In my experience, I’ve found most teachers understand the need to save beyond their STRS Ohio pension in order to meet retirement goals. The 403(b) is perhaps the most common type of retirement savings account utilized for this purpose. However, many teachers don’t seem to be fully aware of other options, nor do they understand the future tax consequences of their decision.
As previously discussed, a 403(b) is a tax-deferred retirement savings account available to most members of STRS Ohio. 403(b)s are separate from the three retirement plan options offered by STRS Ohio (i.e. Defined Benefit, Defined Contribution, and Combined), but may be used to supplement the retirement income provided by one of the plans. Participation in a 403(b) is voluntary and does not impact STRS Ohio retirement benefits.
In addition to the “traditional” 403(b) plan outlined above, teachers may be eligible to contribute to a Roth 403(b) or Roth IRA. A key difference between the traditional and Roth options is the tax treatment of contributions and earnings. Under the Roth option, you pay income taxes on contributions today and receive distributions during retirement tax-free, provided certain criteria are met. Contributions under the traditional plan are made on a pre-tax basis today, but distributions during retirement are treated as taxable income.
There are many variables when deciding which type of account is best for your situation. Some factors to consider include: Current household income (high-income earners may not be eligible to contribute to a Roth IRA), projected retirement income, and overall financial goals.
However, one item that’s consistent for participants in the STRS Ohio defined benefit plan is that a pension will be received during retirement. Your pension will be paid on a monthly basis and reported as taxable income. And, as is the case with most retirees, you will need the pension to live on and likely won’t have an opportunity to shelter it from taxes.
The thing to consider is pension income automatically places recipients in a minimum income tax bracket, which then impacts taxes on other sources of retirement income. For example, if pension income alone places a retired teacher in the 25% Federal tax bracket, any additional income received from 403(b) distributions will also be taxed at 25%…or more!
Retirees without a pension may adjust 403(b) or other retirement account distributions to optimize their tax situation. However, this typically isn’t an option for teachers.
So how does this play into your savings decisions today?
The reality is no one knows what the tax brackets will look like in the future. My hunch is taxes will go up, but that’s just a guess. As a result of expecting future pension income and not knowing what future taxes will look like, it’s important for teachers to diversify retirement savings by making use of accounts that have various tax consequences today and in the future. The 403(b) should be considered as a savings option, but so should a Roth 403(b), Roth IRA, or even an investment account that doesn’t provide tax-deferred or tax-free benefits.
Each situation is unique and requires planning. However, just like it’s prudent to diversify your investment holdings, tax diversification is a prudent savings strategy!