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 Included in the Bush Administrations Fiscal Year 2006 Budget were some changes to the way you can fund your 403b plan - the new Roth 403b. In this publication we're going to discuss the benefits of a Roth 403b along with the rules of these plans including withdrawals / distributions, contributions, and income taxes.
Background of the Roth 403b
Starting in January 2006, operators of traditional 403b plans can offer their employees what's being called a Roth 403b plan. In essence, offering "Roth" treatment of funds going into a 403b account.
A Roth 403b combines the contribution features of 403b plans with the tax-free growth advantage of Roth IRAs. Employees currently offered the ability to fund their retirement plans via 403b plans may now be offered the option of participating in a Roth 403b. With this new plan, you'll never have to pay federal income taxes on the growth portion of your account, or your contributions, when you withdraw the money.
Roth 403b Fund Requirements
There are very few requirements of these new Roth 403b plans. Employers have the opportunity to consolidate a variety of retirement funds into what are called Employer Retirement Savings Accounts, or ERSAs. These ERSAs will be available to all employers that meet some pretty simple qualifications.
As previously mentioned, the proposal becomes effective for the years beginning after December 31, 2005. In most situations, that translated into January 1, 2006. Retirement money placed into a Roth 403b has to be kept in an account that is separate from other funding. That's about it as far as employers are concerned.
Benefits of Roth 403b Plans
Many employees already participating in a 403b plan at work will be offered the opportunity to participate in Roth 403b. For those people, the question they are going to be asking themselves is simply this: "Should I fund a Roth 403b or stick with my existing 403b plan?"
The answer to that question has to do with each plan's income tax treatment of contributions and withdrawals and what they believe their income tax bracket will be in retirement. By making before before-tax contributions to your traditional 403b plan, you're reducing your current tax liability. With Roth 403b contributions, you'll be making after-tax contributions:
- While before-tax contributions act to reduce your taxable income today, you're going to pay income taxes on the contributions and earnings when they're distributed to you at retirement.
- Roth 403b contributions won't reduce your taxable income right now. But these contributions, and the earnings on them, are tax-free at retirement - as long as you're at least age 591/2 and your Roth 403b account is at least five years old.
So if you believe you're in a higher tax bracket today than you will be in retirement, then sticking with a 403b plan might be your best move. If you think your tax bracket will stay the same or increase in your retirement years, then a Roth 403b is probably your best move.
Roth Treatment of 403b Contributions
The key here is that plan administrators can elect to make available to their employees Roth treatment of contributions to retirement savings plans such as a 403b plan. The intention of the proposed change would be to help consolidate all of the retirement accounts that permit employees to make after-tax contributions to a retirement savings account.
Roth 403b Contribution Limits
ESRAs need to follow the rules previously outlined for 401k plans with additional simplifications - we've already talked about 401k contribution rules in a previous article. Employees can defer or contribute up to $15,500 in wages annually in 2007 and 2008. And like other retirement plans, there is an additional catch-up contribution of $5,000 for employees 50 and older. The maximum total contribution limit - which also includes employer contributions - is the lesser of $45,000 or 100% of the employee's compensation in 2007. The maximum total contribution limit in the year 2008 is $46,000.
For information on the contribution limits for the years 2009 and beyond, take a look at our article on 403b Contribution Rules.
Roth 403b Withdrawals and Distributions
Like its predecessors, the Roth 403b was established as a retirement plan. That means the IRS looks down on early withdrawals that occur before age 59 1/2. Hardship or other types of withdrawals are subject to the same 403b rules and penalties that are currently on the books. And the Roth 403b minimum distribution rules are also similar to 403b withdrawals plans - meaning you need to start to take mandatory distributions when you reach age 70 1/2.
Taxes on Roth 403b Distributions and Contributions
The tax liabilities associated with employee contributions and distributions from an ERSA would be the same as the plans that the ESRA is replacing. That means the employee could fund an ERSA with pre-tax monies, after-tax contributions, or Roth contributions. The exact type of contribution will depend on the plan's design.
Distributions of Roth 403b (after-tax) contributions, and the earnings of those same contributions, would not be included in income for tax purposes. Other distributions - such as those made on a before-tax basis - would be included as taxable income. So the rules are similar to those of existing plans, but the introduction of the "Roth" concept and its benefits add to the plan's overall attractiveness as a retirement fund.
Roth 403b Income Tax Rules
The income tax rules for a Roth 403b are fairly easy to remember if you think of the plan using these two rules of thumb:
- This type of plan allows you to put money into your account on an after-tax basis - just like a Roth IRA. And just like a Roth IRA, the distributions from a Roth 403b are free from federal income taxes.
- If your employer contributes to your Roth 403b - such as the case when employers match funds - then those contributions have gone into an account on a before-tax basis (you never paid income taxes on your employer's contributions.) Therefore the portion of your Roth 403b funding that comes from employer contributions is subject to federal income taxes upon withdrawal.
In most cases, an employer's matching contributions to Roth 403b will be placed in a traditional 403b account.
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