Comparing the Saver's Tax Credit and Roth IRA

[FIPurpose]

Recently I have been thinking about how the advantages of these 2 items compare I thought I would do a deeper analysis of whether it is better to put money into a tIRA or RothIRA when in the 15% tax bracket.

My assumptions will be based on Married Couples that both have the ability to max out a 401k.

The 15% tax bracket for 2014 is at $73,800

The Saver's Tax credit starts at $60,000 which maxed out for 2 people provides: $400
at $39,000: provides an $800 credit
and at $36,000: provides a $2000 credit

The 15% tax on $13,800 (The difference between $73,800 and $60,000) is $2070. This means that You are paying an initial $2070 to put that into Roth Investment Accounts.

So assuming that you can put money into tax advantaged accounts and reach an AGI of $60,000 compare these outcomes:

1. Put money into ROTH IRA or 401k when inside the 15% tax bracket.
   Roth accounts:$13,800
   Taxable Accounts: 0
   
2. Put money into tax deferred accounts:
   Non-Roth accounts:$13,800
   Taxable Account:$2,470
   
The value of accounts for a single year after 20 years (assume avg. return of 8%):
1.
   Roth Account: $64,321
   Taxable: $0
   
2.
   Non-Roth Accounts: $64,321
   Taxable Account: $11,513
   
Now option 1 is now tax-free and has a true value of $64,321

If we assume that the money in option 2 is still taxed at 15% (though truly likely smaller in retirement):
   Non-Roth Account value after tax: $54,673
   Taxable Account: $11,513
   Total: $66,186
   
Value of your account if you can make it to the $800 credit:
   Non-Roth Account: $54,673
   Taxable Account: $13,377
   Total: $68,050
   
Value of your account if you can make it to the $2000 credit:
   Non-Roth Account: $54,673
   Taxable Account: $18,970
   Total: $73,643
   
And this is only the difference 1 year makes (up to almost $10,000).

Hopefully someone else can verify me on this. My knowledge of tax law is limited, but I'd like to find out what other people think the pros and cons of this are.

[skyrefuge]

The way you set up the comparison between traditional and Roth (equal tax rates at both funding and withdrawal, ignoring dividends/capital gains, which an entirely reasonable way to do it), the final, after-tax value of each method is expected to be identical given the same initial funding. Thus, the difference in the final values in the scenarios you ran is due entirely to the addition of the Savers Credit in Scenario 2 (compounded at 8% for 20 years). So yes, your math checks out. (and it makes the particular tax bracket you choose irrelevant, since they cancel out.)

I think for most Mustachians, the choice between Traditional and Roth shelters is clear: do Traditional as much as you can, and Roth only when you no longer have the option for Traditional. If going Traditional also allows you to get a tax credit that you otherwise would not have gotten, then that just makes the argument for Traditional even stronger.

So the question then is how common is a household who has the potential to qualify for a Savers Credit, but screws themselves out of it because they contributed to a Roth rather than a Traditional shelter? My gut feel is that would be a rare beast indeed, since the numbers have to fall just right. But if it happens to fit your personal situation, then yeah, lucky you!

[FIPurpose]

There are a lot of people who start doing Roth contributions when they hit the 15% tax bracket. I've heard many say that even on this board. Without the tax credit, I'm not sure if that would still hold true.

Obviously doing math at the same level, the credit is the only difference, but it is important to realize that in retirement most of us won't be spending in the $60-70k range. So your effective tax rate will be lower than what is presented and it only adds to that benefit.

I am definitely changing my investing strategy after I found this out, I may move to exclusive tax deferred accounts even.

[skyrefuge]

There are a lot of people who start doing Roth contributions when they hit the 15% tax bracket.

Really? What's the theory behind that? Or by "hit the 15% tax bracket", do you mean "if their income does not EXCEED the 15% tax bracket"?

In my mind, the prototypical Mustachian is a relatively high earner, likely in the 25% bracket and above, and, as you note, will see far lower effective tax rates in retirement (and probably still will even if overall rates rise in the future). Thus, a Traditional is a pretty clear choice: avoid 25% taxes now, and pay less than 10% taxes in retirement.

But sure, I guess if someone is in the 15% bracket now, expects their expenses in retirement to close to their income now, and thinks overall tax rates will rise, then a Roth might be better for them. That person just isn't a prototypical Mustachian (since a relatively low income combined with a low savings rate don't lend themselves to a particularly early retirement).

[wtjbatman]

Some of us have a low income (15%) and still manage a very reasonable savings rate (50%).

I know we're a rare breed. Please, no pictures.

[Mazzinator]

OP, welcome to the club ;)

https://forum.mrmoneymustache.com/welcome-to-the-forum/optimize-your-taxable-income/

[teen persuasion]

The math is very different at a lower income level and with kids involved. 

DH maxes his 401k, I don't have access to one, maxing Roths for both of us, 3 kids still claiming for now.  Our AGI would make us eligible for $2k Saver's Credit, but we owe $0 tax.  That is why we are doing Roths - there is no benefit at this point for us to do tIRAs.

In a few years, we plan for DH to stop working, while I continue part-time.  I'll continue to fund Roths for both of us so we are eligible for the Saver's Credit, and convert rollover IRAs to Roth up to the $36k income limit to make use of the $2k credit.  As long as my part-time income is below the start of the EIC phase-out, we would be eligible for the full EIC (refundable) on the one kid we will be claiming at that point.

[skyrefuge]

The math is very different at a lower income level and with kids involved.

Good point, thanks. As an unmarried-without-kids, I tend to forget how crazy-generous the tax code is to parents. If your taxes are in fact 0, and an IRA deduction doesn't make them go negative, then it's a no-brainer to choose a Roth instead.