403(b) Story: Roth IRA vs 403(b)
by Susan Johnston Taylor
If you work for a public school system, a ministry, an institute of higher education or another nonprofit, then you may have the option to set aside money for retirement using an account called a 403(b). This is named for a section of the tax code. All income earners (or spouses of income earners) also have the option to save for retirement in a Roth IRA.
So, which one makes more sense? We’ll explain how they work and the differences below.
A Roth IRA allows you to contribute post-tax money to a retirement account. Once you reach age 59 ½, you can withdraw your contributions and earnings without paying any additional income tax. You can come open a Roth IRA instead of or in addition to an employer-sponsored retirement plan such as a 403(b).
- Ability to withdraw funds in certain situations. Because they are funded with after-tax money, you can withdraw the amount that you invested into a Roth IRA penalty and tax-free at any time. So if you invested $5,000, you can withdraw that $5,000 at any time. IN addition, the earnings in your Roth IRA can sometimes be used for special expenses like a down payment, educational or certain emergency expenses. These early Roth IRA withdrawals have special rules. For example, you must have your account open at least five years, but this can be a huge benefit of a Roth, especially for teachers and other nonprofit workers who don’t have large incomes to begin with. A 403(b) may allow you to borrow funds in certain circumstances but not all employers allow 403(b) loans.
- Low fees. With a Roth, you’re not limited to whatever provider or investment options your employer chooses. You can shop around and choose a brokerage that offers a low-cost Roth and investment choices that you understand.
- Greater transparency. Because 403(b) plans are not bound by the same rules as 401(k)s, many people complain that the fee structure and investment options for 403(b)s are hard to understand. That’s gradually changing as employees demand better 403(b) options, but many Roth IRA providers already provide clear fee disclosures and investment options.
- Lower contribution limits. For tax years 2016 and 2017, you can contribute up to $5,500 per year (or $6,500 if you’re over age 50 by the end of the year). This is a great way to start saving. But if a Roth is your only retirement savings vehicle, it may provide enough income in retirement to bridge the gap between your expenses and Social Security income.
A 403(b) account allows you to contribute pre-tax money your retirement savings and defer taxes until you withdraw those funds (tax-wise, it’s the inverse of a Roth IRA).
While 403(b) accounts are essentially the teacher, minister or nonprofit worker’s equivalent of a 401(k) retirement account, participants do not get some of the same protections as their corporate counterparts. For instance, not all 403(b) plans are not subject to The Employee Retirement Income Security Act of 1974 (ERISA), which requires plan overseers or employers to act in participants’ best interest.
However, if your employer offers a low-cost 403(b) or offers to match some of your contributions, you might decide to save in a 403(b) plan despite some of the potential drawbacks.
- Higher contribution limits. Per the IRS, employees can contribute up to $18,000 per year to a 403(b) for tax year 2016 and 2017. Those over age 50 can make an additional catch-up contribution of $6,000 each year. Depending on your salary, you might not be able to contribute up to this limit, but the more money you save for retirement (especially early in your career), the more that money can grow over time and the more financial security you’ll have in retirement.
- Potential for employer match. Not all employers offering 403(b) plans will match employee contributions. But if yours does (for instance, they might match 50 percent of the first $5,000 you contribute each year), consider contributing at least enough money to maximize your match. Eighty percent of ERISA-qualified 403(b) plans offered employer contributions in 2013, reports a study released by BrightScope and the Investment Company Institute. You will not get an employer match in a Roth.
- Potentially better tax treatment. Depending on your income and situation, you may be in a lower tax bracket once you retire versus when you were working. So, paying taxes on money in a 403(b) when you withdraw it in retirement may be cheaper than paying taxes on income before you contribute it to a Roth. However, the tax code can change over time, so it’s very hard to predict which type of account will offer a more favorable tax treatment.
- Often have confusing investment options. Because the nonprofits, schools and other employers providing 403(b)s tend to have small staffs, the 403(b) market has not be an attractive one for many investment companies. Some 403(b) participants say the investment options and the accompany explanations can be overly confusing.
- High fees are common. The investments inside of 403(b) accounts can be complicated and riddled with fees. In fact, a 2016 report released by human resources advisory company Aon found that 403(b) participants collectively face $10 billion in excess fees every year. A low-cost Roth IRA might offer lower fees.
Of course, you don’t have to choose between a Roth IRA or a 403(b). If you have the funds, you can contribute to both. That would mean some of your retirement funds would be dispersed tax-free and some of it would be subject to taxes. Depending on your tax bracket in a given year once you’re in retirement, you could choose whether to pull money from your Roth or your 403(b). Some people use a Roth to supplement their 403(b) or 401(k) savings.
Understanding the differences between these retirement accounts can help you make a more informed decision between them. However, it’s better to pick a strategy and start saving for retirement now than let indecision keep you on the sidelines and postpone your financial goals.