Roth vs Traditional Tax Optimization

[Jwolfe]

I’m looking for some advice on whether I should be investing my 403b money in a Roth or traditional. Common sense dictates that if I will be in a lower tax bracket upon retirement I should invest in traditional. Looking at the federal tax brackets however I would anticipate remaining in the same bracket of 12%.

I currently make just under 80k a year while my wife stays at home with our 3 kids. The standard deduction alone places me in the 12% bracket (up to $80,251 currently married filing jointly) for many years to come. With the bottom of the 12% bracket being $19,750 I will not fall into the lower bracket upon retirement. So I guess the perks of investing traditional now would be more money in my pocket/investments now - pay taxes later and the perks of a Roth would be the opposite. Thoughts on which direction to head with this?

[dandarc]

We're supposed to be agnostic in this scenario where the tax rate would be the same if rates don't change. But if you're OK with 12%, you might go Roth to lock that in right now. If you want to hit your number faster and have confidence you might be able to manage your income well in your withdrawal phase, then you might go traditional.

I'd also look really hard at your numbers - if you get down to the top 12% bracket on standard deduction alone, you might have an opportunity to stack where suddenly traditional IRA contributions become fully deductible if you go traditional in the 403b whereas if you go Roth you can only do a partial tIRA contribution and deduct it. Also possible that some tax credits might come into play if you go traditional rather than Roth.

Also do you have state income tax where you are? Open to moving somewhere else down the road? That could move the math significantly.

I tend to be a "when in doubt, go with traditional" kind of person. But it is your money, and only you know your full situation. So long as the choice is "traditional vs. Roth" and not "contribute at all vs. buy a bunch more useless stuff" there isn't a wrong answer really.

[terran]

If you expect to be in the same bracket then it doesn't matter either way, but I would tend towards Roth in that case. Remember that only things like pension, social security (maybe not all of it depending on total income) and tax deferred retirement account withdrawals will be taxed, so if most of your money will be in Roth then you probably won't be in the 12% bracket, but rather 0% (standard deduction) or 10%.

A couple of things to consider that might tip the scales in favor of traditional are the savers tax credit and if you plan to move to a lower/no income tax state.

A couple of things to consider that might tips the scales in favor of Roth are if you plan to get health insurance through the ACA and want to maximize subsidies and if you plan to move to a higher income tax state. Remember that you also need a minimum income to qualify for ACA subsidies, so you'll want at least enough in traditional to hit that until you reach medicare age.

[dhc]

A common mistake with this discussion, and one you seem to have made, OP, is to compare only marginal tax rates. While deductions reduce taxes now by your marginal rate, if all of your retirement income will come from tax-advantaged accounts, then the first $19,750 (or whatever any brackets below 12% are then) will be taxed at less than your marginal rate.

[Jwolfe]

That’s a good point and I did forget that the first 19k is 10% then the next roughly 60k would all be at 12% and so on. So in theory, all things being equal the tax bracket is less relevant than the actual income. Example: income now of 80k results in paying 10% of 19k and 12% of 60k. Whereas a lower income, albeit still in the 12% bracket, would effectively pay less tax because you may only pay 12% on say 30-40k instead of 60. This is obviously really simplified but the bigger issue is that it assumes that tax brackets and percentages remain the same from now until retirement.

Of course all of this could be solved by investing in a traditional and moving to a state that doesn’t tax retirement income... that seems like the simplest solution if the family is in.

Outside of moving states traditional seems like the better bet If you expect tax percentages to remain similar and matching inflation. If tax rates hike by retirement, Roth seems safer. Sound about right?

[terran]

A common mistake with this discussion, and one you seem to have made, OP, is to compare only marginal tax rates. While deductions reduce taxes now by your marginal rate, if all of your retirement income will come from tax-advantaged accounts, then the first $19,750 (or whatever any brackets below 12% are then) will be taxed at less than your marginal rate.

No, you're the one making the common mistake. The OP had it right that comparing marginal tax rates now and in retirement is the correct comparison, comparing effective rates is incorrect.

[dhc]

That’s a good point and I did forget that the first 19k is 10% then the next roughly 60k would all be at 12% and so on. So in theory, all things being equal the tax bracket is less relevant than the actual income. Example: income now of 80k results in paying 10% of 19k and 12% of 60k. Whereas a lower income, albeit still in the 12% bracket, would effectively pay less tax because you may only pay 12% on say 30-40k instead of 60. This is obviously really simplified but the bigger issue is that it assumes that tax brackets and percentages remain the same from now until retirement.

Of course all of this could be solved by investing in a traditional and moving to a state that doesn’t tax retirement income... that seems like the simplest solution if the family is in.

Outside of moving states traditional seems like the better bet If you expect tax percentages to remain similar and matching inflation. If tax rates hike by retirement, Roth seems safer. Sound about right?

Yes, your bottom-line summary sounds about right, although if you're suggesting inflation has something to do with tax rates you've lost me there.

A common mistake with this discussion, and one you seem to have made, OP, is to compare only marginal tax rates. While deductions reduce taxes now by your marginal rate, if all of your retirement income will come from tax-advantaged accounts, then the first $19,750 (or whatever any brackets below 12% are then) will be taxed at less than your marginal rate.

No, you're the one making the common mistake. The OP had it right that comparing marginal tax rates now and in retirement is the correct comparison, comparing effective rates is incorrect.

I'm sorry, but that's simply not true and I stand by what I wrote initially. Note that I specifically said "if all of your retirement income will come from tax-advantaged accounts". Of course, in real life it's rarely that simple, so in some actual circumstances all retirement income from tax-advantaged accounts may end up being taxed at your marginal rate (this would occur anytime you had enough other retirement income to fill up any lower brackets), but there are also numerous circumstances, such as OP's example above, where a portion of retirement income from a tax-advantaged account is taxed at lower than your marginal rate.

You may have misread what I written and thought I was suggesting comparing effective tax rates both now and in retirement, which would also be incorrect; I'm not. The correct comparison, again, with the caveats listed above, is marginal tax rate now vs effective tax rate in retirement.

I suppose I could also have added a caveat along the lines of "and assuming you don't already have so much saved in a pre-tax tax-advantaged account that you'll already fill any brackets below your marginal rate for the entirety of your retirement", but that seemed to be getting too far into the weeds, which I guess I've now done.

If OP and I are both still misunderstanding, it would be significantly more helpful if you would provide reasoning rather than simply saying I'm wrong and providing no evidence.

[Joel]

Said another way, your marginal tax rate in retirement will not be 12% unless you have enough ordinary income at that age or have filled up your retirement accounts enough to generate that much each year.

For example, if I have $0 in tax deferred accounts at retirement and I’m 100% Roth, my tax rate would be zero. Obviously, there is social security and possibly other sources of income that may fill up your retirement tax brackets. However if takes a million dollars to produce $40k year indefinitely, and $40k per year is likely to be in a relatively low tax bracket upon retirement. So I would certainly make the argument for people without a pension to really focus on putting $1m in tax deferred over their lifetime. Too many people simplify the calculation of their expected tax rate in retirement and may be making less than optimal decisions in that regards.

[seattlecyclone]

You may have misread what I written and thought I was suggesting comparing effective tax rates both now and in retirement, which would also be incorrect; I'm not. The correct comparison, again, with the caveats listed above, is marginal tax rate now vs effective tax rate in retirement.

No.

The effective rate in retirement is a completely useless number for this purpose. People keep suggesting that this number is relevant to this decision, and they are wrong.

We're looking at whether it makes the most sense to contribute to Roth or traditional this year. Suppose that based on your prior and planned contributions outside of this year, you expect to have $325k in pre-tax retirement accounts when you retire. No pensions or other sources of regular (non-capital-gains/qualified-dividends) taxable income, just the IRA/401(k)/403(b)/whatever. Per the 4% rule you might then plan to withdraw $13k/year from your pre-tax retirement account. That's $450 above the standard deduction for a single person. You'd pay 10% tax on this $450, making your effective tax rate be $45/$13,000, or 0.35%.

Now this year you have some more money to contribute. Let's say it's $12.5k (pre-tax) you have to save this year, and you expect it to double by the time you retire. If you put it in your pre-tax retirement account that will bring your balance up to $350k, and increase your annual withdrawals by $1,000. Now instead of expecting to be $450 over the standard deduction every year, you expect to be $1,450 over the standard deduction. You'll pay 10% tax on this amount, making your effective tax rate be $145/$14,000, or 1.04%.

Are these effective tax rates actually useful for this decision? No! How am I supposed to use this 0.35% (or 1.04%) rate to decide anything? It's not as though I'm actually paying 1.04% on this year's withdrawals. I'm already filling up that standard deduction just from money I've contributed (or plan to contribute) in other years.

What matters is the marginal rate. Before you made this year's contribution you expected to have $13,000 regular income during retirement, and afterward you expected to have $14,000. Before this year's contribution you expected to pay $45 tax, and afterward you expected to pay $145. That's a 10% rate you're paying on the $1,000 of annual withdrawals attributable to this year's contribution. Always compare the marginal rates.

[MustacheAndaHalf]

I’m looking for some advice on whether I should be investing my 403b money in a Roth or traditional. Common sense dictates that if I will be in a lower tax bracket upon retirement I should invest in traditional. Looking at the federal tax brackets however I would anticipate remaining in the same bracket of 12%.

While we can't know future tax rates, right now taxes are at historic lows.  Using a Roth IRA in the 12% bracket locks in taxes for decades, while a Traditional IRA gives you uncertainty for decades.  I'd favor the Roth IRA.

On the flip side, with a Traditional IRA you have the choice to convert to a Roth IRA.  But converting the entire amount to a Roth IRA takes time, because you want to stay in a lower tax bracket while converting.  The time required can be a problem if the U.S. government raises taxes (I forgot to mention: the U.S. is the 6th most indebted country by debt to GDP ratio, right behind #5 Lebanon).

[terran]

Here's a good resource for the Roth vs Traditional decision: https://www.bogleheads.org/wiki/Traditional_versus_Roth. In particular, see under "Common Misconceptions" for why future effective tax rate is the wrong metric to use and marginal tax rate should be used.

[dhc]

We're looking at whether it makes the most sense to contribute to Roth or traditional this year. Suppose that based on your prior and planned contributions outside of this year, you expect to have $325k in pre-tax retirement accounts when you retire. No pensions or other sources of regular (non-capital-gains/qualified-dividends) taxable income, just the IRA/401(k)/403(b)/whatever. Per the 4% rule you might then plan to withdraw $13k/year from your pre-tax retirement account. That's $450 above the standard deduction for a single person. You'd pay 10% tax on this $450, making your effective tax rate be $45/$13,000, or 0.35%.

Now this year you have some more money to contribute. Let's say it's $12.5k (pre-tax) you have to save this year, and you expect it to double by the time you retire. If you put it in your pre-tax retirement account that will bring your balance up to $350k, and increase your annual withdrawals by $1,000. Now instead of expecting to be $450 over the standard deduction every year, you expect to be $1,450 over the standard deduction. You'll pay 10% tax on this amount, making your effective tax rate be $145/$14,000, or 1.04%.

Are these effective tax rates actually useful for this decision? No! How am I supposed to use this 0.35% (or 1.04%) rate to decide anything? It's not as though I'm actually paying 1.04% on this year's withdrawals. I'm already filling up that standard deduction just from money I've contributed (or plan to contribute) in other years.

What matters is the marginal rate. Before you made this year's contribution you expected to have $13,000 regular income during retirement, and afterward you expected to have $14,000. Before this year's contribution you expected to pay $45 tax, and afterward you expected to pay $145. That's a 10% rate you're paying on the $1,000 of annual withdrawals attributable to this year's contribution. Always compare the marginal rates.

Aha - thanks for the detailed response, @seattlecyclone - this is exactly what I wish @terran would have included instead of just "you're wrong."

I think in my case, I was both over-simplifying and getting hung up on terminology. Because while you're correctly using "marginal rate" to refer to the actual rate at which these dollars from this year will be taxed, either now or later, many people (including me, previously) conflate "marginal" with "tax bracket". Because future retirement income isn't totally predictable now, it's not as simple as saying "well, I'll be in the 12% bracket, so my marginal rate will be 12%".

All that said, on the whole, if tax brackets and rates never changed, I suspect most people who expect to retire in the same bracket as they are now would be better off deferring taxes than putting everything in Roth, because the marginal rate on some of those dollars on retirement is likely to be lower than their current marginal rate, and is at least not going to be higher. But simply comparing with your future effective rate is not a perfect stand-in for actually doing the calculation.

[EvenSteven]

We're looking at whether it makes the most sense to contribute to Roth or traditional this year. Suppose that based on your prior and planned contributions outside of this year, you expect to have $325k in pre-tax retirement accounts when you retire. No pensions or other sources of regular (non-capital-gains/qualified-dividends) taxable income, just the IRA/401(k)/403(b)/whatever. Per the 4% rule you might then plan to withdraw $13k/year from your pre-tax retirement account. That's $450 above the standard deduction for a single person. You'd pay 10% tax on this $450, making your effective tax rate be $45/$13,000, or 0.35%.

Now this year you have some more money to contribute. Let's say it's $12.5k (pre-tax) you have to save this year, and you expect it to double by the time you retire. If you put it in your pre-tax retirement account that will bring your balance up to $350k, and increase your annual withdrawals by $1,000. Now instead of expecting to be $450 over the standard deduction every year, you expect to be $1,450 over the standard deduction. You'll pay 10% tax on this amount, making your effective tax rate be $145/$14,000, or 1.04%.

Are these effective tax rates actually useful for this decision? No! How am I supposed to use this 0.35% (or 1.04%) rate to decide anything? It's not as though I'm actually paying 1.04% on this year's withdrawals. I'm already filling up that standard deduction just from money I've contributed (or plan to contribute) in other years.

What matters is the marginal rate. Before you made this year's contribution you expected to have $13,000 regular income during retirement, and afterward you expected to have $14,000. Before this year's contribution you expected to pay $45 tax, and afterward you expected to pay $145. That's a 10% rate you're paying on the $1,000 of annual withdrawals attributable to this year's contribution. Always compare the marginal rates.

Aha - thanks for the detailed response, @seattlecyclone - this is exactly what I wish @terran would have included instead of just "you're wrong."

I think in my case, I was both over-simplifying and getting hung up on terminology. Because while you're correctly using "marginal rate" to refer to the actual rate at which these dollars from this year will be taxed, either now or later, many people (including me, previously) conflate "marginal" with "tax bracket". Because future retirement income isn't totally predictable now, it's not as simple as saying "well, I'll be in the 12% bracket, so my marginal rate will be 12%".

All that said, on the whole, if tax brackets and rates never changed, I suspect most people who expect to retire in the same bracket as they are now would be better off deferring taxes than putting everything in Roth, because the marginal rate on some of those dollars on retirement is likely to be lower than their current marginal rate, and is at least not going to be higher. But simply comparing with your future effective rate is not a perfect stand-in for actually doing the calculation.

I think a lot of people get mixed up with terminology especially around the bolded bit. Roth and Traditional contributions shouldn't be looked at as lump sums, but as the marginal rate for each dollar. So when comparing, you should be looking at the marginal rate for each dollar going in vs each dollar coming out, not at the marginal rate on the last dollar. The terminology around effective, average, and marginal rates is confusing in this situation.

Clear as mud?

[pdxvandal]

My income is similar and the past few years I've chosen to do a little bit of both. This year, I'll put in $4.5k into a tIRA and $1.5k into a Roth IRA.

[MDM]

Because while you're correctly using "marginal rate" to refer to the actual rate at which these dollars from this year will be taxed, either now or later, many people (including me, previously) conflate "marginal" with "tax bracket". Because future retirement income isn't totally predictable now, it's not as simple as saying "well, I'll be in the 12% bracket, so my marginal rate will be 12%".

Correct.  Marginal tax rate - Bogleheads goes into more details.

...people who expect to retire in the same bracket as they are now

It can be a useful exercise to check such expectations.  In other words, what income sources will exist in retirement and how will those be taxed?  One may also find that expectations formed at age 25 change by the time one is, say, age 55....

...would be better off deferring taxes than putting everything in Roth

Yes, if everything is in Roth, the retirement marginal rate will be 0%.

[teen persuasion]

How much do you intend to contribute to the 403b?  Would it be enough to get your AGI in range to be eligible for the Saver's credit?  That would be a lean to traditional side signal - it would increase your tax savings now.

Do you intend to retire early?  That would lean toward traditional contributions - you will have years of lower income to convert from traditional to Roth, and it will be earlier years, before the traditional accounts have grown large.

Do you intend to work right up to SS/RMDs?  That would lean to Roth - many years of contributions, no time for conversions, long-term growth inside the accounts.  But sometimes our plans can detour - what if you plan to work forever, but events beyond your control cut your career short?  Some of each might be better than all traditional or all Roth.

Personally, we do all traditional as much as possible in employer plans, and max 2 Roth IRAs.  But we are in the middle of EITC eligibility, so there's a much bigger advantage to reducing w2 wages and AGI, because the phaseout rate for EITC is 21%, actually 27.3% when you include the state EITC match of 30%, on top of state and federal tax rates.  So the marginal rate for us is in the 40% range for traditional contributions, a definite positive.  The refundable EITC credit plus refundable portions of CTC we then use as additional savings - we use those for Roth IRAs, because there's little additional tax advantage at that point (tIRA contributions don't increase EITC as employer plan contributions do).  Fully funding one 403b likely won't quite get you to eligibility for EITC, unless your w2 wages and AGI are also reduced by health insurance contributions and HSA contributions thru payroll, as the cutoff for MFJ 3 kids is at $56,844.  Even if you can drop below that, the credit is small - the 21% marginal rate is only from that point downward.

[SeattleCPA]

I tend to be a "when in doubt, go with traditional" kind of person.

+1

[fyre4ce]

At a 12% rate today, I'd want to lock that rate in for at least a portion of my savings. 12% is historically low - rates could rise, you could move to a state that taxes IRA withdrawals, etc. Without knowing anything more about your situation, I'd aim for maybe 1/2-2/3 Roth, and the rest traditional, to make sure I can fill up the lowest brackets in retirement, and have some pre-tax money I could Roth-convert in a lower-income year.

Make sure that your actual marginal rate, including any tax credits and such, is actually 12%.

[Morning Glory]

I have similar income to you and do all traditional for two reasons:

1 it gets our AGI low enough to get a $400 savers credit

2 our state tax rate is high (~7.5%) and we want to move states eventually

[robartsd]

1 it gets our AGI low enough to get a $400 savers credit

I'm currently cycling my retirement contributions a bit to maximize the savers tax credit (2020 MFJ, AGI <= 39000: savers credit = $2000, federal income tax <$1500). I have access to both a 401k and 457b, so I have plenty of space for lowering my AGI (with a pension contribution as well, income isn't quite high enough to need more than one of these plans plus traditional IRAs).

When filing my 2018 taxes, I realized that I was saving enough that my AGI was close to the 20% savers credit threshold (43000 for MFJ in 2021), so I thought about what it might take to hit that threshold, then I noticed how little the difference between the 20% threshold and 50% threshold was; so I decided to try a cyclical strategy instead. I increased my taxable savings in 2019 (while still qualifying for the $400 credit). In 2020 I signed up to max out my 457b. 10% pay cut (lowering FICA taxes) and stimulus checks made hitting the target easier than expected, so I plan to keep AGI below the 50% credit threshold for 2021 (and likely 2022 as well). Based on my 2019 and 2020 taxes, the marginal rate for these contributions works out to about 15% after the impact on the tax credit (actually it is the last dollar needed to qualify had a marginal rate of about 60,000%).

[Morning Glory]

That is a good strategy @robartsd . I might just do that this year. We are planning to downsize our house, so I could possibly defer all of my income after that depending on what we get for it and whether we buy a new place. I have a 401a and 403b and 457b, plus tIRA x2 so lots of space. I'm currently only contributing to the 401a while we work on some house repairs.