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Subject:  Re: Just when things were going ok, the rules ch Date:  1/5/2009  1:54 PM
Author:  BruceCM Number:  65044 of 88530

Pre-tax is the only way to go if you have the option and can invest in something worthwhile. You are already maxxing out your IRA, and I'm assuming taking full advantage of any employer matches with your TSA. I chose to max out my TSA first because it was pre-tax, and now am contemplating an IRA to diversify.

Pre-tax is desirable, as it effectively is, through Fed and State income reduction, reducing the amount one is paying into their retirement plan. For example, if a teacher earns $50,000/yr and contributes 10% of gross salary to her 403(b), her gross 403(b) contribution would be $5,000. But if her Fed + State marginal tax rate (tax rate paid on last dollar earned) is 20%, then her tax bill will be reduced by .2 X $5,000 = $1,000. So her NET household cashflow is reduced by $4,000 instead of $5,000, which would be the reduction if she contributed to a non tax-deductible savings plan. That's the good news.

The bad news are expenses. Unfortunately, for many (most?) 403(b) plans, the cost of this tax savings are expenses, and in some cases, exorbitant expenses that can effectively, over time, eliminate the tax benefit.

In the above example, assuming the teacher's wage rises by an average of 3%/yr and the average annual investment return with ZERO expenses is 9%, the future accumulated value after 20 years, assuming a constant 10% of salary contribution will be $316,525. With 403(b) expenses of 3%, this future value will drop to $233,504, while a Vanguard mix of index funds with an average expense ratio of .25% will result in a future balance of $308,412, a $74,908 (24.2%) difference from a typical high-expense 403(b).

So if a teacher's employer offers only a high-expense 403(b), it may be in
the teacher's best interest to contribute as follows:

1. To the 403(b) to the extent of employer matching (rare for most school districts)
2. Then to one's deductible traditional IRA
3. If not #2 (due to an adjusted gross income that exceeds the TIRA deductibility limit), then to one's Roth IRA
4. Then to a taxable brokerage or mutual fund account. If using a taxable account, it is generally best to keep income-producing investments (such as bond funds or income stocks) in the Roth IRA and growth funds/stocks in the taxable account.

This approach takes advantage of the 'free' (if any) contributions from the employer, very low expenses, full flexibility, full liquidity and capital gains tax rates in long term investments.

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