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Why everyone keeps advising Roth 403b vs traditional one?

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I am just starting with my 403b and I wonder why everyone keeps advising Roth 403b vs traditional one? Is it because most people expect taxes to go up when we retire? Are there any other reasons?

I already have Roth IRA, so I was thinking about opening traditional 403b to tax diversify my accounts. Am I doing it wrong?

Thanks!

 

 

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WIC,

I copied and pasted the info below from a website. It should answer your question. I have both type of accounts. It mentions 401k but it would equally apply to a 403b

 

The basic difference between a traditional and a Roth 401(k) is when you pay the taxes.  With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your money—both contributions and earnings—grows tax-deferred until you withdraw it. At that time, withdrawals are considered to be ordinary income and you have to pay Uncle Sam his due at your current tax rate; there may be state taxes as well. (With certain exceptions, you'll also pay a 10 percent penalty if you're under 59½.)

With a Roth 401(k), it's basically the reverse. You make your contributions with after-tax dollars, meaning there's no upfront tax deduction. However, withdrawals of both contributions and earnings are tax-free at age 59½, as long as you've held the account for five years.

So it mostly comes down to deciding when it's better for you to pay the taxes—now or later. And that depends a lot on your timeframe as well as what the future may look like.

Weighing now versus later

A tax deduction now can seem like a pretty good deal, but you have to think ahead. Under today's tax rules, every dollar you withdraw from a traditional 401(k) could be reduced 20 or 30 percent (or more!) come retirement time, depending on your tax bracket. That means that you’ll have to save that much more to fund your retirement cash flow. 

If you're young and confident that you'll be earning more and in a higher tax bracket in the future, the Roth 401(k) may be a good choice. But even if you're in your 40s, 50s or 60s, you might want to take a close look at the Roth option. 

Why? Because even if you end up in a lower income tax bracket when you retire, withdrawals from your traditional retirement accounts could potentially kick you into a higher tax bracket. That could increase your tax bill—including potential taxes on Social Security benefits—and may reduce your disposable income. Higher taxable income could also increase the costs of your Medicare B premiums in retirement. So giving up the tax deduction now may be well worth having tax-free withdrawals later on. 

Hedging your bets with both

The good news is that when it comes to a traditional vs. a Roth 401(k), you don't necessarily have to make an all-or-nothing choice. You may be able to have both, and decide year-by-year where you want to make your contributions. 

 

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Tony's info is good.  I don't know who "everyone" is who advises Roth over traditional.  That isn't the case on this board.  Sometimes people advise Roth for people in the early stages of their careers, because their current tax rate is relatively low, and the benefits of compounding tax-free over a long period of time are great.  On the other hand, if the immediate tax deduction will allow or incentivise you to contribute more into a traditional IRA or or 403b, that's a good argument for the traditional account. 

As I see it, your choice to diversify between both a Roth and a traditional account is an excellent one, since both are good options, and there is no way to know which is optimal; that would require knowing what the tax laws will be decades from now.

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To decide between Roth and Traditional you have to understand the progressive nature of our tax code. Let's use the 2020 tax code for a hypothetical single person who has the most simplistic tax situation imaginable...

  • The first $12,400 they earn is taxed at 0% due to the standard deduction.
  • The next $9,875 they earn is taxed at 10%
  • The next $30,250 they earn is taxed at 12%
  • The next $45,400 they earn is taxed at 22%
  • ...and so on until they reach the 37% tax bracket where every additional dollar is taxed at 37%.
A lot of people incorrectly believe that if they're in the 22% bracket then all of their income is taxed at 22%. In reality, every dollar you earn has its own tax rate. Your effective tax rate is equal to your total tax paid divided by your total income. Your highest tax bracket is called your marginal tax rate.
 
Traditional vs Roth Qualitative Explanation
When you contribute to a Roth account those dollars are taxed first, which is based on your (high) marginal tax rate. When you eventually withdraw that money, no taxes will be owed since they were already paid.
 
When you contribute to a Traditional account those dollars go into the account tax-free, which means you get to avoid that (high) marginal tax rate. When you eventually withdraw that money, that money will be taxed but it'll fill up your lower tax brackets before you get to your highest tax bracket. This is why the Traditional account is very likely to be superior for most folks in most situations.
 
Traditional vs Roth Quantitative Explanation
Just for fun let's put this into mathematical terms. Suppose you invest $P dollars in each type of account for N years and you get an annualized 7% return:
 
Traditional Value = $P * (1.07)^N * (1 - TaxRateInRetirement)
Roth Value = $P * (1 - TaxRateWhileWorking) * (1.07)^N
 
You can see there are common terms in those equations so let's get rid of them:
 
Traditional Value = 1 - TaxRateInRetirement
Roth Value = 1 - TaxRateWhileWorking
 
We know the TaxRateWhileWorking is equal to your (high) marginal tax rate while you were working. We know your TaxRateInRetirement will be based on that money filling up the lower tax brackets during retirement. So if TaxRateInRetirement is less than your TaxRateWhileWorking then the traditional account will generate more value.
 
What if my retirement income is greater than my income while working?
First of all, if you fall into this case then you've got nothing to worry about in retirement, but it is true that a Roth may become more appealing since you'll find yourself in higher tax brackets in retirement. However, even in this case a 100% Traditional may still be better than 100% Roth because you'll get to fill up the lower tax brackets even if your marginal tax bracket is higher.
 
The most important thing to say about this case is that you made a big mistake while planning for retirement because you oversaved significantly. You would have been better of retiring earlier or spending more money during your working years.
 
What if other income fills up my lower brackets during retirement?
If you have social security income or income from a pension then that'll fill up your lower brackets first, making a Traditional less appealing. Notice that I didn't say it makes a Roth superior. The odds are the effective tax rate associated with your Traditional withdrawals will still be appreciably less than your marginal tax rate while working because you will likely still take advantage of some of the smaller tax brackets and your marginal tax rate in retirement likely won't be higher than your marginal tax rate while working anyways. This scenario just reduces the appeal of Traditional, it doesn't eliminate it.
 
What about Roth conversions?
Suppose you saved a bunch of money in a Traditional and when you retire you aren't taking social security or any other forced income like pensions. Well you can convert that traditional money to a Roth account, which means the first group of dollars won't be taxed at all, the next group of dollars will be taxed at the lowest rate, and so on. This is a best of both worlds scenario, where you can avoid your (high) marginal tax rate while working and pay rock bottom tax rates to convert it to a Roth later in life. This increases the appeal of using Traditional accounts.
 
What if tax rates change?
I commonly see people destroy their portfolios by making decisions based on their personal politics. My advice to you is to simply not engage with this thought pattern at all. Taxes may go up when you retire or they may not. If you indulge in this scenario it is often the Liberals who are most apt to increase tax rates, but remember their philosophy is about raising taxes disproportionately for the wealthy. If you're wealthy you'll be fine regardless. If you're not wealthy, then even in this scenario (which may or may not come to pass) your taxes may not increase too much. Again, just don't even engage in this line of thinking. Nobody knows nothing as they say.
 
My Thoughts
I view this Traditional vs Roth discussion as an optimization that ultimately won't have a huge impact on you. If you haven't already figured out how to minimize your spending, maximize your saving, and reduce costs to as close to 0 as possible then you shouldn't even be thinking about Traditional vs Roth. However, if you begin to think about Traditional vs Roth just know that nobody can give you a definitive answer because it depends on future tax rates, market performance, when you'll die, when you'll take SS, if you have a pension, if your pension will be cut due to poor funding, and so on.
 
Most people in most scenarios are probably better off using a Traditional account for the reasons described above. In an ideal world you'd invest exactly enough in a Traditional account such that every dollar you withdraw is taxed less than or equal to your marginal tax rate while earning that initial investment and every other dollar should go to a Roth account. Again, nobody can tell you that magical number because we can't see the future. Another rule of thumb, if you're in the beginning of your career and making almost nothing, but you'll quickly climb the income tax brackets (like a young doctor for instance) then a Roth is your friend early on...or if you're temporarily in a low income situation (maybe you got fired, maybe you took a couple years off to raise a kid, whatever) then a Roth may also be great for you. But generally, I think Traditional is best. If you want to address these unknowns by investing in both, that sounds reasonable to me too.

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On 7/28/2020 at 7:00 PM, EdLaFave said:

To decide between Roth and Traditional you have to understand the progressive nature of our tax code. Let's use the 2020 tax code for a hypothetical single person who has the most simplistic tax situation imaginable...

 

Oh wow, I have never seen so detailed comparison between Roth and traditional, including math, thank you very much! Makes a lot of sense! Thank you guys all for all the points, I am so glad I found this forum. Yeah, it is hard to predict the future, so I think the safest approach is to contribute more to traditional accounts and maybe invest a bit to Roth as well, just in case.

By the way, I have discovered an interesting thing about 403b and 457b which I did not know about. Maybe it is a public knowledge here. Some providers allow creating nested brokerage accounts within 403b and 457b which dramatically expand the type of investments allowed in these accounts. They almost become like IRAs, but with much higher contribution limits. Amazing deal in my opinion.

 

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