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More on IRAs for Doctors www.schwartzaccountants.com

By Andrew D. Schwartz, CPA

Each winter, when my staff and I meet with our physician and other clients to review their tax information, we get this question a lot, “Should I go with the Roth version of my employer’s 401(k) or 403(b) plan, or should I stick with the traditional version?”

Taxpayers first had the option of contributing money to a Roth account back in 1998. Remember, when you contribute money to a Roth account, you elect to forego a current year tax break in exchange for a promise from the government that distributions taken from the Roth account down the road won’t ever be taxed.

Through 2005, the only access you had to these tax-free accounts was to contribute to a Roth IRA. Many middle-income and high-income taxpayers never had the opportunity to contribute to a Roth IRA, however, since their incomes exceeded the relatively modest threshold based on their filing status. (The Roth IRA threshold for 2012 is $125k for single individuals and $183k for married couples.)

What Congress Likes

Congress liked that people were giving up a current year tax break by opting to go with a Roth IRA instead of to a Traditional IRA, so decided to expand this opportunity to 401(k) plans and 403(b) plans. As we wrote in our October 2005 Newsletter in an article called The New Roth 401k and 403b, employers could begin to offer the Roth version of these plans as of January 1, 2006.

What’s the difference between the Traditional and Roth versions of these popular retirement savings plans? With the traditional 401(k) or 403(b) plan, the salary deferrals you make reduce your taxable salary and grow tax deferred. You will then owe income taxes on distributions taken from these accounts when you retire.

Example:

As a doctor, let’s say you earn $200k, and you max out your 403(b) salary deferrals for $17k during the year. In this case, your W-2 will report taxable wages of $183k in Box 1. Assuming you are in the 33% federal tax bracket, the $17k you contribute into your 403(b) plan saves you $6,667 in federal income taxes. That’s a pretty good tax break I would say.

What happens if you instead decide to go with the Roth version of the 403(b) plan for your salary deferrals? When you contribute money to a Roth account, you forego a current year tax-break. Your W-2, therefore, will report the full $200k as taxable wages in Box 1, instead of $183k that would be reported had you gone with the Traditional 403b. The benefit of giving up this tax break is the tax-free treatment of the compounded growth on the $17k of salary deferrals. In other words, you won’t owe any federal income taxes on the distributions taken from this account when you retire.

The Max Factor

When my clients ask me for advice about the Roth 401k or 403b plan, I immediately look at Box 12 of theirW-2 forms to see how much they contributed in salary deferrals during the prior year. According to the instructions of the W-2 form, here are the relevant codes that show up in Box 12 of the W-2 form:

Code D – Elective deferrals to a section 401(k) cash or deferred arrangement. Also includes deferrals under a SIMPLE retirement account that is part of a section 401(k) arrangement.

Code E – Elective deferrals under a section 403(b) salary reduction agreement

Code AA – Designated Roth contributions under a section 401(k) plan

Code BB – Designated Roth contributions under a section 403(b) plan

What I’m looking to see is whether this client is maxing out their salary deferrals during the year. If a client is contributing to the Roth version of the 401k and 403b plan, and is falling short of the $17k max ($22.5k max if 50 or older), I strongly suggest that they consider contributing only to the Traditional version until they are able to max out their contributions.

Assessment

In my opinion, socking away as much money as possible each year into these tax-advantaged, creditor protected accounts takes priority over worrying about saving taxes later. Remember, if money is tight, you have the choice of contributing $10,333 into a Roth 401k account, or taking advantage of the $6,667 tax break offered by traditional 401k plans and putting away the max of $17k into the Traditional 401k account.

I think a financial planning twist on Alfred Lord Tennyson’s poem about lost love sums this up best, “Tis better to save and be taxed than never to have saved at all.”