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Convince Me To Convert A Traditional 403b To A Roth One?

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So here I am, with the kids grown, the divorce finalized, and at age 52, the sight of retirement in the not-too-distant future. I've got a defined-benefit state pension that will pay about $28K/yr when I retire, and about $100K of 403b's, 457s, Roth IRAs, and POC ( <-- plain ol' cash), with many more 10's of K to be added to that pile in the next few years. I should be in good shape to continue my standard of living when I retire, but I might as well maximize my benefits, right?

 

OK, so now I discover that 403b's also come in Roth versions, and (if I understand correctly), old 403b's can be Roth-ified by paying the income taxes on them. That means I have to figure out whether that makes sense to do.

 

On the surface, the Roth plans and traditional plans should be equally attractive: if you are in the t% tax bracket, and the 403b asset appreciates at p% per year for n years, you can go traditional (each dollar today grows to (1+p)^n, on which you will pay taxes upon distribution, leaving you with (1+p)^n (1 - t) of spending money), or you can go Roth (each dollar today becomes just (1-t) to invest, but that grows to

(1-t) (1+p)^n , all of which is yours to spend upon distribution); but thanks to the commutative property of multiplication, these numbers are equal, and the plans are equally good. [Perhaps I should have said at the outset that I'm a mathematician? ...]

 

Yet the details of the plans, and of my situation, will make the plans unequal. But I don't understand all the ins and outs very well, so I ask here for the pros to tell me what considerations I have missed.

 

Reasons to stay traditional:

1. It's easier: I'm already signed up for a traditional 403b :-) And I'm sure a trad-to-Roth conversion must involve a lot of paperwork

2. Conversion requires cash to pay income taxes. I can get cash by lessening my current 403b deductions, but with the markets poised to make big recoveries "soon", this is not a good time to be out of the market.

3. My heirs will have a bigger pile (if I don't spend it) because there will be a factor of (1-t) missing in my analysis above.

4. 403b distributions are free of state income taxes: that is, since I'm in Illinois where state income taxes are 3% of income, the first factor called 1-t above is .03 smaller than the second factor called 1-t

 

Reasons to switch to Roth 403b's:

1. I will soon move to Texas, with 0% income tax. This undoes argument #4 above, and in fact if I was wrong about state taxes on 403b distributions, my time in Texas would be a good time to convert. (Note: I have family in NJ and can imagine retiring there. I hear they DO tax 403b income. True?)

2. Perhaps my income tax bracket will rise in the future, so better to apply the factor of (1-t) now. (Aha! A violation of the commutative law? :-) ...) I don't know how likely this is: I am in the 15% tax bracket and am extremely unlikely to move into either the 10% or 25% bracket any time in my life, so the only likely risk is that the political climate would call for changing the brackets.

3. I understand the Roths have rules allowing non-penalty withdrawals ahead of retirement (at age 59-1/2, after 5 years) That could provide flexibility I don't have with traditional plans.

4. The 22K/yr limit on 403b's effectively allows me to invest more per year with the Roth plan than traditional plan: I can earmark 26K/yr for tax advantaged saving by paying 15%+3% income taxes (US+IL) now, leaving 22K to invest in a Roth plan, which I can receive tax-free upon retirement. (The importance of this argument is lessened because the 22K 403b and 22K 457 limits together exceed the amount I can set aside and still be able to eat every day. But maybe if I win the lottery...)

 

I started a Roth IRA last year, not being wildly convinced that this was a better idea than putting more

into my 403b, but the amounts are small (6K/yr cap) so I figured it would be a token move to diversify my holdings a bit. The Roth 403b has a 22K/yr limit, though, so now we're talkin' real money.

 

So ... what have I misunderstood about the options? What other arguments have I overlooked?

 

BTW my employer offers the same plan providers for both 4013b plans, so it's not like I have

better investment options with traditional (vs Roth) or anything like that.

 

I look forward to learning more about the subtleties of 403b''s ...

 

dave

 

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Your questions are not easy to answer because no one knows the future and the details of your personal situation now and or the future. The general consenses is to cover all your bases. Have some money in a tax deferred account ,some money in a regular taxable account using tax managed funds and certainly take advantage of the roth 403b as well. I recommend a 33% split in each category.

 

I'm not an expert though. Just telling you what I am doing or trying to do.

 

 

 

Tony

 

I should have mentioned too that no one knows what the government will do either and thats a worry. That leads me to think you might be better to go 100% roth 403b. That way the money is yours free and clear should taxes go up.

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As Tony says, nobody knows about the future, including tax-rate-wise (for example, what happens if the gov't adopts a consumption tax to replace or augment the income tax?). In general, it seems to me, it is better to defer paying taxes on retirement funds for as long as possible, since your money continues to work for you until you withdraw it. Unless you're in an unusual situation that warrants it--such as a year of no income in which your tax rate for the conversion would be extremely low, plus you can afford to pay that tax from non-retirement monies--it's hard to see the logic in rolling your 403b into a Roth and taking a big tax hit now. However, if you can afford to contribute the annual maximum to the Roth, it seems reasonable to diversify your tax-privileged holding between the two sorts of account as you go forward. If you can't manage to max it out, though, my tendency would be to stay with the traditional account, so that you can put a larger dollar amount away, and just deal with the eventual taxes year by year, during retirement. The traditional 403b is still a good deal.

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You need to answer the following questions before converting to a Roth:

 

1. what tax benefit will you gain by converting to a Roth? If as you believe, you will be in the same bracket (15%) in retirement then there is no benefit to converting to a Roth because all the Roth does is prepay the taxes that would be paid on the benefits in retirement.

 

2. How will you pay the taxes on the conversion? Paying the taxes from the converted amount is self defeating because it leaves less to compound in the tax free Roth account. Since you are only 52 if you pay taxes with the retirement funds you will be subject to an additional 10% tax on the amount used to pay the taxes.

 

3. If you pay taxes with non retirement funds will you lose money by not being able to invest the funds? Remember the cost of converting to a Roth is not just the taxes paid but the future value of the investment gains that would have accrued on the taxes.

 

4. If you convert to a Roth will you lose tax deductions that you would otherwise benefit from because your income is too high? Will you be better off converting in 2010 when you can defer the taxes due for converting until 2011 and 2112.

 

5. How long will you be able to defer before taking distributions? The primary advantage of the Roth is the ability to defer commencement of payment until you die which could be 30-40 years. If you are only going to defer for 10 years then you will be better off with a traditional IRA where you will not be taxed until you receive the benefits and you will not be paying any taxes up front.

 

Despite what some people believe the US congress will never adopt a consumption tax because it is regressive since poor people would be taxed all of their income (instead of getting tax credits under the current system)and will only benefit rich people who will no longer have to pay an income tax.

 

The analysis for contributing to a roth 403b is the same as converting.

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Correct me if I am wrong, but you are not able to convert a 403b to a Roth 403b.

 

Conversions to Roth IRAs are allowed, but you are only 52, and still employed. You do not have a qualifying distribution event, so your 403b money is stuck as is.

 

 

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Correct me if I am wrong, but you are not able to convert a 403b to a Roth 403b.

 

Conversions to Roth IRAs are allowed, but you are only 52, and still employed. You do not have a qualifying distribution event, so your 403b money is stuck as is.

 

 

According to his post he plans to move to TX next year which will result in his termination from his present state job in IL where he has a 403b.

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Correct me if I am wrong, but you are not able to convert a 403b to a Roth 403b.

 

Conversions to Roth IRAs are allowed, but you are only 52, and still employed. You do not have a qualifying distribution event, so your 403b money is stuck as is.

 

 

According to his post he plans to move to TX next year which will result in his termination from his present state job in IL where he has a 403b.

 

Ah, thanks for the correction. I see that now under point #1.

 

 

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Thanks to all who replied. It sounds like it's not an easy, overwhelming case for one option or the other,

but I do like the idea of having some tax-deferred and some tax-paid retirement funds, to give me

more options in later years.

 

I do feel obliged to respond to this point:

 

> If you pay taxes with non retirement funds will you lose money by not being able to invest the funds?

> Remember the cost of converting to a Roth is not just the taxes paid but the future value of the

> investment gains that would have accrued on the taxes.

 

This feels so right but I think it's wrong! Suppose e.g. you have $1700 in a traditional IRA and you think

you might convert it to Roth. You know you'll need $255 to pay off the taxes. You worry that maybe

you would be better off leaving the $1700 as a traditional IRA and investing the $255 in, say, the same

fund as the IRA (some stock-market mutual fund, maybe). You have a crystal ball that reveals that

the market will grow by say 180% by the time you retire. Shouldn't you invest the $255?

 

Answer: no, it doesn't matter. If you convert the IRA, you have to sit down now and write a check

to Uncle Sam for $255. Bummer. But you have $1700 which will grow to be $4760, and it's all yours

when you retire. Now, the alternative leaves the IRA as traditional, so you can fill out the same check but

use it to open a little Roth just with that $255. Now your $1700 grows to $4760 again but you owe 15%

taxes on that (leaving 4046), and meanwhile the $255 Roth has grown to $714 tax free. Total after

taxes: 4760 again! Or maybe instead of opening a mini-Roth with the $255, you say to your self,

"hey, if I can spare $255 out of my checking account, I can instead elect to divert $300 from tomorrow's

paycheck to my traditional IRA, making its total $2000." (You feel you can do this because you weren't

going to see those $300 anyway -- only $255 after income tax) Then your traditional-IRA with $2000

in it will grow to $5600; 'course then you have to pay 15% tax on that before spending it: that

will leave $4760 AGAIN!

 

So the differences between traditional and Roth plans is going to be subtle: it depends on people having

CHANGING tax rates, or in some cases depends on inheritance rules, contribution limits, withdrawal schedules, etc. -- important but comparatively technical aspects of the decision.

 

And trust me, it really is all because of the commutative property of multiplication :-)

 

dave

 

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And trust me, it really is all because of the commutative property of multiplication :-)

 

dave

 

 

Dave,

Great question and discussion.

I have a question: What if your assumption of 180% market increase was not so generous and was only 65%, that’s 5% over 13 years (I am assuming that you might be applying this to your situation and assuming you will work another 13 years until you retire at 65).

If I remember my math classes, commutative property of multiplication works in the negative too, what if there were negative returns in the market over an extended period of time?

Given these two scenarios, would your analysis and conclusions remain the same?

Steve

 

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Regardless of the market performance, if all else is equal (investment performance, taxes before/after) then you will not find a net gain in either the Roth or the Traditional as shown in Dave's math.

 

You will only find a gain if there is a change in circumstance - if taxes are higher/lower in the beginning or the end. Or if there was an actual difference in performance between the choices in each plan.

 

Dave, you're spot on with your evaluation :)

 

 

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Thanks to all who replied. It sounds like it's not an easy, overwhelming case for one option or the other,

but I do like the idea of having some tax-deferred and some tax-paid retirement funds, to give me

more options in later years.

 

I do feel obliged to respond to this point:

 

> If you pay taxes with non retirement funds will you lose money by not being able to invest the funds?

> Remember the cost of converting to a Roth is not just the taxes paid but the future value of the

> investment gains that would have accrued on the taxes.

 

This feels so right but I think it's wrong! Suppose e.g. you have $1700 in a traditional IRA and you think

you might convert it to Roth. You know you'll need $255 to pay off the taxes. You worry that maybe

you would be better off leaving the $1700 as a traditional IRA and investing the $255 in, say, the same

fund as the IRA (some stock-market mutual fund, maybe). You have a crystal ball that reveals that

the market will grow by say 180% by the time you retire. Shouldn't you invest the $255?

 

Answer: no, it doesn't matter. If you convert the IRA, you have to sit down now and write a check

to Uncle Sam for $255. Bummer. But you have $1700 which will grow to be $4760, and it's all yours

when you retire. Now, the alternative leaves the IRA as traditional, so you can fill out the same check but

use it to open a little Roth just with that $255. Now your $1700 grows to $4760 again but you owe 15%

taxes on that (leaving 4046), and meanwhile the $255 Roth has grown to $714 tax free. Total after

taxes: 4760 again! Or maybe instead of opening a mini-Roth with the $255, you say to your self,

"hey, if I can spare $255 out of my checking account, I can instead elect to divert $300 from tomorrow's

paycheck to my traditional IRA, making its total $2000." (You feel you can do this because you weren't

going to see those $300 anyway -- only $255 after income tax) Then your traditional-IRA with $2000

in it will grow to $5600; 'course then you have to pay 15% tax on that before spending it: that

will leave $4760 AGAIN!

 

So the differences between traditional and Roth plans is going to be subtle: it depends on people having

CHANGING tax rates, or in some cases depends on inheritance rules, contribution limits, withdrawal schedules, etc. -- important but comparatively technical aspects of the decision.

 

And trust me, it really is all because of the commutative property of multiplication :-)

 

dave

 

 

If you are going to be in the same tax bracket in retirement the roth is no better than the traditional IRA and you are out of pocket on the income taxes you paid. If you move to a state with no income tax and convert the roth will be advantageous if you later move to a state with an income tax when you receive the benefits.

 

If you will receive social security benefits and your taxable income is over $25,000 a Roth will benefit you because the income tax on social security will be reduced if you receive benefits from a Roth IRA instead of a taxable IRA.

 

However the Roth benefits from a longer deferral period. If you commence Roth distributions when you retire you will receive less tax free money than if you wait until 70 or 75 to commence distributions. If you convert to a Roth will the increased income eliminate tax benefits you would otherwise be entitled to in the year of conversion?

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It would seem to me that you would want to pay income tax on the smaller portion of your investment.

 

To keep it simple let's say you invest $5000 in Roth and it grows to $10,000. You can get $10,000 tax free since you paid the taxes on $5000 when you invested.

 

Now lets do the opposite.

 

Let's say you put $5000 tax free in a 403b and it grew to $10,000. Now when you withdrawal the money you will be paying taxes on $10,000.

 

In general it is better to pay taxes up front.

 

Hope this helps.

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To keep it simple let's say you invest $5000 in Roth and it grows to $10,000. You can get $10,000 tax free since you paid the taxes on $5000 when you invested.

 

Now lets do the opposite.

 

Let's say you put $5000 tax free in a 403b and it grew to $10,000. Now when you withdrawal the money you will be paying taxes on $10,000.

 

But that's not a comparable situation. If you could afford to invest $5K into a Roth, then at that same

moment you could have invested more in the 403b. For example if you are in a 28% bracket, and you

find you have $5K available to put into your Roth, then you could have directed your employer to put

6944.44 into the 403b without changing your available spending money. (You would reduce your tax

withholding by 28% of this, which is 1944.44, thus decreasing take-home pay by exactly $5K, same as

you did by sending $5K into your Roth.) So over this time period when investments double, your

403b can grow to 13888.88. Yes, you have to pay taxes on it, but the tax bill (in the 28% bracket) is --

wait for it -- exactly 3888.88, leaving you with $10K, exactly the same as with the Roth.

 

So at this level of computation, there is NO DIFFERENCE between Roth and non-Roth options.

Trust me, it really is because of the commutative property of multiplication :-) .

 

There are several caveats which can tip the balance towards either Roth or non-Roth.

1. If you play the numbers with $16K rather than $5K, then in order to get equal payoffs, as indicated

above, you would have to invest more into your 403b than is permitted by law. In that case, choose Roth.

2. I assumed your tax rates now and upon retirement would be equal. If you are wealthy now but will

live frugally then, the 403b is better; if you expect no change in your lifestyle but expect tax rates to

increase (looked at the US deficit lately? ...) then the Roth is better. And what if you move from a state

with state income taxes to one without any, or vice-versa?

3. I just found out I could get Uncle Sam to give me a tax credit for having contributed to my IRA last

year -- but only if my income were a little lower. So I will recharacterize a 2009 Roth contribution as

a traditional IRA, lowering my AGI by a few hundred $$, and pocketing $200 in tax credits.

4. Roths have different rules regarding required minimum withdrawals, nominal age of retirement,

inheritance rules, etc. If you have a lot of money to put into these funds, get the help of a qualified

investment- and tax-advisor.

 

dave

 

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It would seem to me that you would want to pay income tax on the smaller portion of your investment.

 

To keep it simple let's say you invest $5000 in Roth and it grows to $10,000. You can get $10,000 tax free since you paid the taxes on $5000 when you invested.

 

Now lets do the opposite.

 

Let's say you put $5000 tax free in a 403b and it grew to $10,000. Now when you withdrawal the money you will be paying taxes on $10,000.

 

In general it is better to pay taxes up front.

 

Hope this helps.

 

why is it better to pay taxes up front?

 

Doesnt the question depend on whether you will be in a higher or lower bracket in retirement?

 

Using your example, $5000 grows to $10,000 after 10 years at a rate of 7.18%. After calculating opportunity cost (the time value of the taxes paid which could have been invested) if you are in the 25% bracket when you contribute $5000 to the Roth, your opportunty cost on $1250 in taxes paid after 10 years @ 7.18% will be $2500 which when subtracted from the $10,000 withdrawal leaves a net amount of $7500.

 

If you invested in a tax deferred 403b plan that grows to $10,000 in 10 years at 7.18% and are in the 15% bracket when you withdraw the funds your opportunity cost is $1500 for a net amount of 8500 ($10,000-1500) or $1000 more than the amount in the Roth.

 

So the pre tax investment is a better deal because you didnt pay taxes upfront.

 

If you were in the 15% braket at the time the contribution was made to the Roth and at withdrawal the value would be the same, about $8500. $5000 * .15 = 750 tax. Future value of $750 @7.18% * 10 =$1500 which when subtracted from $10,000 leaves a net amount of $8500 or the same as the net amount in the tax deferred 403b.

 

If you are in a higher bracket in retirement the Roth will be the better deal.

 

If you pay taxes upfront you forfeit the opportunity to invest those funds at a market rate of return. Its your choice as to what you think will be the better deal for you.

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