Is a Lower Effective Tax Rate Incentive to do a Roth IRA?

[onecoolcat]

My wife and my effective tax rate was 5.8% in 2014.  This makes me think it was probably a good idea that we did Roth IRA's in 2014, wouldn't you say?

We expect to make about twice as much in 2015 but we are both maxing our 401ks this year so that will bring our income to about 20k more than it was this year.  If we do traditional IRAs in 2015, then I calculated we would have a taxable income of around 60k, which I think is taxed at approx. 20%.  Since we would not be taxed on nearly half of our income if we do traditional IRAs, our effective tax will be somewhere between 10-12%.  This is pretty low and it makes me wonder whether throwing the 11k at Roth IRAs would be better.  It seems like a good idea but I've been reading a lot lately about how Roth IRAs are always inferior to traditional but I'm not buying it completely. If we do the Roth IRAs, our taxable income will be around 70k, so it will raise our effective tax rate but I think it will still right around 15%.

Also, Im new to the whole investing thing.  I funded a Roth IRA for 2014 (VTSMX) just last week.   Originally I had planned to just keep putting my IRA contributions into VTSMX and convert it to the version with the lower expense ratio (when I reach 10k).  If I decide to do a traditional IRA instead this year, could I combine my Roth and traditional VTSMX shares to get into the admiral shares?

And I'm almost positive, but for tax purposes, your 401k contributions are taken out of your taxable income before you are taxed on your Roth, correct?  That could change everything if that's not the case, because we would go from being taxed at 15% to 35%.

[nereo]

The standard advice is that if your current tax rate is less than what you expect to pay in taxes upon retirement, Roth is the way to go.  For the majority of people though, they win out having an t-IRA.  With your 5.8% tax rate you might just be an exception.

One of the hardest parts to the calculation is that no one knows for sure what the tax code and tax rates will be like decades from now.

See this excellent post by Curry Cracker on the t-IRA/ROTH debate, and why t-IRA almost always wins.
http://www.gocurrycracker.com/roth-sucks/

[Joel]

You should be comparing your marginal rate now to your marginal rate upon retirement to make this determination. Your effective rate means nothing. If you reduce your taxable income now, you could likely save 25% now. Whereas upon retirement, depending upon how much you have built up in tax deferred accounts, could likely be less than 25%.

[johnny847]

You should be comparing your marginal rate now to your marginal rate upon retirement to make this determination. Your effective rate means nothing. If you reduce your taxable income now, you could likely save 25% now. Whereas upon retirement, depending upon how much you have built up in tax deferred accounts, could likely be less than 25%.

Nope. Marginal rate now to expected average rate of taxes paid on your withdrawals is what you should be using. In many (but certainly not all) scenarios, not all of your traditional 401k and IRA withdrawals will be taxed at you future marginal rate. I have a more detailed explanation on my blog https://fiby40.wordpress.com/2015/01/15/retirement-accounts-part-1/

[beltim]

You should be comparing your marginal rate now to your marginal rate upon retirement to make this determination. Your effective rate means nothing. If you reduce your taxable income now, you could likely save 25% now. Whereas upon retirement, depending upon how much you have built up in tax deferred accounts, could likely be less than 25%.

Nope. Marginal rate now to expected average rate of taxes paid on your withdrawals is what you should be using. In many (but certainly not all) scenarios, not all of your traditional 401k and IRA withdrawals will be taxed at you future marginal rate. I have a more detailed explanation on my blog https://fiby40.wordpress.com/2015/01/15/retirement-accounts-part-1/

This is a little less wrong than Joel, but it's still wrong.  You want to maximize after tax income, and your method does that for one scenario - you only ever contribute to one type of retirement account, and you don't have any other sources of income in retirement.  Since this isn't true for the overwhelming majority of people, it's a pretty bad approximation.

[Joel]

You should be comparing your marginal rate now to your marginal rate upon retirement to make this determination. Your effective rate means nothing. If you reduce your taxable income now, you could likely save 25% now. Whereas upon retirement, depending upon how much you have built up in tax deferred accounts, could likely be less than 25%.

Nope. Marginal rate now to expected average rate of taxes paid on your withdrawals is what you should be using. In many (but certainly not all) scenarios, not all of your traditional 401k and IRA withdrawals will be taxed at you future marginal rate. I have a more detailed explanation on my blog https://fiby40.wordpress.com/2015/01/15/retirement-accounts-part-1/

When I say your marginal tax rate upon retirement, it is correct. If you will have ordinary income (from a pension or other means) you have already filled up that part of the tax bracket. You should accumulate enough in tax deferred accounts while you expect it to produce income that is taxed at a marginal tax rate below or equal to what you are currently at.

That means you should put at least 250k into tax deferred accounts as it would produce 10K per year tax free. Alternatively, if you have 10k in a pension or some other form of income, you have already filled up the 0% tax bracket. Therefore making your effective rate upon retirement irrelevant, and making your 10% marginal rate the relevant %.

[johnny847]

You should be comparing your marginal rate now to your marginal rate upon retirement to make this determination. Your effective rate means nothing. If you reduce your taxable income now, you could likely save 25% now. Whereas upon retirement, depending upon how much you have built up in tax deferred accounts, could likely be less than 25%.

Nope. Marginal rate now to expected average rate of taxes paid on your withdrawals is what you should be using. In many (but certainly not all) scenarios, not all of your traditional 401k and IRA withdrawals will be taxed at you future marginal rate. I have a more detailed explanation on my blog https://fiby40.wordpress.com/2015/01/15/retirement-accounts-part-1/

This is a little less wrong than Joel, but it's still wrong.  You want to maximize after tax income, and your method does that for one scenario - you only ever contribute to one type of retirement account, and you don't have any other sources of income in retirement.  Since this isn't true for the overwhelming majority of people, it's a pretty bad approximation.

No, I specifically address this in post, if you actually read it

Now, I did say that typically not all of your 401k withdrawals are taxed at your marginal rate. We can certainly construct examples where all of your 401k withdrawals are actually taxed at your marginal rate. Suppose Bob had a pension that provided him $50,000 in 2014. In this case, his pension income already puts him in the 25% bracket. So long as he did not withdraw more than $49,500 from his 401k in 2014, he would stay in the 25% bracket, and hence, all of his 401k withdrawals would be taxed at his marginal rate. But what I said when I introduced traditional accounts is still true – I specifically said we should compare the marginal tax rate now to average tax rate of 401k withdrawals. It’s just that in this case, the average tax rate of 401k withdrawals is equal to his marginal tax rate.

When I say your marginal tax rate upon retirement, it is correct. If you will have ordinary income (from a pension or other means) you have already filled up that part of the tax bracket. You should accumulate enough in tax deferred accounts while you expect it to produce income that is taxed at a marginal tax rate below or equal to what you are currently at.

This becomes incorrect when you mix in income from long term capital gains and qualified dividends, because your marginal tax rate isn't actually necessarily applied to your 401k withdrawals. I specifically provide a graph of this situation in my post.

That means you should put at least 250k into tax deferred accounts as it would produce 10K per year tax free. Alternatively, if you have 10k in a pension or some other form of income, you have already filled up the 0% tax bracket. Therefore making your effective rate upon retirement irrelevant, and making your 10% marginal rate the relevant %.

We concern ourselves with the effective rate [of traditional IRA or 401k withdrawals] upon retirement because you have a choice: make a traditional contribution or make a Roth contribution. With probability one, one of these choices is going to be better than the other. The only way to know if the Roth is going to be better is to compare what would happen if you made a traditional contribution instead.

[Joel]

When someone does not have ordinary income upon retirement or a sizeable stash of tax deferred money, the traditional accounts are better. At a certain point, onc enough is saved, the roth accounts will be become better. For example, someone in the 10% bracket is making roughly 20k per year right now. In order to produce 20k per year upon retirement, they need about 500k (see 4% rule). Assuming this person expects to keep making around 20k the rest of their life, they should save roughly 500k in traditional accounts, and then switch over to roth accounts. They would have the same marginal tax rate upon retirement, however, their effective rate would be much lower. If they continued to make traditional retirement contributions, they would be saving 10% now, at a cost of paying a 15% marginal tax rate in the future. Theres almost never a point when their expected effective rate would be above their current 10% marginal rate, so in your suggestion, they would always make traditional contributions, but at this point they clearly have enough. In reality, they probably only need 250k in tax deferred accounts to fill the 10k per year one can get tax free. After that their marginal rate upon retirement is the same as current, so in theory it should not matter whether they do traditional or roth. But as discussed above, there is a limit to when the traditional would no longer be a good idea, and it when your marginal tax rate upon retirement is greater than or equal to what it is now.

[johnny847]

When someone does not have ordinary income upon retirement or a sizeable stash of tax deferred money, the traditional accounts are better. At a certain point, onc enough is saved, the roth accounts will be become better. For example, someone in the 10% bracket is making roughly 20k per year right now. In order to produce 20k per year upon retirement, they need about 500k (see 4% rule). Assuming this person expects to keep making around 20k the rest of their life, they should save roughly 500k in traditional accounts, and then switch over to roth accounts. They would have the same marginal tax rate upon retirement, however, their effective rate would be much lower. If they continued to make traditional retirement contributions, they would be saving 10% now, at a cost of paying a 15% marginal tax rate in the future. Theres almost never a point when their expected effective rate would be above their current 10% marginal rate, so in your suggestion, they would always make traditional contributions, but at this point they clearly have enough. In reality, they probably only need 250k in tax deferred accounts to fill the 10k per year one can get tax free. After that their marginal rate upon retirement is the same as current, so in theory it should not matter whether they do traditional or roth. But as discussed above, there is a limit to when the traditional would no longer be a good idea, and it when your marginal tax rate upon retirement is greater than or equal to what it is now.

Ah I see what you're saying. The key part that I was missing is once they have enough in the 401k to fill the lower brackets.
I fell into the trap of comparing total cost vs total benefit, as opposed to marginal cost vs marginal benefit at every step.

I need to update my blog post. I also need to reanalyze what happens when you throw LTCG into the mix. But actually I don't think it'll change much, since people should be maxing their retirement accounts before contributing to a taxable account (well with maybe the exception of the 401k fees are tremendously bad - I've seen one guy at Bogleheads show a 401k with funds averaging 2% in fees!!). And people who are able to max their retirement accounts will almost certainly be retiring into a lower bracket than their working years.

Thanks for the discussion Joel!