs, and possibly pay the same rate as you would today. RMD age is 70.5 today, but no telling where it will be in 30 years.

If all your money is in Roth, you have none of that flexibility. You paid the taxes already and locked in 28%.

[Like2Plan]

At the 28% bracket, to have $1,000 on hand you actually paid $388.89 of taxes.

$1388.89 * (1-.28) = $1000.00

You are obviously right, I had not considered the part about paying taxes on taxes.

If the traditional contribution is increased to make up for the tax savings, I can see where it comes out pretty much the same (assuming the same tax rate).

With the traditional 403b money, you have more flexibility. Pension doesn't start until 65, and you want to retire at 60? Great. Withdraw/convert some/all into low brackets during those years. Left the company before accruing full pension benefit, so it's payout only has you in the 15% bracket? Withdraw/convert as you see fit. Started single today, and are withdrawing into married brackets in retirement? Great, you have that option. Pension is more than you expected? Not ideal, but you can choose to postpone until RMDs, and possibly pay the same rate as you would today. RMD age is 70.5 today, but no telling where it will be in 30 years.

If all your money is in Roth, you have none of that flexibility. You paid the taxes already and locked in 28%.

Over 30 years, it is really hard to tell what will happen in the future. I doubt the tax rates will go lower. On the other hand, a person may end up in a lower bracket (hopefully with good retirement planning that won't happen). Or, Congress could figure out a way to tax the Roth accounts...