Retirement Planning: Roth vs. Traditional Contributions for Ministers

For ministers still in active service, understanding the nuances between Roth and traditional contributions is a significant aspect of retirement planning, particularly in the context of the housing allowance. Each type of contribution has its benefits and implications, and the choice between them can significantly impact your financial situation in retirement.

Traditional Contributions and the Housing Allowance

Traditional retirement contributions, typically pre-tax, reduce your taxable income in the year they are made. This can be a strategic way for ministers to manage current tax liabilities, especially if you’re in a higher tax bracket during your working years. However, it’s important to remember:

• Withdrawals from traditional retirement accounts during retirement are taxed as ordinary income.
• For retired ministers, the portion of these withdrawals designated as a housing allowance can be excluded from taxable income, offering a tax-efficient way to cover housing expenses in retirement.

Being able to withdraw from your 403(b)(9) as housing allowance means you have a rare opportunity to have “double tax-free” money. By “double tax-free,” I mean the funds can go into your retirement plan tax-deferred and come out tax-free as a housing allowance. 

In short, you will never pay income tax on the portion of your money distributed as housing allowance.

You still need to follow the housing allowance rules to be sure the distributions will qualify as housing allowance.  

Roth Contributions: Post-Tax Benefits

On the other hand, Roth contributions are made with after-tax dollars, meaning:

• Although there’s no immediate tax benefit, withdrawals in retirement, including earnings, are generally tax-free.
• For ministers, Roth accounts do not provide the direct benefit of a tax-free housing allowance in retirement since withdrawals are already tax-free.

Since you can receive (limited) tax-free distributions from your traditional 403(b)(9), a Roth may be less valuable to you than every other person you meet.  

Personal note: If your financial planner isn’t familiar with 403(b)(9) housing allowance withdrawals, you need to find a financial planner who is.

So What Should You Do?

Questions like this are complex and very personal. The typical financial advice you will hear on blogs and podcasts is to make Roth contributions. For you, as a minister, this advice will leave you paying more in taxes.

For most people, the “order of operations” for retirement savings looks something like this:

1) Roth 

2) Traditional

3) Non-qualified (no tax preference)

For you, it will be more like this:

1) Traditional up to enough to cover housing expenses

2) Roth

3)Traditional

4) Non-qualified (no tax preference)

Finding the optimal balance between Roth and traditional contributions can be complex, and I recommend you seek professional assistance.

Leveraging Roth Conversions

A Roth conversion involves transferring funds from a traditional IRA or 403(b) plan to a Roth account. This can be a strategic move for ministers in certain situations:

• Lower Income Years: If you anticipate lower income in specific years before retirement (e.g., during a sabbatical), converting to Roth during these years can mean paying taxes at a lower rate.
• Retirement Income Planning: Conversions can also be part of a broader retirement income strategy, especially if you expect to be in a higher tax bracket in retirement or want to hedge against future tax rate increases.

When Roth Conversions Make the Most Sense

• Before Designating Housing Allowance: Consider a Roth conversion in the years leading up to retirement but before designating retirement funds as a housing allowance. This strategy can be beneficial if you expect significant non-housing-related expenses in retirement.
• Estate Planning Considerations: Roth accounts are advantageous for estate planning, as they provide tax-free distributions to heirs.

Conclusion

Deciding between Roth and traditional contributions and considering Roth conversions are important decisions that require a thorough understanding of your current financial situation, future income expectations, and retirement goals. For ministers, these decisions are further complicated by the considerations of the housing allowance. Working with a financial advisor who understands the unique financial landscape of clergy members can help navigate these choices effectively, ensuring a retirement strategy that aligns with your financial and ministerial objectives.