Uncle Sam provides you with two important tax-saving benefits when you save through your 403(b) or 457 plan: pre-tax contributions and tax-deferred growth.
The money you contribute to a traditional 403(b) or 457 plan is subtracted from your paycheck before federal and state income taxes are deducted. Let’s take this example: Suppose you are in the 25% federal tax bracket and 8% California income tax bracket. If you contribute $100 in a pay period, it doesn’t reduce your take-home pay by $100. Instead, that $100 contributed to your account could reduce your take-home pay by just $67.
Put another way, let’s say your gross paycheck is $2,100. After federal and state taxes are deducted, your net pay is $1,407. However, if you make a $100 pre-tax contribution to your 403(b) plan, your net pay would be calculated like this: $2,100 - $100 = $2,000 – 33% federal and state taxes = $1,340 net pay. Your paycheck is reduced by $67, but you’ve saved $100.
Note that this is a simplified example that doesn’t take into account the effect of other deductions from your paycheck. But it does illustrate how pre-tax contributions work in your favor.
What about Tax-Deferred Growth?
The benefit of a tax-deferred account is that taxes are deferred until withdrawal. Any earnings in the account – such as interest, dividends and capital appreciation – remain in the account until you begin withdrawing money at retirement.* You will have to pay taxes on the money once you start withdrawing it. However, you may have already benefited from many years of compounding interest. And, there is a possibility that you will be in a lower tax bracket after you retire. Finally, you can control the amount of money you withdraw from your 403(b) or 457 plan in retirement (subject to required minimum distributions), which allows you some control over your tax bill in retirement.
* Taxes will be due upon withdrawal in a traditional 403(b) plan. Distributions before age 59 ½ (age 55 upon separation from service) may incur a 10% tax penalty. 10% does not apply to 457 plans.
A tax-deferred retirement plan like a traditional 403(b) or 457 can help grow your savings over time. For example, the chart compares a taxable account with a tax-deferred account. The amount invested is the same ($200 a month), and the annual rate of return is the same (6%). The only difference is that the taxable account figures in an annual 33% combined federal and state income tax rate, while the 403(b) account grows tax-deferred.*
* Return shown is for illustration only and does not represent the return of any actual investment. Your results will vary. Taxes will be due upon withdrawal. Distributions before age 591⁄2 (age 55 upon separation from service) may incur a 10% tax penalty (does not apply to 457 plans).