Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

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camillus
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Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by camillus »

Hi all,

I recently had more confidence in my decision to choose to invest retirement contributions in my wife's 403(b) over a Roth IRA, but I'd like some second opinions.

Some stats:
-Married, mid 30s
-State tax 4.25%(?)
-Wife is clergy. This get technical, which is distracting on these threads. She is paid a housing allowance. She pays federal income tax but not FICA. She pays SECA on income she earns where she teaches as a professor.
-15% tax bracket (due to housing allowance keeping us below the 25% bracket)

Decision

So we all know the benefits of a Roth IRA especially in the 15% bracket (though I am no as ra-ra Roth IRA as some). One of the benefits of a Roth IRA is complete control over investments, including seeking lowest possible expense ratios.

Now for the 403(b) through TIAA. My wife's employer is "R1" which means that expense ratios are typically around 0.70% :shock:
One of my strategies with funds already here is to use Traditional as my bond component of my total portfolio as a way to evade high ERs in this 403(b). I am also planning on trying to improve the plan, though this thread assumes that won't happen.

Now for the interesting upside of the 403(b). Since my wife is clergy, she is taxed with SECA (15.3%) and not FICA (7.#%). BUT, any 403(b) elective contributions are completely untaxed by "payroll" tax, meaning contributions to her 403(b) gets a 15.3% bump in addition to the 15% deferral of income tax and 4.25% state tax.

How should I weigh having to pay higher expense ratios in the 403b (0.70%) against the tax savings of avoiding SECA (15.3%)? Should I chose the Roth instead?

Another wrinkle of the clergy 403b is that moneys distributed in retirement can be designated as "housing allowance" and exempt from tax, so deferred going in, tax free going out.

Let me know if I've been clear enough. My wife is in a position for the first time next year to max out her 403(b) and that's the occasion for my asking this question. Thank you!
51% US / 34% ex-US / 15% “bond”
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ruralavalon
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by ruralavalon »

camillus wrote: Fri Oct 27, 2017 11:51 pm Hi all,

I recently had more confidence in my decision to choose to invest retirement contributions in my wife's 403(b) over a Roth IRA, but I'd like some second opinions.

Some stats:
-Married, mid 30s
-State tax 4.25%(?)
-Wife is clergy. This get technical, which is distracting on these threads. She is paid a housing allowance. She pays federal income tax but not FICA. She pays SECA on income she earns where she teaches as a professor.
-15% tax bracket (due to housing allowance keeping us below the 25% bracket)

Decision

So we all know the benefits of a Roth IRA especially in the 15% bracket (though I am no as ra-ra Roth IRA as some). One of the benefits of a Roth IRA is complete control over investments, including seeking lowest possible expense ratios.

Now for the 403(b) through TIAA. My wife's employer is "R1" which means that expense ratios are typically around 0.70% :shock:
One of my strategies with funds already here is to use Traditional as my bond component of my total portfolio as a way to evade high ERs in this 403(b). I am also planning on trying to improve the plan, though this thread assumes that won't happen.

Now for the interesting upside of the 403(b). Since my wife is clergy, she is taxed with SECA (15.3%) and not FICA (7.#%). BUT, any 403(b) elective contributions are completely untaxed by "payroll" tax, meaning contributions to her 403(b) gets a 15.3% bump in addition to the 15% deferral of income tax and 4.25% state tax.

How should I weigh having to pay higher expense ratios in the 403b (0.70%) against the tax savings of avoiding SECA (15.3%)? Should I chose the Roth instead?

Another wrinkle of the clergy 403b is that moneys distributed in retirement can be designated as "housing allowance" and exempt from tax, so deferred going in, tax free going out.

Let me know if I've been clear enough. My wife is in a position for the first time next year to max out her 403(b) and that's the occasion for my asking this question. Thank you!
Wow, I had no idea it was this confusing for clergy. I was not clergy but was effectively self-employed, did have to pay the self employment tax, and didn't even realize how that might affect tax considerations around my 401k contributions.

I don't think I have the answer for you, just some thoughts.

1) Like you I am not a Roth enthusiast, because most people are likely better off with traditional contributions. So she should consider a traditional IRA as an alternative to 403b contributions. Don't limit the thought process to just a Roth IRA, especially if she will not have any pension.

2) For most people without a pension, traditional contributions are likely better than Roth contributions. But a pension changes that analysis. For an explanation Google the TFB blog post "The Case Against Roth 401k" , and also the TFB blog post "Most TSP Participants Should Switch to the Roth TSP".

3) Being in the mid-30s with perhaps 30 years to retirement, the extra 0.60% in expense ratios in the 403b compared to a Vanguard traditional or Roth IRA has very significant impact on end-value of her investments. That's a loss probably in the range of about 15% in the end-value.

4) I don't know how to estimate the tax effects from the self employment tax, housing allowance, etc. but would guess that the effect is likely not as large as the approximate 15% loss resulting from the higher expense ratios.

5) Is there actually any way she avoids both FICA and the self-employment tax? I don't think she saves the 15.3%, but I am certainly not a tax expert.

6) You might PM grabiner and ask a tax guru to comment.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link: Bogleheads® investment philosophy
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ThePrune
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by ThePrune »

camillus wrote: Fri Oct 27, 2017 11:51 pm Wife is clergy. This get technical, which is distracting on these threads. She is paid a housing allowance. She pays federal income tax but not FICA. She pays SECA on income she earns where she teaches as a professor.
-15% tax bracket (due to housing allowance keeping us below the 25% bracket)
Just checking if you are aware that when a designated housing allowance exceeds a minister’s actual housing expenses and the fair rental value of the home, the minister must report the “excess” housing allowance as wages for federal income tax purposes on line 7 of Form 1040.
Now for the 403(b) through TIAA.
Call it by it's full name: 403(b)9. This distinguishes it from the much more common 403(b)7, with different rules, utilized by public school teachers.
My wife's employer is "R1" which means that expense ratios are typically around 0.70% :shock:
One of my strategies with funds already here is to use Traditional as my bond component of my total portfolio as a way to evade high ERs in this 403(b). I am also planning on trying to improve the plan, though this thread assumes that won't happen.
Yes, it's high from the perspective of Vanguard fees. But I've seen church plans with fees 2 to 3 times higher! If the funds available seem to be broadly diversified and allow for a reasonable asset allocation, I wouldn't skip the 403(b)9 plan just because of a 0.7% ER.
Now for the interesting upside of the 403(b). Since my wife is clergy, she is taxed with SECA (15.3%) and not FICA (7.#%). BUT, any 403(b) elective contributions are completely untaxed by "payroll" tax, meaning contributions to her 403(b) gets a 15.3% bump in addition to the 15% deferral of income tax and 4.25% state tax.
But this isn't really a "free bump", since it also reduces her Social Security wage base, thereby permanently reducing her eventual Social Security benefits. Now the size of the Social Security reduction might be quite small (she is contributing little to the 403(b)9 plan) or significant (she is maximizing her 403(b)9 contributions).
How should I weigh having to pay higher expense ratios in the 403b (0.70%) against the tax savings of avoiding SECA (15.3%)? Should I chose the Roth instead?
This can't be answered until the Social Security benefit reduction effect is quantified and added into the calculation. If I had to work this decision out quantitatively, it would be necessary to create a preliminary retirement plan (cash flow model) to understand how all these factors would affect your income, taxes and assets throughout retirement.
Another wrinkle of the clergy 403b is that moneys distributed in retirement can be designated as "housing allowance" and exempt from tax, so deferred going in, tax free going out.
I'm not sure that this is a correct statement. I do know that the following is true
Guidestone Financial Resources wrote:The IRS has ruled that retired ministers are eligible for a housing allowance exclusion if a portion of a retired minister’s pension income from a denominational pension fund is designated as a housing allowance by the pension board or the designation is approved by the former church/employer; the retired minister has severed his relationship with the local church and relies on the church pension fund for his pension; and the pension paid to the retired minister compensates him for past services to the denomination or to local churches of the denomination.
Unless your wife's 403(b)9 includes church contributions which are designated as "housing allowance for retirement", there is no way to argue that a portion of withdrawals constitute a compensation for past services that can then be considered an ongoing housing allowance.
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ruralavalon
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by ruralavalon »

While searching on a completely different issue about contributions to multiple plans, I came across www.guidestone.org , which contains a minister's tax guide.
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by grabiner »

ThePrune wrote: Sat Oct 28, 2017 8:50 am
camillus wrote: Fri Oct 27, 2017 11:51 pm Now for the interesting upside of the 403(b). Since my wife is clergy, she is taxed with SECA (15.3%) and not FICA (7.#%). BUT, any 403(b) elective contributions are completely untaxed by "payroll" tax, meaning contributions to her 403(b) gets a 15.3% bump in addition to the 15% deferral of income tax and 4.25% state tax.
But this isn't really a "free bump", since it also reduces her Social Security wage base, thereby permanently reducing her eventual Social Security benefits. Now the size of the Social Security reduction might be quite small (she is contributing little to the 403(b)9 plan) or significant (she is maximizing her 403(b)9 contributions).
And this is the main issue; how much is the reduction of SECA helping her (or hurting her)? I don't know exactly how this works, but I will assume that it works the same way it does for Social Security.

Every $420 of additional earnings increases your Average Indexed Monthly Earnings by $1. If you are in the 15% tax bracket, your AIME is probably below the second bend point ($5336 in 2017, corresponding to an average annual salary of $64,032), so that increases your Primary Insurance Amount by 32 cents (all numbers adjust for inflation annually). The tax on $420 is $64.26, so it will take 201 months to break even. Since that is close to your life expectancy in retirement, it is close to break-even.

Thus, if my understanding is right, the high costs make a lower-cost IRA (probably Roth in this bracket) preferable to the 403(b)9.
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camillus
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by camillus »

I really appreciate all the expert opinions here! One thing that I will be doing is trying to influence my wife's workplace to improve the 403b by offering some better funds.

To be clear, the 403b is offered through TIAA - not an institution that specializes in divinity schools. I believe the attached college still uses TIAA but made some changes - it used to be the same plan, intended for professors and staff. This makes me suspect it is a 403(b)7 plan, though I am very ignorant on this point.
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by ThePrune »

ruralavalon wrote: Sat Oct 28, 2017 6:50 pm While searching on a completely different issue about contributions to multiple plans, I came across www.guidestone.org , which contains a minister's tax guide.
The ministerial guides are actually located on this webpage
within the Guidestone website. The Guidestone Financial Resources quote I cited earlier was from the PDF article, "Ministerial Tax Issues", which is accessible on this webpage.
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by ThePrune »

grabiner wrote: Sat Oct 28, 2017 8:36 pmAnd this is the main issue; how much is the reduction of SECA helping her (or hurting her)? I don't know exactly how this works, but I will assume that it works the same way it does for Social Security.

Every $420 of additional earnings increases your Average Indexed Monthly Earnings by $1. If you are in the 15% tax bracket, your AIME is probably below the second bend point ($5336 in 2017, corresponding to an average annual salary of $64,032), so that increases your Primary Insurance Amount by 32 cents (all numbers adjust for inflation annually). The tax on $420 is $64.26, so it will take 201 months to break even. Since that is close to your life expectancy in retirement, it is close to break-even.

Thus, if my understanding is right, the high costs make a lower-cost IRA (probably Roth in this bracket) preferable to the 403(b)9.
I checked through this math and agree with the details of grabiner's analysis. It's a very nice way to think through what, at first glance, looked like a difficult problem.

I'd make one change in the portion of the analysis that deals with life expectancy. For college-educated folks, mid-30's and in reasonable health, the life expectancy for a male is just over age 86, for a female about 88.5, but the JOINT (last to die) life expectancy for a married couple is actually closer to age 92. (College educated individuals have a longer life expectancy than the general population. I calculated the above ages using the Society of Actuaries 2012 Individual Annuity Mortality tables.) If Social Security is started at your Full Retirement Age of 67, the odds are that you will be drawing benefits for longer than the 201 months (16.75 years) required to hit the break-even point.
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Re: Roth IRA vs clergy 403(b) bad ERs, 15% tax brkt

Post by camillus »

grabiner wrote: Sat Oct 28, 2017 8:36 pm Every $420 of additional earnings increases your Average Indexed Monthly Earnings by $1. If you are in the 15% tax bracket, your AIME is probably below the second bend point ($5336 in 2017, corresponding to an average annual salary of $64,032), so that increases your Primary Insurance Amount by 32 cents (all numbers adjust for inflation annually). The tax on $420 is $64.26, so it will take 201 months to break even. Since that is close to your life expectancy in retirement, it is close to break-even.
Just returning to this thread to try to process grabiner's math for myself. I admit to some skull sweat here.
The method for calculating SS retirement benefit is explained in this PDF, top of page 2: https://www.ssa.gov/pubs/EN-05-10070.pdf

$420 earnings * 15.3% tax rate = $64.26 tax
$64.26 tax / 32 cents future monthly SS benefit = 201 months
201 months + 67 years FRA = 83 years and 9 months

Longevity can be calculated here: https://www.ssa.gov/cgi-bin/longevity.cgi
FWIW, I have three living grandparents at 85.

Now to factor a reduction in benefits, as described here: https://www.ssa.gov/policy/docs/ssb/v70 ... 3p111.html
(I am 32 years away from FRA of 67.)

Let's do the math for a 25% reduction of benefits implemented sometime in the next 32 years:

420 * 1.33 = 560

$560 earnings * 15.3% tax rate = $85.68 tax
85.68 / 32 = 268 months
268 mo + 67 FRA = 89 years 2 months

*

Ugh. I admit that thinking about this is difficult for me! I keep coming back to the the idea that "investing" the tax savings ourselves as DW's own asset is better than paying into SS, since we retain control and can make rational and flexible decisions at different points in the future. Additionally, this invested tax savings can survive our deaths & be passed to heirs or charity.
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