I understand your point, but how do you account for money taxed at multiple rates in retirement?

For example, lets say Joe spends $40k/year now and in retirement. Joe is married and he and his wife earn $80k/year.

So Joe's marginal rate while working is 15%.

Joe retires and starts withdrawing $40k/year. The first $20,600 has no income tax. The next $18450 is taxed at 10% ($1845 in tax). The remaining $950 is taxed at 15% ($142.50 in tax).

So Joe's retired marginal rate is also 15%. But Joe's average tax rate is (1845+142.50)/40,000 = 5.0%.

Obviously Joe would much rather give uncle sam 5% of his yearly withdrawals than give him 15% up front. Joe's marginal rates are the same but the average rate makes the traditional 401(k)/IRA a huge winner.

Thoughts?

Good question. To answer, we need to make some assumptions.

Beyond "obvious" assumptions such as the tax brackets themselves, there is this: the contributed money is eventually withdrawn. Absent this assumption, Roth is never better (it can be equal) because no withdrawal means no taxes on withdrawal. Joe can withdraw traditional amounts voluntarily, or be subject to Required Minimum Distributions, or Joe's heirs will be subject to RMDs. If Joe's investments do so well that RMDs kick him up to the 25% bracket, he'll wish he had done less traditional and more Roth.

But back to the original question. We need to look at the sources of that $40K in retirement withdrawals.

If the first $30,050 comes from pension, SS, etc., then

*all* of the IRA withdrawals are taxed at 15%. If there is no pension, SS, etc., then things are a little more complicated - but we can still untangle the situation.

Go back to when Joe made his first contribution. Assume that Joe was in the 15% marginal bracket. At that time, Joe's retirement income prospects were bleak: no pension, no SS, and no retirement funds. Gazing into his crystal ball, however, Joe figured he would always be in the 15% bracket while earning. He also knew about the $20,600/yr in deductions/exemptions for withdrawals, so he decided to contribute to a traditional account because the withdrawals would be low enough to be tax free. So far so good.

Now fast forward a few years. Joe has continued to contribute to traditional accounts. Projecting his investment earnings and likely withdrawal time length, he notices that he could expect to withdraw $21K/yr in retirement. Now he realizes that he will have to pay some tax on withdrawals, but still only 10%, so traditional is still better.

Fast forward a few more years, and Joe's investments have grown enough that withdrawals over his retirement life span are projected to hit $39,050/yr.

*The average rate is irrelevant to Joe's decision.* Any future contributions to traditional accounts will be withdrawn at a 15% marginal rate, so Joe might want to switch to Roth (or not) at this point.

If, at the time of Joe's first contribution, his crystal ball predicted a time of earning enough to save 25% on contributions, he might have chosen to contribute to Roth early and save the traditional contributions for later years and the higher marginal rates. Does that all make sense?