Is it Possible for Teachers to Do Too Much Tax-Deferred Savings?
Due to recent changes in legislation, as of October 2023, teachers and all state workers will now have an option to do Roth contributions for Deferred Compensation Retirement Savings, making the need to utilize or open a 403(b) account only relevant for teachers if they are already maxing out the contribution they are making to a 457(b) DCP Account.
Is it Possible for Teachers to Do Too Much Tax-Deferred Savings?
A few times each year, a life-long teacher will approach me about doing some retirement planning, and a close look at their financials will reveal a life spent living well below their means. As their salaries through the years may have increased, their spending did not, and many a financially savvy teacher started routing a large percentage of their income into a 403(b), Deferred Compensation, or in some cases, both. Over time and with investment growth, those funds add up in a big way.
And even though many may not foresee a major lifestyle change or increased need for income in retirement, they are are surprised to find out that, after years of paying taxes at the 12% level, retirement projections have them likely to be on the hook for paying taxes on some of their retirement income at over a 30% tax rate.
How does this happen?
A fifty-year-old teacher with one-million dollars in tax-deferred savings will likely be perfectly comfortable living on their pension and Social Security once they retire. After all, because they’ve been living on a reduced percentage of their income for most of their working years, this may actually be more than they really need to live the life they want in retirement.
But even if they never contribute another penny to tax-deferred savings, by the time they hit age 72, they’ll likely be forced to take Required Minimum Distributions (RMDs) of close to $150,000, and by age 80 these will be likely well over $200,000. That’s on top of their pension income and Social Security. For a married taxpayer (without considering any spousal income) they’ll likely be paying taxes on some of their income at the 28% level, and for a single taxpayer, this will likely push their income into the 33-35% tax bracket*
Suddenly, a teacher who has never seen a tax rate higher than 12% will be staring down a heavy tax-burden in late retirement with very little they can do about it once it begins.
What can be done about it during your teaching career?
If this sounds like the situation you’re currently in as a teacher (or may be in a few years down the road) there are a few things you can do during your career to potentially reduce this gigantic tax burden.
First, look into whether your district offers a Roth 403(b) option as an alternative to a tax-deferred traditional 403(b). Not all districts do, but if yours does, this is a great way to make sure you are paying taxes on at least half of that income now, and to reduce the size of your RMDs in retirement. By 2024, the state of Washington also hopes to offer a Roth option for Deferred Compensation accounts, which may make it possible for teachers to do most of their retirement savings in a Roth account, where they pay taxes now, but not in retirement. However, what percentage to make Roth vs. Tax Deferred to minimize total taxes paid is likely a decision that will take a little number crunching.
If there is no Roth option in your district currently, and if your tax bracket is currently low, make sure you are fully funding a Roth IRA if you are eligible to do so, even if it means putting a little less into your 403(b) or Deferred Compensation account.
Second, work with a financial advisor to determine whether early retirement is an option. You’ve worked hard to save those funds, and they may put you in a good position to retire before your pension and Social Security kick in. If you can retire early and want to, you may be able to spend down enough of these tax-deferred funds in early retirement to keep your later RMDs from creating too heavy a tax burden.
Finally, it may make sense, if you’ve already passed the age of 59 ½, to consider a rolling over some of your 403(b) funds directly into an IRA, and then doing Roth conversions while you are still working. While this option is probably going to be the biggest hassle and can be a bit tricky to calculate and execute while you’re still bringing in a teacher salary, it’s a strategy that you can use if you want or need to keep working, but still want to do something now to help reduce your later RMDs. I’d recommend working with a financial advisor to make sure the rollover and Roth conversion process gets executed in a way that meets your long-term goals related to paying fewer taxes in retirement.
What can be done about it after retirement?
If you have separated from service or retired already but haven’t yet reached the age 72 (and perhaps haven’t started your pension or Social Security). Consider using a series of Roth Conversions during your early retirement years to drive up your taxable income now. By aiming to “fill up” lower tax brackets if you can, you can strategically pay less tax on those distributions now than you will pay later. In all cases where Roth conversions are concerned, just make sure you understand what you will owe the IRS each year, and what you are trying to accomplish before you dive into it, or work with a financial advisor to see if this strategy makes sense for you, and to plan and implement it effectively.
If you’ve found yourself already past RMD age, and looking at taxes higher than you expected, there’s unfortunately, not a lot you can do at this point to change your situation. (But alas, feel thankful that you are in a position where this is the case. High taxes are a pain, but they’re typically also an indicator that you have a stable and lasting income in your retirement.) However, you can consider using a charitable donation directly from your tax-deferred accounts to meet some or all of your RMD requirements each year. If you make your distribution directly from your retirement account to charity, that’s a portion of your RMD that you won’t owe taxes on for the year. So, if charitable donations are a part of your overall spending plan, make sure you’re taking advantage of this opportunity to reduce your taxable income a bit.
*Rates assume that the Tax Cuts and Jobs Act rates expire in 2025 as currently projected.
