Should I convert my 403b to a Roth?

[Guest mjq]

I'm 36 years old, just terminated employment with a non for profit hospital and have $16K in the 403b plan. I intend to return to work at another non for profit hospital in 7-10 years.

Should I keep my $16K within the 403b or consider rolling it into an IRA then into a Roth and paying the taxes now?

I'd appreciate any thoughts you might have.

[Guest Yanikoski]

Rolling over to an IRA will give you some additional investment options, including the ability to manage the investments yourself, if you so choose. If you are happy with the investment you already have, you might as well keep the money in the 403(b) account. If you do wish to roll it over, make sure there is not going to be a penalty (surrender charge) for closing out the existing contract.

Converting to a Roth is another reason for doing an IRA rollover. There are a number of considerations, but for most people, the overwhelming most important one is whether they will be in a higher tax bracket when they take the money out than they are now. If you are in a higher tax bracket now, it makes sense to stick with what you have, instead of paying taxes now. If you are in a lower tax bracket now, it makes sense to pay the taxes and let your future be tax-free. If the tax brackets were exactly the same, it would make no difference (mathematically) which option you chose.

Of course, you don't really know whether you will be in a higher tax bracket when you take the money out. It's not just a question of when you will be taking it (after retirement, or possibly before retirement for some special need) and what your own taxable income will be at that time. It is also a question of what Congress will do over the next several decades. A lot of us think that tax rates are about as low now as they will ever be, because Congress can't be fiscally irresponsible forever. But even so, your income could be lower in retirement than it is now, and that could more than offset future tax rate increases.

In general, the advice we usually give people is that since one does not really know what one's future tax rates will be, the most rational strategy is to keep some money in 403(b)/IRA-type accounts, and some money in Roth-type accounts. This not only hedges your bets, it also gives you options when you are retired -- for example, withdrawing taxable money up to the point where it would kick you into the next tax bracket, and withdrawing Roth money beyond that point.

[jquazza]

I beg to differ on your math. Investment earnings in a Roth IRA are tax free whereas on a 403(b) or Traditional IRA, they are only tax deferred, so, in a Roth, you will pay 0% taxes on the earnings while on the other vehicles, you will pay taxes on the earnings based on your tax bracket. If you stay in the same tax bracket, you therefore have to consider the potential earnings of the taxes you paid upfront in a Roth IRA versus the tax free earning potential.

If you're not going to need the money until retirement, considering your age, say in 25-30 years, chances are you would be better in a Roth.

[Guest Yanikoski]

If you actually do the math, you will see that mine is correct.

To simulate the 403(b) or any pre-tax account, assume that $X is a pre-tax amount, it goes directly into an account, earns any rate of interest (or any pattern of different rates of interest), and is, at some future date, withdrawn and taxed at t%. Call the after-tax remainder, $A.

To simulate a Roth account, assume the same starting value of $X, and tax it at the same tax rate as the pre-tax account, that is, at t%. Put the remaineder in the account, at have it grow at the same rate(s) of return as you assumed for the pre-tax account. At the end of the same period of time, the account will be worth $B.

No matter what values you choose for $X, t%, and the rate(s) of return, $A = $B. Always.

This may seem counter-intuitive, but it is correct, and I'll pay you $100 if you can come up with a valid counterexample based purely on these factors. I do acknowledge in advance that there are differences that result from different tax treatment of early withdrawals and required minimum distributions.

But as I said in my previous post, the overwhelmingly most important variable is whether t% changes over time. Most likely it will...but in which direction?

[WDIK]

I'll pay you $100 if you can come up with a valid counterexample based purely on these factors.

Is this a corollary to "Pascal's Wager"?

[mbozek]

You are missing the obvious - the comparison is between apples an oranges. In a Roth the employee has already paid income tax on the contribution so the Roth calculation begins with less funds than the 403(b). Employee in the 20% tax bracket can invest 100 in a 403(b) annuity but only 80 in a roth after taxes on the comp are taken out. During deferral the net amt invested in the roth will be less than the amount in the 403(b) annuity because of this difference. But the 403(b) distributons must commence at 70 1/2 and tax paid while the Roth can be deferred during both the life of the owner and spouse and paid over the lives of the beneficaries. At some point the amt available in the Roth will exceed the net amt available from the 403(b) annuity after taxes are paid. You also ignore the fact that the marginal rates of taxation on a lump sum at distribution will be greater than than the tax rate on the roth at the time of deferral. One variable which cannot be predicted is future tax rates on the amount of the 403(b) distributions.

[Guest Yanikoski]

You're right, to a point.

If you are NOT bumping up against the pre-tax contribution limit, then the pre-tax and the Roth account are, as I maintain, mathematically equivalent in the main features of their taxation. If someone IS bumping up against the pre-tax contribution limit, then your point is very well taken, and the Roth concept gives you the ability to shelter more income from taxes. I have to agree, that for people eligible for both IRA and Roth IRA accounts who are frustrated at the relatively low contribution limits for those accounts, the Roth is clearly the better deal. But for people looking at IRA-to-Roth conversions, or (after 2005) at Roth 401(k) or 403(b) accounts, this is usually not an issue, and the now-vs.-later tax rates are the primary deciding factor.

As for tax rates on withdrawals, only a fool (or someone with a desperate need for substantial amounts of cash) liquidates their pre-tax account all at once. In the unusual case where this is necessary, though, you are right that the tax is likely to be at a higher amount than it would be otherwise. But even this higher tax bracket might be lower than the current tax bracket -- especially for someone making enough money so that they can afford to exceed the current limits on 403(b) plans.

I hope I am not giving the impression that I am against the Roth concept. I think it's great and I encourage people to take advantage of it. There are a lot of people out there, though, who overstate (or over-generalize) it's advantages. It's not best for everyone, and I still maintain that for most people, a combination is the smart strategy in the long run.

[jquazza]

You don't have to pay the taxes with the IRA assets. Take a $20k distribution from an IRA, roll 20k into a roth, pay the taxes with your other savings... watch it grow tax free.

Is your answer still the same?

[WDIK]

If you count the "other savings" in one scenario, you have to factor them into the other scenario as well. It doesn't matter which pocket I take the money from to buy a pack of gum, I've still got 40 cents less overall.

[jquazza]

Okay, I’ll illustrate with an example:

Assume 20k in an IRA, rate of return 10%, tax bracket 28% for 5 years:

IRA: After 5 years, balance is $32,210.20 –$9,018.87 (taxes) = $23,191.33

Invest the $5,600 would pay in taxes on the Roth at same rate of return and tax bracket = $7,927.97

Total: $31,119.30

Roth IRA: $32,210.20 tax free

My point is there is a difference, which would only get larger as time and earnings increase.

[mbozek]

Even for someone who is not at the pre tax maximum the figures are not mathematically equivalent because of the additional time for compounding without income tax by a Roth results in a residual value which is higher than a tax deferred account after taxes are taken out.

example:

Employee age 30 in 20% tax bracket defers $100 @6% for 40 years in a 403(b) plan which will be worth $1028.57 at age 70. Assume employee takes distributions over 25 years @6% which will yield an annual payment of 58.22 or 46.57 after 20% tax is paid. Total net paid to employee is 1164.25 (25 x 46.57).

If employee makes same contribution to Roth there will be only $80 to invest after 20 is removed to pay tax but distribution can be deferred during life of employee and spouse. Assuming an additional 20 years of deferral the Roth account will be worth $2639 at the death of the spouse. (80 @ 6% x 60). A 25 year payout to a beneficary @ 6% will yield an annual payment of $149.37 which is exempt from tax. Total amount paid to beneficiary is $3734.25 (25 x $149.37).

The reason your example shows no difference between the tax deferred and Roth accounts is that it assumes same deferral period for both the Roth funds and the tax deferred account which eliminates the significant advantage of the tax free compunding and payout of the Roth over a longer period than the tax deferred account. In other words the comparison between a roth and a tax deferred account is apples to oranges because the Roth provides a greater net value to a taxpayer who is willing to defer use of the funds for a longer period than what is allowed for a tax deferred account.

[Guest Joel Lee]

Chuck,

I think its time to pay-up!

[Guest Yanikoski]

I think we're in agreement here on the math. I did specify that the time period had to be the same, as I was trying to rebut jquazza's objection.

As I mentioned in my first post, there are other considerations besides the tax bracket. I merely said that for most people, that is the determining factor in the decision. For people wealthy enough so that they don't actually have to use their retirement savings for their retirement, and they can just hold onto it indefinitely, the Roth is, for the reasons mbozek gives, likely to be the much better choice. There is only a small percentage of the population that falls into this category, however.

I hope that everyone on this web site is among that select group.

[WDIK]

I should have read jquazzas first post more carefully before commenting on his second post. Unless I'm missing something, I must agree with his comment that the tax free accumulation of earnings inside the Roth makes a difference.

Traditional IRA

----------------------------------------------

** Income *IRA Cont *Cum Val Tax Paid

Y1 4549.93 3275.95 *3275.95 356.71

Y2 4549.93 3275.95 *6879.60 356.71

Y3 4549.93 3275.95 10843.39 356.71

Y4 4549.93 3275.95 15203.68 356.71

Y5 4549.93 3275.95 20000.00 356.71

Y6 ***0.00 ***0.00 22000.00 **0.00

Y7 ***0.00 ***0.00 24200.00 **0.00

Y8 ***0.00 ***0.00 26620.00 **0.00

Y9 ***0.00 ***0.00 29282.00 **0.00

10 ***0.00 ***0.00 32210.20 **0.00

**************Tax on

Savings Earnings Earnings Cum Val

Y1 917.27 **0.00 **0.00 *917.27

Y2 917.27 *91.73 *25.68 1900.57

Y3 917.27 190.06 *53.22 2954.68

Y4 917.27 295.47 *82.73 4084.68

Y5 917.27 408.47 114.37 5296.05

Y6 **0.00 529.60 148.29 5677.36

Y7 **0.00 567.74 158.97 6086.13

Y8 **0.00 608.61 170.41 6524.33

Y9 **0.00 652.43 182.68 6994.09

10 **0.00 699.41 195.83 7497.66

Total at Distribution: 32,210.20*.72 + 7,497.66 = 30,689.00

----------------------------------------------------------------------

Roth IRA

----------------------

**Income Tax Paid Roth Cont Cum Val

Y1 4549.93 1273.98 3275.95 *3275.95

Y2 4549.93 1273.98 3275.95 *6879.79

Y3 4549.93 1273.98 3275.95 10843.39

Y4 4549.93 1273.98 3275.95 15203.98

Y5 4549.93 1273.98 3275.95 20000.00

Y6 ***0.00 ***0.00 ***0.00 22000.00

Y7 ***0.00 ***0.00 ***0.00 24200.00

Y8 ***0.00 ***0.00 ***0.00 26620.00

Y9 ***0.00 ***0.00 ***0.00 29282.00

10 ***0.00 ***0.00 ***0.00 32210.20

You can tie in the $1,521.19 difference if you accumulate with interest the taxes paid on the "savings"

Y1 0.00

Y2 25.68

Y3 81.47

Y4 172.35

Y5 303.95

Y6 482.64

Y7 689.87

Y8 929.26

Y9 1204.87

Y10 1521.19

**Edit to try and line up the tables** Okay, I give.

[jquazza]

I feel vindicated, thank you WDIK!

[Guest Yanikoski]

Hi, WDIK --

The only reason this works is that you have picked an amount greater than the maximum IRA contribution to start with. This is basically mbozek's point (which is a valid one): if you are starting with fresh contributions, you can tax shelter a greater amount with a Roth account than with a comparable non-Roth account. If you had compared the Roth IRA to a 403(b) account, however (which was the original question), the "tax paid" on the IRA would be zero in the early years, and the final results would be the same for both accounts.

By the way, for those of you who are interested, you can play with Roth vs. Pre-tax illustrations using our RetirementWorks software -- there is a fully functional demo version on our web site (www.StillRiverRetire.com). It takes into account all of the issues that have been raised here by all of you, plus some others. If you like, it will even do a Monte Carlo analysis of which plan is likely to come out better in a given case (given your favorite assumptions) and recommend a split between pre-tax and Roth accounts based on the results.

[WDIK]

Chuck:

We are in agreement. It looks like you are the only one who actually stayed focused on the original post. I need to make it a habit of reviewing the entire thread rather than just commenting on the newest post. It just goes to show that even when I'm right, I'm often wrong.

[Guest Yanikoski]

WDIK,

Your post was very instructive. If we all end up in agreement, then we're doing OK.

Since the discussion is going, though, I'm wondering whether anyone else out there worries that Congress could, somewhere down the road, impose taxes on Roth accounts. I remember this question being raised when the Roth IRA was first invented, but have heard little discussion of it since.

With the federal budget apparently out of control, and with the Baby Boomers' retirement making the long-term prospects rather dim, is it not at least conceivable, arguably even probable, that 30 or 40 years from now Congress is going to be grasping at any mechanism it can to raise additional revenues in the least painful way? If so, might Roth accounts not be a likely target? I could easily imagine, for instance, that Congress might legislate that a portion (maybe a third) of the GAIN in a Roth account should be taxed at ordinary rates, or that the whole of the gain should be taxed at capital gains rates. Or at least that Roth accounts would be subject to minimum distribution rules, so that the tax shelter cannot be continued as long.

About 25 years ago I read an article explaining how the Social Security retirement fund would enter into a surplus eventually, and the author worried that Congress would spend that surplus and cause an eventual disaster for Social Security. My reaction at the time was: surely, no Congress would be that stupid. Well, now that I see that Congress can not only be stupid, but militantly stupid, I no longer trust them to do the smart or fair thing in any particular case. Should we feel confident that Roth accounts are permanently exempt?