The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: Gatzbie on September 07, 2019, 12:59:16 PM
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Good Afternoon Everyone!
Have read much on what would be best to do on deciding between Roth & Traditional for 401k/IRA Contributions..... but am stuck. Looking at what I have done & what I can still do for 2019 while seeing what I can do better for 2020.
2019 so far:
Age: 25 (Single) Filing Status
Salary: 49k
Pre-Tax 401k: $19k —> Puts AGI to 30k = now eligible for 1st Tier of “Savers Credit” —> $400 Credit
Roth/Traditional IRA — Have the money to max out…undecided on which one….
Mega-BackDoor Roth — Contributing as much as I can until the end of the year (next remaining 16 weeks).
Current Marginal Tax Bracket: 12%
Estimating Future Marginal Tax Rate:
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I have done the calculations utilizing the Investment Order Post, but the crystal ball it creates I feel is hazy because I am young & just starting out. As the years go by, the crystal ball will get clearer….but what to do now while its hazy?
Results Indicate Low future marginal tax rate because I have only just started contributing:
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FV of current Traditional 401k/IRA Balance: $33,897
17 year work period
3% return rate
FV:$56,026.58 x .04 annual withdraw = only $2,241 of ordinary income
FV of Taxable Account Balance: $42,110
17 year work period
3% return rate
FV taxable account balance: $69,601.41 x .02 = only $1,392 in qualified dividends
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Because I’m a little uncertain about these calculations. Should I go with the assumption that because my current marginal tax bracket is low at 12%….should I max out Roth IRA? Also looking back, should I have done Roth 401k instead because of my low tax bracket?
If I get raises in the future & am more in the 22% bracket —> then switch back to Traditional & Pre-tax 401k contributions?
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Crystal balls are usually pretty hazy. My thinking is that for those in the 12% bracket (or the 15% bracket once/if the old brackets come back in 2026 as scheduled) it's pretty much a tossup between Roth and traditional for Mustachians. This is because the 12% bracket allows tax deferred withdrawal between $21,900-51,675 if single and $43,800-103,350 if married, both of which seem like totally reasonable, to downright extravagant spending levels for most mustachians, IMO. And then if you have some of your savings in Roth or taxable you'll be able to save even more without going up a bracket.
If you can qualify for the savers tax credit (which you've figured you can) that might push you towards traditional. If you expect to move to a lower tax state in retirement that might also push you towards traditional.
If you expect tax rates to go up by the time you retire (they're scheduled to go up in 2026 under current law, but not much) then that might push you towards Roth. If ACA subsidies are still around by the time you retire, that's basically another type of tax which might indicate you want more of your spending to come from Roth.
Remember that you'll want at least enough in tax deferred to fill the standard deduction. Since you're clearly comfortable with excel you might try playing around to see the present value (PV) you'll need at retirement to pull out the standard deduction for your expected lifespan, and then find the payment (PMT) you'll need to make into your tax deferred accounts between now and then to reach that balance. You might do the same for the 10% and 12% brackets too. Not perfect, but it will give you some information on the range of balances you might want to target in tax deferred and how much you'll need to put in tax deferred to get there. Adjust as information (like tax law) changes.
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Because I’m a little uncertain about these calculations. Should I go with the assumption that because my current marginal tax bracket is low at 12%….should I max out Roth IRA? Also looking back, should I have done Roth 401k instead because of my low tax bracket?
If I get raises in the future & am more in the 22% bracket —> then switch back to Traditional & Pre-tax 401k contributions?
Didn't check the exact calculations but they seem plausible so let's assume they are correct - well done! What you - and everyone else - lack is a working crystal ball, so there is no "correct" answer to your question now. The 17 year goal for retirement does place a finger on the traditional side of the scales, even saving only 12% now, but it would also be reasonable to choose Roth at a 12% rate "just because...".
Don't worry about exactitude now. Instead, give yourself a well deserved pat on the back for starting early, pick one or the other now, go back to the day job, then reevaluate every year or so.
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I had the same judgement call to make as you.
I’m 28, income is a little higher but still in the same tax bracket as you.
I chose traditional over Roth for both 401k and IRA.
This article from the Mad Fientist helped push me towards traditional over Roth:
https://www.madfientist.com/traditional-ira-vs-roth-ira/
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Crystal balls are usually pretty hazy. My thinking is that for those in the 12% bracket (or the 15% bracket once/if the old brackets come back in 2026 as scheduled) it's pretty much a tossup between Roth and traditional for Mustachians. This is because the 12% bracket allows tax deferred withdrawal between $21,900-51,675 if single and $43,800-103,350 if married, both of which seem like totally reasonable, to downright extravagant spending levels for most
vidmate (https://vidmate.bet/) mustachians, IMO. And then if you have some of your savings in Roth or taxable you'll be able to save even more without going up a bracket.
If you can qualify for the savers tax credit (which you've figured you can) that might push you towards traditional. If you expect to move to a lower tax state in retirement that might also push you towards traditional.
If you expect tax rates to go up by the time you retire (they're scheduled to go up in 2026 under current law, but not much) then that might push you towards Roth. If ACA subsidies are still around by the time you retire, that's basically another type of tax which might indicate you want more of your spending to come from Roth.
Remember that you'll want at least enough in tax deferred to fill the standard deduction. Since you're clearly comfortable with excel you might try playing around to see the present value (PV) you'll need at retirement to pull out the standard deduction for your expected lifespan, and then find the payment (PMT) you'll need to make into your tax deferred accounts between now and then to reach that balance. You might do the same for the 10% and 12% brackets too. Not perfect, but it will give you some information on the range of balances you might want to target in tax deferred and how much you'll need to put in tax deferred to get there. Adjust as information (like tax law) changes.
Why qualifying for the savers tax credit might push you towards traditional? May I know please.
Regards,
Kasey.
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Why qualifying for the savers tax credit might push you towards traditional? May I know please.
Regards,
Kasey.
The saver's credit has a few tiers to it, where being over or under the AGI limit by a few dollars can make a difference of a few hundred on your taxes. If you're over one of those lines by just a couple thousand dollars, it can be advantageous to make enough traditional contributions to get under that line and claim the next higher tier of saver's credit.
The standard advice of comparing your current marginal rate to your future one still applies, it's just that this credit can make your effective marginal rate rather high in the current year.
Crystal balls are usually pretty hazy. My thinking is that for those in the 12% bracket (or the 15% bracket once/if the old brackets come back in 2026 as scheduled) it's pretty much a tossup between Roth and traditional for Mustachians. This is because the 12% bracket allows tax deferred withdrawal between $21,900-51,675 if single and $43,800-103,350 if married, both of which seem like totally reasonable, to downright extravagant spending levels for most mustachians, IMO. And then if you have some of your savings in Roth or taxable you'll be able to save even more without going up a bracket.
If you're planning to retire prior to Medicare age and you plan for the ACA to still exist in something similar to its current form at that time, don't forget to consider the effect that ACA subsidy phase-outs will have on your marginal rate in retirement (https://seattlecyclone.com/marginal-tax-rates-under-the-aca/). Those whose retirement income is between the Medicaid cutoff and 300% of the poverty level will be tacking on at least 12% to the marginal rate imposed by the regular tax brackets. Therefore if you're paying 12-15% total right now, you may want to err on the side of making Roth contributions.
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Why qualifying for the savers tax credit might push you towards traditional? May I know please.
Say you file single with an income at the very top of the 12% bracket ($12,200 standard deduction + $39475 = $51,675). That means you're $19,175 ($51,675 - $32,500) over the top savers tax credit. If you put that $19,175 in traditional 401(k) and IRA then you'll save 12%, but since that also makes you eligible for the savers tax credit you'll save another $200, so your actual marginal tax savings is ($19,175*12% + $200)/$19,175 = 13.04%. Not a huge difference, but thats a worse case scenario. Since the credit is a flat $200 (as long as you contribute at least $2000 to retirement accounts), so the close you are to the limit the more difference it makes. Say you instead make $37,500, only $5000 over the limit. Then your marginal rate on that $5000 in the traditional vs Roth decision is ($5000*12%+$200)/$5000 = 16%, and so on like that with the marginal rate growing as you're income gets closer to the tax credit cutoff. Since there's no savers credit in retirement, if tax rates stay the same then you'll pay higher taxes on the same amount of income in retirement as you will now (if you qualify for the credit).
Crystal balls are usually pretty hazy. My thinking is that for those in the 12% bracket (or the 15% bracket once/if the old brackets come back in 2026 as scheduled) it's pretty much a tossup between Roth and traditional for Mustachians. This is because the 12% bracket allows tax deferred withdrawal between $21,900-51,675 if single and $43,800-103,350 if married, both of which seem like totally reasonable, to downright extravagant spending levels for most mustachians, IMO. And then if you have some of your savings in Roth or taxable you'll be able to save even more without going up a bracket.
If you're planning to retire prior to Medicare age and you plan for the ACA to still exist in something similar to its current form at that time, don't forget to consider the effect that ACA subsidy phase-outs will have on your marginal rate in retirement (https://seattlecyclone.com/marginal-tax-rates-under-the-aca/). Those whose retirement income is between the Medicaid cutoff and 300% of the poverty level will be tacking on at least 12% to the marginal rate imposed by the regular tax brackets. Therefore if you're paying 12-15% total right now, you may want to err on the side of making Roth contributions.
Excellent point. If healthcare costs continue to be tied to income this is a big vote in favor of Roth over traditional when the current and future expected marginal rates are otherwise close.