Saving for retirement requires balancing risks against potential rewards in investments. How investment income is taxed is another critical consideration. Individuals can pay taxes now by investing after their income is taxed and watch their money grow tax-free; a Roth IRA is one way to do this. Another option is to save money on a pre-tax basis and pay the taxes after retirement, such as with a 401(k) or 403(b) plan through an employer. Both methods of saving have pros and cons.
Here, we’ll compare the Roth IRA with the 403(b) plan. Roth IRAs are available to anyone and are not tied to an employer. However, 403(b) plans are tied to specific types of employers: public school systems, nonprofit organizations, and select hospitals and churches.
Roth IRAs are usually separate investments but may be offered as an option in a 403(b) plan. Employer-matched funds aren’t available with a Roth, but there are tax advantages to consider. Most commonly, Roth IRAs are opened through a brokerage, independent of employment. Individuals make contributions to a Roth IRA after taxes, making withdrawals tax-free in retirement. You can withdraw contributions tax-free after five years. Maximum contributions are $6,000 annually, with a $1,000 catch-up option for individuals who are over 50. This catch-up contribution provision allows older workers to set aside more earnings for retirement. Income limits for single and married-filing-jointly contributors apply.
Roth IRAs that are not housed under an employer plan allow investors to choose investment companies as well as the various investments in the plan. Roth IRAs do not have required minimum distributions beginning at age 70½ and may be held for the account holder’s lifetime.
Employer-based 403(b) plans, similar to 401(k) plans, invest money on a pre-tax basis and often include employer-matched funds. Employer matches are a percentage of your contributions up to a specified limit set by the employer. Investment options for 403(b) plans are chosen by the employer. Options commonly include age-based investment categories, such as plans that contemplate a targeted retirement in 2030. Employees have several other investment choices varying from lower-risk to higher-risk options, depending on their investment preferences.
There are no income limits for enrolling or maintaining 403(b) plans. Yearly contribution limits are $19,500, but individuals over 50 can contribute an additional $6,500 per year. Employees may begin penalty-free withdrawals at age 59½ and are taxed at their current tax bracket. Employees typically can take loans against the plans, but those loans must be paid back if they terminate employment.
Those who anticipate their post-retirement income to be lower than their current income, thus moving to a lower tax bracket, will benefit from the tax-deferred earnings of 403(b) plans. They also pay fewer taxes at the time the investments are deducted on a pre-tax basis. A 403(b) plan is tied to the employer and may stay with the employer’s investment manager if you switch employers. They may also be rolled over into a new employer’s plan or a separate IRA.
Roth 403(b) Plans
You can also invest post-tax dollars in 403(b) plans through a Roth 403(b) option that some employers offer. The employer-sponsored Roth 403(b) doesn’t have income limits like regular Roth IRAs and is open to any employee. Contribution limits are the same as with regular 403(b) plans: up to $19,500 per year with a catch-up provision of up to $6,500 for those over 50. As in regular 403(b) plans, both employees and employers may contribute, but employer contributions aren’t required. Employer matching contributions are made on a pre-tax basis, so they are taxed upon taking distributions.
Roth 403(b) holders may take distributions starting at age 59½ as long as the account has been open for at least five years. Unqualified distributions are subject to a 10% penalty, with some exceptions for those who leave their jobs or become permanently disabled. Roth 403(b) plans have required minimum distributions starting at age 70½, at which time investors cannot make new contributions. Roth 403(b) plans may offer the same terms, investment options, and management fees as an employer’s regular 403(b) plan.
Balancing Tax Advantages
Roth IRAs and 403(b) plans have tax advantages depending on your current and future needs. Having both investment types is helpful for retirement savings, but prioritizing one over the other requires some consideration. Those investing during their peak earning (and tax-paying) years may benefit from tax-deferred 403(b) investments. In contrast, those who anticipate their earnings to go up in the future may benefit more from post-tax Roth IRA investments. Roth IRAs also allow for tax-free growth, which is especially advantageous for younger investors.
Roth IRA holders invest post-tax but can use their earnings tax-free after the earnings have grown over the years. Roth IRAs can also provide tax advantages to those who anticipate moving into a higher tax bracket when they begin withdrawals, as they will be non-taxable. Holders of 403(b) plans pay taxes upon withdrawing their money and likely will be in a lower tax bracket when they retire. This type of tax-deferred growth allows employees to invest with tax benefits that make investing more affordable.
Weighing Retirement Plan Options
Diversifying retirement investments is a wise move in case markets change or if your income goes up or down in the future. Investing in both a Roth IRA and 403(b) is often the best option. Take advantage of employer contributions, as it is free money. For example, an employer could do a 50% match on contributions up to 6%.
Employees who are younger or are in a low tax bracket may benefit the most from a Roth IRA or Roth 403(b) that allows tax-free growth. Those in higher tax brackets may benefit most from the deferred tax of a regular 403(b), especially if they anticipate being in a lower tax bracket after retirement. Employer-sponsored accounts have limited investment options, which makes Roth IRAs more attractive to those who want highly customized investment options.
When considering retirement investments, remember the most important thing is to save and invest money. In planning your investment approach, consider tax benefits that can help you immediately and tax benefits that will be beneficial years from now.
Balancing your retirement funds can be very complicated, with numerous options for investment risks and returns as well as tax considerations that affect you today and in the future. For expert assistance in maximizing the benefits of your retirement investments, contact 3D Partners Wealth Advisors. We can help you with long-term financial planning, maximizing your ability to benefit by strategically measuring tax impacts and potential risks and rewards.