Need advice: traditional 403(b) vs. Roth 403(b) vs. Roth IRA vs. taxable account

[Silhan]

I'm currently in my early thirties and plan to retire at around age 50 with a paid off house.

Conventional wisdom says I should contribute to a traditional 403(b) [or 401(k)] in order to get the full employer match, then to contribute to a Roth IRA, then to continue contributing to the 403(b) or to an after-tax account. That's exactly what I've been doing.

However, my employer recently started offering a Roth 403(b).

At first glance, it seems that I should contribute to the new Roth 403(b) instead of the traditional 403(b) in order to take advantage of my current low tax rate and because I plan to retire early. If I choose this option, my employer's matching contributions will continue to be pre-tax.

So here's my question: upon retirement, what percentage of my nest egg should I have in each type of account: pre-tax, Roth, and taxable?

For simplicity, let's assume that I'll be in the same tax bracket as I am today (though I personally believe that future tax rates will be higher due to significant unfunded government liabilities).

What other issues should I consider?

Thanks.

 

[LOL!]

What's your marginal income tax bracket now? If it is under 15%, then the Roth IRA may make sense. If it is 15% or over, it's hard to see how the Roth makes any sense at all.
What will be your income tax bracket when your retire at age 50? I am pretty sure you will be in a lower tax bracket than you are now, or how else could you retire early? You can then convert your 403b or 401k to a RothIRA while in a lower tax bracket than now.
So avoid the Roth until you have contributed $15,500 to your 401k.
And there is no preferred %-age in taxable, Roth and tax-deferred. You could have 100% in any one of them if that's all you can do. What's more important is the analysis I described at the beginning of my post.

 

[Silhan]

My current marginal tax rate is 15% (federal). My main reason for leaning toward the Roth 403(b) was because I see today's low tax rates going only one direction in the future: up.

But you make a good point that my taxable income in retirement will likely be lower than it is today because I will no longer be contributing to my Roth IRA, and will instead be withdrawing from it, potentially putting me into a lower tax bracket.

You've given me some good things to think about. Thanks.

 

[brewer12345]

How easy is it to switch between Roth and regular 401ks? At 15%, the Roth sounds attractive, but if you go into a higher bracket or tax rates go up, you might wish to switch back.

 

[cute fuzzy bunny]

Look hard at the details on that 403b. My wifes had a 550 page prospectus and once you fully unwound the total costs, the funds were extremely expensive and there was a stiff penalty for rolling over or withdrawing the funds within 10 years.

Bad fund choices, high expenses, and wrapped up in a variable annuity. Better than an after tax investment...but not by much.

 

[MooreBonds]

My current marginal tax rate is 15% (federal). My main reason for leaning toward the Roth 403(b) was because I see today's low tax rates going only one direction in the future: up.

But you make a good point that my taxable income in retirement will likely be lower than it is today because I will no longer be contributing to my Roth IRA, and will instead be withdrawing from it, potentially putting me into a lower tax bracket.

Diversification not only works with our investments themselves, but also with accounts...if you're truly torn between them, why not divy it up 50% Roth/50% Traditional? That way, you're guaranteed to not miss out.

 

[BigBob]

Ditto what MooreBonds says about tax diversifying.
Vanguard put together a lengthy document here:
http://www.pcarbi.org/retirement/Roth%20403b/TaxDiversificationandRoth403b.pdf
and several others have discussed this concept. (Mod can fix the link if necessary)
I am in the same boat as you, and the direction I have decided to go is to attempt to at least get close to 1/3 Roth, 1/3 Regular 401K, and 1/3 taxable accounts. This gives me pretty good leverage when pulling out funds. Some years I will need to pull out more from taxable accounts or more from Roth to "optimize" my taxation. I think it is a pretty good plan considering that we don't know what kind of tax laws we will have 10-20 years from now. I am not sure I can get to the 1/3 taxable, since I have not yet maxxed my 401K contributions, but at least that is a direction I want to head.

 

[jIMOh]

If you are nearly 100% Roth, your effective tax rate will be close to zero. Exemptions (standard and dependants) should mask the taxes on the RMD from the match.

That is gambling, though... too many eggs in Roth basket.


There is an inflection point I have found with the Roth vs Traditional 401k...

I want the T401k amount to be $X, when it hits $Y, the RMD is in a higher current tax bracket, so before I get to $Y, I need the 401k to switch to a Roth.

I am about you age and have pondered this for years. I did not switch to Roth 401k, but will probably be singing a different tune shortly.

 

[Silhan]

brewer12345: It's pretty easy for me to switch between traditional and Roth--just a matter of filling out a one-page form, and the change will take effect the following month.

cute fuzzy bunny: I'm fortunate to have a good 403(b). My money is invested in a slice-and-dice portfolio of Vanguard institutional shares. When I separate from my employer, I can roll the traditional and Roth 403(b) funds over immediately to traditional and Roth IRA's. However, I believe there are some restrictions on how and when I will be able to withdraw the rolled-over Roth funds.

MooreBonds and BigBob: The issue of tax diversification was what originally prompted this post. I was thinking along the same lines as you--that 1/3 each in pre-tax, Roth, and taxable would give me the most flexibility in withdrawing the funds in retirement. But I wanted to ask in order to make sure I wasn't oversimplifying the issue.

jIMOh: In retirement, I'd like to withdraw enough each year from pre-tax accounts to use up the standard deduction and exemptions, then withdraw the remainder of my living expenses from taxable and Roth accounts. As you say, I wouldn't have to pay any taxes on the pre-tax money--as long as the RMD's aren't too large when that time comes. But I imagine there might be some scenarios, as LOL! suggets, where it might be better to put the money in a pre-tax account initially, and then to roll it over to a Roth IRA later.

And, as CFB has pointed out in the past, if our national income tax ever gets replaced by a national sales tax, I wonder whether money spent from Roth and taxable accounts would be subject to it, which would effectively result in double taxation of the same dollars--income tax when the money was earned, and national sales tax when the money would be spent.

 

[jIMOh]

jIMOh: In retirement, I'd like to withdraw enough each year from pre-tax accounts to use up the standard deduction and exemptions, then withdraw the remainder of my living expenses from taxable and Roth accounts. As you say, I wouldn't have to pay any taxes on the pre-tax money--as long as the RMD's aren't too large when that time comes. But I imagine there might be some scenarios, as LOL! suggets, where it might be better to put the money in a pre-tax account initially, and then to roll it over to a Roth IRA later.

And, as CFB has pointed out in the past, if our national income tax ever gets replaced by a national sales tax, I wonder whether money spent from Roth and taxable accounts would be subject to it, which would effectively result in double taxation of the same dollars--income tax when the money was earned, and national sales tax when the money would be spent.

I think you could get more tax efficient than your plan.

1) use standard deduction against IRA (traditional) RMD's. RMD's are taxed as ordinary income, ordinary income rates are much higher than capital gains rates. For planning purposes, I think this makes more sense.

2) Use taxable accounts to keep overall tax bracket low. LTCG and qualified dividends are taxed differently, and there is less of a need for the deductions to offset these, as they are taxed lower.

3) In the end you need a "given" income stream. Conventional wisdom suggests to defer taxes as long as possible, or contribute at one tax rate, and withdraw at a lower one as much as possible.

3a) If you can contribute to a Traditional 403b now at 15 or 25% bracket, then roll this over to a Roth account when in a lower bracket, that is money in your pocket.

3b) Income is best if it comes from
a) Roth/ tax free bonds
b) Capital gains and qualified dividends
c) ordinary income

Minimize c), maximize a) is lowest tax bite any given year.

 

[Silhan]

1) use standard deduction against IRA (traditional) RMD's. RMD's are taxed as ordinary income, ordinary income rates are much higher than capital gains rates. For planning purposes, I think this makes more sense.

I believe we're in agreement, but perhaps I misunderstood you. Isn't pre-tax the same as traditional?

 

[cute fuzzy bunny]

And, as CFB has pointed out in the past, if our national income tax ever gets replaced by a national sales tax, I wonder whether money spent from Roth and taxable accounts would be subject to it, which would effectively result in double taxation of the same dollars--income tax when the money was earned, and national sales tax when the money would be spent.

It already happens quite a bit. We've all had income taxed, then invested it and have the dividends paid out by the investments taxed, then spent the money and paid sales tax on the items purchased.

I'm surprised we have any actual monetary value left over at all...


I predict the national sales tax kicks in around 2027...because thats when i'll be starting to look at taking money out of our Roth.

In the meanwhile, we both have a sizeable regular IRA, and we're contributing heavily to Roths. By the time we get into our sixties it should be about 50/50.

If we can manage a low tax profile, we'll take money from the IRA's. If we cant, we'll take it from the Roths. At least we have some flexibility.

 

[jIMOh]

I believe we're in agreement, but perhaps I misunderstood you. Isn't pre-tax the same as traditional?

I thought it said POST TAX, my mistake