Many people are not participating in their 403b plans as much as they could because they don’t fully understand the opportunity and potential benefits. Some employers have stopped contributing to their employee’s retirement plans leaving more employees to question the value of participating. The 403b can seem complex and the plan’s representatives may not always be knowledgeable, accessible, or helpful unfortunately.
While not exhaustive, in this article I want to explain some of the key benefits of a 403b, including income tax reduction, tax-deferral, and the potential for increased compounding. These benefits may sound complex at first, but I’ll do my best to explain them and provide an example so you can see the benefits for yourself. Your 403b has the potential to help you build wealth over the long-term. Here is how:
Income Tax Reduction
When you make a pre-tax contribution into a 403b account you tell Uncle Sam not to tax you on that money yet. Instead, you’ll be taxed on the money when you withdraw it from the account as income. Making pre-tax contributions to a 403b can lower taxable income for the year. Lowering taxable income reduces the amount of income taxes for the year.
Earned Income – Pre-tax contributions = Taxable Income
For example, a household in the 24% income tax bracket who contributes $20,500 could lower their taxable income by $20,500 and save or defer $4,920 in income taxes. A household in the 32% income tax bracket could save or defer $6,560 in income taxes.
Tax-deferral
A typical investment account can incur capital gains taxes when an investment is sold for a profit or gain (or the investments themselves realize a gain like mutual funds can). These capital gains taxes are a cost and drag on the overall profitability of investing.
Tax-deferred accounts work differently. Pre-tax contributions made in a tax-deferred account like a 403b don’t incur capital gains taxes each and every year like a typical investment account. Instead, since the money is meant for retirement, it is taxed as income upon withdrawal after age 59 ½ or age 55 in some cases. Note: If withdrawn prior, a 10% penalty may be assessed by the IRS, so it’s important for these dollars to be invested for the long-term.
Potential for Increased Compounding
Closely related to the benefits of tax-deferral, is the increased potential for compounding. Since the costs of capital gains taxes don’t erode the profitability of tax-deferred investments (such as a 403b) there is more money to work and hopefully grow. Eliminating unnecessary capital gains taxes can increase the potential for compounding growth. Tax-deferral can be a more tax-efficient way to invest.
The more money that goes into the account the more that is invested for potential compounding growth. Additionally, the more money that is not eroded by capital gains taxes, the greater potential for compounding growth.
What It Can Look Like
So, what do the benefits look like? Let’s look at a hypothetical example. If we continue our previous 24% income tax bracket and $20,500 pre-tax contribution example, the potential value after 25 years with a hypothetical annualized rate of return of 8% would produce $1,618,566. But what about income taxes? Let’s assume the household stays in the 24% tax-bracket. If they withdraw the money over time the taxes on withdrawal after age 59 ½ would be $388,455.84, leaving a value of $1,230,110.16 after taxes.
For comparison, let’s take some of those same assumptions but look at a typical investment account. Instead of contributing $20,500 a household in the 24% tax bracket would have to pay $4,920 more in income tax, so they would contribute $15,580. After 25 years of investing with a hypothetical annualized rate of return of 8% the potential value would be $917,042.
The difference between the hypothetical results is $313,068.16 and this doesn’t account for the potential tax drag of capital gains for a typical investment account. The savings could be even more for a household in a higher tax bracket. Additionally, while the example uses $20,500 (which is the amount of money 403b and 401k participants can contribute in 2022), employers may contribute more (up to $40,500), and individuals age 50 or older can make catch-up contributions of $6,500 a year.
These are just a few examples of how you can use a 403b to manage your money more efficiently and more effectively. There are more benefits to 403bs and 401ks and additional ways to use them in the greater context of your financial life. If you would like to explore your opportunities, be sure to reach out.
Sojourn well,
Sean M. Williams, CFP®