increase DCFSA to leverage more ROTH space in 12% bracket?

[JJ-]

I'm trying to find a way to visualize a long term tax optimization scenario against short term spending impacts for day care. Long story short, with us being in the 12% bracket based on AGI the DC tax credit is better than funding a DCFSA. However, a recent thread made me think that while we're in the 12% bracket funding more ROTH tax advantaged accounts instead of traditional accounts makes more sense.

If I increase my DCFSA contributions it opens up a bit more ROTH space. However, I start losing value on taxes on the DC tax credit. The tax credit difference for every $5000 not going to DCFSA in 12% bracket is approx $700. In other words, I lose out on $700 by contributing to DCFSA.

So, does it make sense to give up $700 to invest more in ROTH IRA/401k as opposed keeping the $700 and doing more in taxable? Is there an easy way to visualize whether this makes sense, or if it makes sense up to a certain break even point?



Is there a way to do an analysis to figure out whether I should

[MDM]

If I increase my DCFSA contributions it opens up a bit more ROTH space.

How does that work (specific numbers if possible)?

[pasadenafr]

I don't know how DCFSA and DC tax credit work, so I won't comment on that.

However, investing in Roth as opposed to traditional 401(k) only makes sense if your tax bracket in retirement will be higher than your current one (if equal, then maybe the ability of managing your tax level is important to you)

Let's say you have $1,000 to invest.

* You invest $880 in Roth and pay $120 in taxes. After 20 years at 5%, you have $925.06
* You invest $1,000 in Traditional. After 20 years at 5%, you have $1,051.21. You pay 12% tax on that, and you're left with... $925.06

So, how sure are you that in retirement, you will be in a higher tax bracket than 12%?

[JJ-]

If I increase my DCFSA contributions it opens up a bit more ROTH space.

How does that work (specific numbers if possible)?

Sorry, this is what I get for assuming everybody knows my numbers or what I mean by ROTH space. Numbers below, Roth space means lower AGI and taxable income enough to have more ROTH contributions at 12% rate.

Right now our taxable income is targeted to be right at $81,000. When I say increase DCFSA contributions that means I have contributed only $5,000 to the DCFSA and have up to $10,500 to put in there. If I increase DCFSA contributions by $5500 that lowers taxable income by $5500, meaning I can now fill up more post tax ROTH 401k contributions to that $81,050 mark effectively taxed at that 12% rate.

However doing so, with AGI low, I give up the opportunity of taking more advantage of the dependent care tax credit for 2021 which is a better deal than the DCFSA deferrals. $5k pretax deferred in DCFSA is $1200 in tax savings, but $5k pretax into checking account is $3800 *50% dep care credit = $1900. The difference between the $1900 $1200 is $700 and makes the DCFSA kind of a raw deal.

I don't know how DCFSA and DC tax credit work, so I won't comment on that.

However, investing in Roth as opposed to traditional 401(k) only makes sense if your tax bracket in retirement will be higher than your current one (if equal, then maybe the ability of managing your tax level is important to you)

Let's say you have $100 to invest.

* You invest $880 in Roth and pay $120 in taxes. After 20 years at 5%, you have $925.06
* You invest $1,000 in Traditional. After 20 years at 5%, you have $1,051.21. You pay 12% tax on that, and you're left with... $925.06

So, how sure are you that in retirement, you will be in a higher tax bracket than 12%?

I think if I think about it as an extra tax rate (14% =$700/$5000) would I pay 12%+14% to invest in a ROTH the answer is no because I don't think we'll be at a 26% tax rate. Even though it's not necessarily a tax it kinda feels like a tax and may work for this exercise. Or maybe a load fee in this case...

Am I thinking about this right?

[MDM]

However doing so, with AGI low, I give up the opportunity of taking more advantage of the dependent care tax credit for 2021 which is a better deal than the DCFSA deferrals.

If you have two kids in care, and the care cost is at least $10.5K, the case study spreadsheet indicates DCFSA contributions cost you 38% in federal income tax.  Seems taking the credit is the better choice.

[JJ-]

However doing so, with AGI low, I give up the opportunity of taking more advantage of the dependent care tax credit for 2021 which is a better deal than the DCFSA deferrals.

If you have two kids in care, and the care cost is at least $10.5K, the case study spreadsheet indicates DCFSA contributions cost you 38% in federal income tax.  Seems taking the credit is the better choice.

Yeah I think I was way overthinking it. Thank you for the affirmation on the DCFSA being a raw deal.

[EvenSteven]

However doing so, with AGI low, I give up the opportunity of taking more advantage of the dependent care tax credit for 2021 which is a better deal than the DCFSA deferrals.

If you have two kids in care, and the care cost is at least $10.5K, the case study spreadsheet indicates DCFSA contributions cost you 38% in federal income tax.  Seems taking the credit is the better choice.

Yeah I think I was way overthinking it. Thank you for the affirmation on the DCFSA being a raw deal.

I wouldn't go so far as to say it's a raw deal, but rather sub-optimal for your individual situation. A dcFSA is better for some people, while the dependent care tax credit is better for others.

[JJ-]

However doing so, with AGI low, I give up the opportunity of taking more advantage of the dependent care tax credit for 2021 which is a better deal than the DCFSA deferrals.

If you have two kids in care, and the care cost is at least $10.5K, the case study spreadsheet indicates DCFSA contributions cost you 38% in federal income tax.  Seems taking the credit is the better choice.

Yeah I think I was way overthinking it. Thank you for the affirmation on the DCFSA being a raw deal.

I wouldn't go so far as to say it's a raw deal, but rather sub-optimal for your individual situation. A dcFSA is better for some people, while the dependent care tax credit is better for others.

Right, thank you for clarifying for others that the DCFSA is usually better in every year except this year and may still be for many folks. For lower income people it can be sub optimal.

[GodlessCommie]

There is a line of thinking that if one targets FIRE, plans to live off investments, and their target spending is below $80k for a married couple, then Roth IRA almost never makes sense.

Counterintuitive, but the logic seems to be solid - you can expect 0% tax rate under conditions above, and no amount of taxes today is lower than that.

https://www.gocurrycracker.com/roth-sucks/

[MDM]

... 0% tax rate under conditions above, and no amount of taxes today is lower than that.

That part is correct.

GCC's suggestion that "marginal vs. effective" is how one should compare traditional vs. Roth, however, is not correct.  See Traditional versus Roth - Bogleheads for more on that.

[JJ-]

There is a line of thinking that if one targets FIRE, plans to live off investments, and their target spending is below $80k for a married couple, then Roth IRA almost never makes sense.

Counterintuitive, but the logic seems to be solid - you can expect 0% tax rate under conditions above, and no amount of taxes today is lower than that.

https://www.gocurrycracker.com/roth-sucks/

I often think about this. Surprisingly enough, I think about the both scenarios, how it's easy to stay below the 12% rate with a small enough income in retirement and leverage roth conversions and capital gains, but also b) how if you don't act fast enough (i.e., quit soon enough), you blow past it and end up well into much higher tax brackets thanks to compounding interest. I don't know if we're in a right spot to be able to know where we will be, but it's an interesting perspective also on the value of the taxable account over the ROTH.

GCC's suggestion that "marginal vs. effective" is how one should compare traditional vs. Roth, however, is not correct.  See Traditional versus Roth - Bogleheads for more on that.

For some reason, effective tax rate never had a spot for utility in my brain. It was always kind of a " well look at that" figure that showed up when I was tinkering about in spreadsheets and doing taxes. I've leaned more on which marginal bracket income fell into and how to optimize that way. I will 100% admit my brain isn't quite working tonight to understand the misconception in favor of the traditional, so I will have to come back to it tomorrow.

Thanks @GodlessCommie for the reminder that ROTH isn't always as good as it seems for young people.