One of the more fundamental financial decisions a person makes is contributing to a retirement plan. In most hospital systems, the retirement plan options are 403(b)s (and 457 plans, although 457 plans technically are not retirement plans). Within retirement plans, a matching benefit is often offered, which leads one to think the sole purpose of the retirement plan is to accept an employer’s match and store money for an eventual retirement. While this may be so, the true value of retirement plans is much deeper: tax deferral.
When you opt in to a retirement plan, you often get to choose traditional contributions or Roth contributions. The decision can have a significant impact on your future. What’s the difference and which one should you do?
A traditional retirement plan allows for tax deferrals of contributions, where the Roth retirement plans don’t. This is what separates the two decisions. Once income is deferred, it usually becomes qualified money, which carries stringent rules, especially when the funds are distributed, e.g., retirement. Roth contributions are not deferred, which means you pay taxes on all contributions, and since taxes have already been paid, Roth retirement plans carry significant advantages over many other types of accounts, such as tax-free distributions.
The fundamental difference of a traditional and a Roth retirement plan is the position of the tax break. traditional retirement plans offer a tax break on the contribution, where the Roth does not. Roth plans offer a tax break on the distribution, where the traditional does not. Both plans offer tax deferred growth. See chart for quick analysis of traditional vs. Roth Retirement plans:
It appears Roth retirement contributions would make sense for just about anyone; however, there is a premium for Roth funds that’s not always considered, especially for those who are in high income tax brackets. This premium is so high that it’s entirely possible it could end up underperforming traditional retirement plans. Let’s take a closer look at the actual cost of Roth retirement accounts.
One very simple calculation I always consider is the gross cost of Roth contributions vs. the gross savings of traditional retirement plan contributions. The calculation is overly simple, it’s often overlooked. Since retirement plan tax deductions are taken “from the top” of your income, the contributions only affect your highest tax bracket. Let’s look at an example:
The second-highest tax bracket in 2023 is 35% and is assessed on incomes between $231,250 and $578,125, so it affects many physicians making decisions on retirement plan contributions. The maximum annual 403(b) contribution in 2023 is $22,500. If you made, let’s say $400,000 and maxed out the 403(b) in Roth contributions, you would pay a 35% tax on the contribution:
$22,500 x .35 = $7,875
The total cost to contribute $22,500 to the Roth 403(b) is $30,375 (not including state income taxes) because you put the money into the Roth account and paid taxes on that contribution.
If you instead chose to fund a traditional 403(b), there would be a tax deferral on the contribution. The tax deferral would be same as the tax assessed on the Roth 403(b), which is $7,875, so the gross cost to contribute $22,500 to a traditional 403(b) is $14,625
$22,500 - $7,875 = $14,625
You put the $22,500 into the traditional account and received a tax deduction for doing so.
In both the traditional and Roth retirement accounts, the 2023 contribution totals would show $22,500, yet the cost to get the $22,500 into the account varied wildly. The Roth account was assessed a premium, and the traditional retirement account was given a discount. If this exercise is repeated year after year, the cost savings can be dramatic. After 20 years (given the same tax brackets and contribution limits), here are the differences in cost between Roth and traditional retirement plan contribution costs:
Roth 20-Year Contribution Totals at $22,500 Annually: $450,000. Total Cost of Roth contributions: $607,500
Difference: ($157,500), meaning there was an additional $157,000 in taxes paid in order to contribute to the Roth plan.
Traditional 20-Year Contribution Totals at $22,500 Annually: $450,000. Total Cost of traditional contributions: $292,500
Difference: $157,500, meaning there was a total of $157,500 of income taxes deferred by contributing to the traditional plan.
The difference between traditional vs. Roth over 20 years: $315,000. This means the gross tax cost to contribute to a Roth retirement plan instead of a traditional retirement plan is $315,000. That means it cost an additional $315,000 of income taxes over a 20-year period to utilize the Roth retirement plan, assuming the same tax brackets and contribution limits were unchanged. If either taxes or contribution limits increase over the next 20 years, the tax savings on the traditional retirement plan will be even greater.
Let’s fast forward to retirement. There are plenty of flaws with this assumption, but it’s almost always assumed that you’ll be in a lower tax bracket in retirement. I have never liked this assumption, because the definition of retirement is never really defined. In most models, it’s assumed a person doesn’t work in any capacity during retirement, and lives solely off of accumulated assets and Social Security. In this case, it is likely the retiree will be in a lower tax bracket (assuming tax brackets are unchanged) because there is no earned income flowing in. To keep it simple, let’s assume no earned income.
If a person contributed $22,500 each year for 20 years and earned an average interest rate of 6%, the ending account balance would be $827,675, ignoring any employer matching (since the match would have been the same for either account). If a Roth account was chosen, this $827,675 account balance would have cost an additional $157,000 in income taxes. If a traditional account was chosen, there would have been $157,000 of tax deductions. If the tax deductions were able to be saved and invested at the same 6% instead of paid in extra tax, the tax savings account would grow to approximately $288,767. That “side account” of $288,767 can be added to the overall asset pool for retirement, giving the traditional retirement plan account owner $1,116,442 in assets.
If the retiree is indeed in a lower tax bracket during retirement and had a 20-year retirement (this is not likely, but it is the same timeframe as the accumulation study), then $72,160 could be distributed annually from each retirement plan for 20 years, earning 6% and ultimately spending the account to a zero-balance. This would result in approximately $7,581 in income for the traditional retirement plan holder (assuming 2023 tax rates and standard deduction does not change and was able to file MFJ). Over the next 20 years, the traditional retirement plan holder would pay $151,620 in income taxes. This figure is similar to the original $157,000 in tax savings recovered from the tax deductions, illustrating that tax deferred savings is truly just delaying the tax; however, the biggest difference is the retiree with the traditional retirement plan being able to save and redirect the annual tax savings from the retirement plan tax deduction, which created the additional account totaling $288,767. The improved cash flow during the working years allowed this individual to save more money. This tax savings account could have been used to provide additional income or to be allowed to grow as a backup to the retirement plan once it was distributed in full.
Many physicians employed by hospital systems are offered retirement plans, oftentimes with many choices attached to the plan. One of the most common choices is to opt for a Roth option. While Roth retirement plans offer fantastic benefits, such as tax-free distributions, the annual tax benefit for high income earners is difficult to ignore in a traditional retirement plan. In order to take advantage of the Roth benefits, a backdoor Roth IRA could be considered alongside the traditional retirement plan. In the example above, the biggest difference came from recapturing the tax savings from the traditional retirement plan, highlighting the importance of diligent saving.