Author Topic: Question regarding best strategy if you have access to Roth 403(b) & Roth 457b  (Read 813 times)

rudged

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My university employer revised our retirement options to now include access to both a Roth 403(b) and a Roth 457b plan. I work as a professor and plan to continue working as long as the work is meaningful and my health permits. I'm currently 56 and you may know that at the age of 59 1/2 you are allowed to start rolling over your contributions to a 403(b) plan (not those of your employer) into a Roth IRA. I've currently saved enough in my 403(b) to anticipate that when I start taking required minimum distributions the amount will exceed my needs (and my current income).

Contributions to 403b and 457b plans are pre-tax and therefore lower my taxable income, which so far has left me with an effective marginal tax rate of 12% (the next higher level is 20%. So I'm strategizing how best to take advantage of my current low tax rate when I turn 59 1/2.
 
One strategy would be simply to reduce my contributions to the 403b and 457b plans and direct as much money as possible into the Roth 403(b) and Roth 457b plans consistent with my remaining in the 12% tax bracket. I've determined that so long as I contribute at least $7K to the 457b plan, my total taxable income for the year would stay within the 12% bracket. The other strategy I've been toying with is that of maximizing my contributions to the 403b and 457b plans (reducing my taxable income as much as possible), with the idea that I would then roll over as much per year as possible from previous contributions my existing 403b account into a Roth IRA provided I pay the taxes on these roll overs (which can easily be done by directing my employer to increase the amount of each paycheck that is deducted for taxes).

Is there any advantage to pursuing the first strategy rather than the second? or am I just over thinking this?

MDM

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...which so far has left me with an effective marginal tax rate of 12% (the next higher level is 20%.
The words "effective" and "marginal" often mean different things, but sometimes are used together - see Marginal tax rate - Bogleheads.  Assuming you simply mean "marginal" (e.g., no state tax and in the federal 12% bracket) the next higher level is 22%.

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So I'm strategizing how best to take advantage of my current low tax rate when I turn 59 1/2.
Excellent question, regardless of age.  The Traditional versus Roth choice depends on the marginal tax rate you could save now vs. the marginal tax rate you would have to pay on withdrawals later.

Have you estimated your marginal rate on future withdrawals, for different amounts (including zero) of SS benefits, pension, and RMDs?

rudged

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Thanks for your reply. Yes, marginal. We pay no state taxes.

rudged

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OK. I think I figured this out.

Using the first strategy, for each $1K pre-tax I contribute to the 457b plan, I'd have the opportunity to contribute an additional $1 K post tax to the Roth 457b plan. Using the second strategy, each $1K pre-tax contribution to the 457b plan would give me the opportunity to pay taxes on the roll over of existing contributions to the 403(b). If I wanted to maximize the amount of savings being moved into a tax advantaged environment (and I could afford it), the first strategy would be the way to go.

I already have to contribute $7K into the 457b plan just to keep our income within the 12% marginal tax rate, and the total amount I can contribute to either a 457b or Roth 457b plan (or some combination of the two) will be $26 K given my age [and a recent post to the effect that both 457b plan contribution limits and catch up provision are being raised by $500each]. So I could contribute up to $9.5 K into the 457b to be able to contribute up to $9.5K in the Roth 457b. And I can do all of this prior to age 59 1/2, since no roll overs of previous contributions to the 403(b) plan would be involved.

All the above being said, this would substantially reduce my take home pay. So I'm inclined to think that when I do reach 59 1/2 I will probably use contributions to the 457b account to allow me to roll over from the 403(b) plan while remaining in the low marginal tax rate. I particularly like the idea I can wait until November to decide, as some of my income comes from summer teaching and it is always possible my class will be cancelled.

MDM

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Unless you live in a state (Illinois is one - not sure of others) that does not tax withdrawals from traditional retirement accounts, contributing $X to a traditional account and in the same year converting $X from traditional to Roth is the same as contributing $X directly to Roth.

One can't make lump sum contributions to an employer plan (401k/403b/457b) the way one can to an IRA.  Contributions come from each individual paycheck, so waiting until November might be too late.

Have you estimated your marginal rate on future withdrawals, for different amounts (including zero) of SS benefits, pension, and RMDs?

rudged

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Unless you live in a state (Illinois is one - not sure of others) that does not tax withdrawals from traditional retirement accounts, contributing $X to a traditional account and in the same year converting $X from traditional to Roth is the same as contributing $X directly to Roth.

One can't make lump sum contributions to an employer plan (401k/403b/457b) the way one can to an IRA.  Contributions come from each individual paycheck, so waiting until November might be too late.

Have you estimated your marginal rate on future withdrawals, for different amounts (including zero) of SS benefits, pension, and RMDs?

I live in Michigan. The contributions to the 457b plan would be from my paycheck; it is the partial conversion from the existing 403(b) account into an IRA and ultimately a Roth IRA that I anticipate I could do in the fall of the year.

I have tracked down an estimate of my SS. I don't have a pension. With regard to RMDs, my plan is to not take them until I have to by law, which is to say it is so far in the future (at least 15 years) that I don't know whether getting an estimate would be particularly helpful given so much depends upon how the market does between now and then. My thought is that I have every reason to believe given how much I have accumulated that the RMDs will be in excess of my current income, and as such, will knock me into a higher marginal rate.

seattlecyclone

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As MDM pointed out, there's no real mathematical difference between contributing a dollar directly to a Roth retirement account vs. contributing a dollar to a pre-tax retirement account and then converting a dollar of pre-tax savings to Roth.

In general the way to minimize your taxes on a long-term basis is to keep your marginal tax rate as consistent as possible from year to year. If you have every reason to believe that your RMDs will be more than your current income, you might consider doing Roth conversions every year up to the top of your current 12% tax bracket. This will serve to reduce your eventual RMDs, and therefore minimize the chance that they'll go into the next higher tax bracket. Another benefit of doing this is that when you go on social security your marginal rate while taking social security will actually be higher than your tax bracket in many cases due to how social security income gradually transitions from being untaxed income to being mostly-taxed income as your other income increases.

Also since you have no immediate plans to retire, and you expect to have more than enough money saved up when that eventually happens, I want to make sure you're aware of the option of qualified charitable distributions from your IRA. Once you turn 70 you have the option of making charitable donations directly from your IRA, up to $100,000 per year, and these count toward the amount you would otherwise need to withdraw as an RMD. These donations are excluded from your income rather than deducted in the itemized deductions. This can be more advantageous than simply withdrawing the money and then donating it for a couple of reasons. First, if you wouldn't itemize but for the charitable contributions, you get the full tax benefit of the standard deduction plus the donation, rather than losing out on the benefit of whatever portion of your donation (and other itemized deductions) was less than your standard deduction. Secondly, because these qualified charitable distributions are excluded from your income they don't touch your AGI at all. This may cause less of your social security to be taxed, among other things.

Finally, I know you enjoy your job enough to keep doing it for the foreseeable future. Have you considered asking for whatever parts you find least enjoyable to be removed from your job description? You have a position of strength here. Worth a try to use it, right?

MDM

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My thought is that I have every reason to believe given how much I have accumulated that the RMDs will be in excess of my current income, and as such, will knock me into a higher marginal rate.
If that is your belief, and you further believe you will have the same or higher work income until RMDs start, then the indicated action is to stop all traditional contributions and go 100% Roth.

rudged

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My thought is that I have every reason to believe given how much I have accumulated that the RMDs will be in excess of my current income, and as such, will knock me into a higher marginal rate.
If that is your belief, and you further believe you will have the same or higher work income until RMDs start, then the indicated action is to stop all traditional contributions and go 100% Roth.

Agreed. I am currently fully funding both a Roth IRA and a spousal Roth IRA and plan to fully fund the Roth 403(b) starting next year. I just got enamored with the idea that by making additional contributions to a 457b, it would allow me to roll over some of my previously contributions to the 403b. So my (happy) dilemma is whether to pursue the strategy of contributing to a 457b in order to roll over the 403b money into a Roth IRA OR invest the extra outside of retirement accounts. I guess I've been assuming it is always preferable to take advantage of tax advantaged accounts.

rudged

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As MDM pointed out, there's no real mathematical difference between contributing a dollar directly to a Roth retirement account vs. contributing a dollar to a pre-tax retirement account and then converting a dollar of pre-tax savings to Roth.

In general the way to minimize your taxes on a long-term basis is to keep your marginal tax rate as consistent as possible from year to year. If you have every reason to believe that your RMDs will be more than your current income, you might consider doing Roth conversions every year up to the top of your current 12% tax bracket. This will serve to reduce your eventual RMDs, and therefore minimize the chance that they'll go into the next higher tax bracket. Another benefit of doing this is that when you go on social security your marginal rate while taking social security will actually be higher than your tax bracket in many cases due to how social security income gradually transitions from being untaxed income to being mostly-taxed income as your other income increases.

Also since you have no immediate plans to retire, and you expect to have more than enough money saved up when that eventually happens, I want to make sure you're aware of the option of qualified charitable distributions from your IRA. Once you turn 70 you have the option of making charitable donations directly from your IRA, up to $100,000 per year, and these count toward the amount you would otherwise need to withdraw as an RMD. These donations are excluded from your income rather than deducted in the itemized deductions. This can be more advantageous than simply withdrawing the money and then donating it for a couple of reasons. First, if you wouldn't itemize but for the charitable contributions, you get the full tax benefit of the standard deduction plus the donation, rather than losing out on the benefit of whatever portion of your donation (and other itemized deductions) was less than your standard deduction. Secondly, because these qualified charitable distributions are excluded from your income they don't touch your AGI at all. This may cause less of your social security to be taxed, among other things.

Finally, I know you enjoy your job enough to keep doing it for the foreseeable future. Have you considered asking for whatever parts you find least enjoyable to be removed from your job description? You have a position of strength here. Worth a try to use it, right?

Thanks for your thoughtful reply. Yes, mathematically it makes no difference. This year I have been fully funding a 403b and a 457b plan and the practical effect has been to keep me well within the 12% marginal rate. I've calculated that I can switch to fully funding a Roth 403(b), but to stay within the 12% marginal rate I'd have to contribute at least $7K to the 457 plan. The suggestion about donations is a good one and I will certainly consider it when the time comes.

I don't know that as a university professor I can pick and choose what parts of my job to do, but I do have a lot of discretion. I have to teach, but am given a lot of latitude regarding which classes. I have to do research, but I get to choose what projects. I have to do service, but again, precisely what I do is largely up to my discretion. Our university does allow faculty retiring to cut back to part time teaching, but as I understand it, it would be made in the context of a firm commitment on my part regarding when I will retire. We also have the option of going on sabbatical (one semester at full pay or two semesters at half pay), contingent on a proposal for what the faculty member would do during the time away. I'm thinking seriously of going for a year long sabbatical after I turn 59 1/2, as the half pay option would presumably open up an interesting opportunity to roll over some of my 403b contributions into a Roth IRA.