Should employees choose a Roth 457 or a traditional 457b?

Sam Finance 1 Comment

“Before answering this, there are two important things to know : from what has been publicized SO FAR

1. the 457b is accessible penalty-free at “separation from service” as opposed to age 59.5 for the Roth 457


2. this is a PERSONAL DECISION based on many factors including age, pension eligibility, involvement in 401k’s & IRAs, etc…”

The answer to this question depends mostly on two variables:

An individual’s Income Tax rate in retirement?

Whether an individual can afford the $16,500k in pre-tax 457b contributions.  
The basic difference between a Roth 457 and a regular 457b is that the Roth version is funded with after-tax contributions while the traditional 457b is funded with pre-tax contributions. In other words, with a Roth 457 you pay taxes today in return for a tax-free status in retirement. A regular 457b saves you taxes today, but withdrawals are taxed in retirement. Thus, the choice between the two 457 versions comes down to a gamble on whether income taxes will be higher or lower in retirement.

This is a question that nobody can answer with certainty. Marginal income tax rates have declined over the last two decades and there have been several recent attempts to further lower income taxes. If taxes were to continue to decline, a regular 457b would be the better option. The same is true for individuals who expect their marginal tax rate do be lower in retirement as a result of lower incomes.

Yet, economists argue that income taxes will likely rise in the future. The current record of federal budget deficits may eventually result in higher taxes. Similarly, liquidity problems in the Federal Pension and Medicare systems may force future governments to raise tax rates. For these reasons many economist predict slightly increasing income tax rates in the future.

Roth 457 accounts are better if taxes are higher in retirement, while regular 457b accounts do better if taxes are lower in retirement. While different tax rate assumptions will make a difference, affordability of making high 457b contributions may be more significant. Roth 457s are after-tax accounts and therefore allow employees to stack away more funds relative to using a regular 457b. Maxing out the $16,500 contribution limit after tax equals roughly $22,000 pretax assuming a 30% marginal tax rate. Thus, the Roth 457 effectively increases the amount of money that can be saved for retirement. These additional funds can then build up tax-free over a potentially long period of time. This is especially beneficial to high-income individuals who were previously unable to participate in Roth-type retirement savings accounts due to income limitation.

If an employee can afford it, making maximum contributions to a Roth 457 may be the best option.

Yours truly,

bag of money

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