Taxes: marginal rate now vs effective rate in retirement

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Topic Author
krick
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Taxes: marginal rate now vs effective rate in retirement

Post by krick »

I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
Thesaints
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Thesaints »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
Your friend is correct, as long as tax rates stay the same and retirement income comes from 401k's (et sim.).
InvisibleAerobar
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by InvisibleAerobar »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
a possibility that future tax brackets might change, so that the first cent of your annual distribution is taxed at the same or a higher bracket; or perhaps your social security and/or pension will fill up the lower brackets first, and that the first cent of your annual distribution is applied to the same or a higher bracket

but other than that, you are thinking about this a level deeper than your friend is, as you correctly recognize that the first cent of annual distribution from your 401(k) likely will not be in your highest marginal bracket, whereas during contribution is skimmed off the top, so to speak
Last edited by InvisibleAerobar on Mon Apr 22, 2019 4:50 pm, edited 2 times in total.
delamer
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by delamer »

Different types of income are taxed differently.

Long-term capital gains are taxed at a lower rate than income on a W-2. Social Security is taxed at ordinary income rates, but not all of it is taxed (85% maximum).

Both LTCG and SS are more common in retirement than during working years

So to say that if you have the same amount of income in retirement as while working that you’ll pay the same amount in taxes is incorrect (for most people).
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gasdoc
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gasdoc »

You might consider diversifying your Roth and non-Roth contributions, because you really can't predict future tax laws and income tax rules. This will give you different "buckets" from which you can withdraw money most optimally.

gasdoc
Lee_WSP
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

krick wrote: Mon Apr 22, 2019 4:37 pm My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
Yup. You're not saving a lot of "future taxes" by taking the deduction now. Plus we don't know whether future taxes will be higher or lower than they are now. And you don't know how much you will withdraw during retirement.

What we do know is that the ROTH will grow tax free and you can withdraw the whole amount or let it ride for your beneficiaries if you don't need it. Can't do that if you have to take required distributions at 70.5.

A ROTH is the best vehicle if you're young and not in a top tax bracket.
gluskap
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gluskap »

I think the difference is do you plan on taking out as much money in retirement as you make now? With a paid off house, which is what I plan to have when I retire, I plan to take out much less money then what I am making now. So I intend to pay less in taxes in retirement.
Topic Author
krick
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by krick »

InvisibleAerobar wrote: Mon Apr 22, 2019 4:48 pm but other than that, you are thinking about this a level deeper than your friend is, as you correctly recognize that the first cent of annual distribution from your 401(k) likely will not be in your highest marginal bracket, whereas during contribution is skimmed off the top, so to speak
This was exactly my point but he insists that I am wrong or at least looking at it the wrong way.
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TomatoTomahto
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by TomatoTomahto »

gluskap wrote: Mon Apr 22, 2019 4:50 pm I think the difference is do you plan on taking out as much money in retirement as you make now? With a paid off house, which is what I plan to have when I retire, I plan to take out much less money then what I am making now. So I intend to pay less in taxes in retirement.
We don’t plan to take out as much money in retirement as we make now, but why does that matter if what we take out puts us at an equal marginal tax bracket?

I’m not predicting future tax brackets, but if you give me an opportunity to debate the “higher brackets” or the “lower brackets,” I know which side I’d feel more comfortable debating in favor of.
I get the FI part but not the RE part of FIRE.
Lee_WSP
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

bradpevans
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by bradpevans »

Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?





Q.
Lee_WSP wrote: Mon Apr 22, 2019 4:49 pm [quote=krick post_id=4507915 time=<a href="tel:1555969048">1555969048</a> user_id=49115]
My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
Yup. You're not saving a lot of "future taxes" by taking the deduction now. Plus we don't know whether future taxes will be higher or lower than they are now. And you don't know how much you will withdraw during retirement.

What we do know is that the ROTH will grow tax free and you can withdraw the whole amount or let it ride for your beneficiaries if you don't need it. Can't do that if you have to take required distributions at 70.5.

A ROTH is the best vehicle if you're young and not in a top tax bracket.
[/quote]
Lee_WSP
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
cherijoh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by cherijoh »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
Your effective tax rate isn't what you need to worry about.

When if comes to the contributions you need to worry about the incremental taxes deferred - not your effective tax rate. If you are solidly in one tax bracket then your deferred tax rate will be your marginal tax bracket. (It could be a blend of two brackets if your contribution drops you into the next lower tax bracket).

On the back end, you do the same thing and look at how much extra taxes you expect to be paid on the withdrawals. Of course that is the tricky part, since you don't really know what tax rates will be in the future or how other potential income will be taxed. So it could be better, worse or a wash (as your coworker asserted).

However, you can stack the deck in your favor by retiring early, paying expenses by selling taxable investments (subject only to capital gains taxes), delaying SS and doing Roth conversions in the early retirement period and pay taxes on the conversions at a lower tax rate than what you defered years earlier. The taxes you avoided paying by doing pre-tax contributions gives you the seed money to start the after investments (which you sell during early retirement to minimize taxes).

Some of us in early retirement have also benefited from the recent change in marginal tax brackets - all my contributions were made at a deferred tax rate of 25%, but I'll be doing my conversions at a lower rate even if I end up with equivalent income. (If the tax rates do revert to pre-2018 levels, people now making pre-tax contributions could face a headwind in the future and end up paying more tax).

If you employer's plan allows you to do in-service Roth conversions, you may also have the opportunity to do some Roth conversion arbitrage while you are still employed based on flucuating share prices. Let's say you purchase Fund A in your 401k biweekly over the course of a few years at a "deferred" tax rate of 22%. You have 1000 shares at an average cost of $25/share. If a there is stock market correction and the share price of Fund A drops below your average cost, you could do an in-service Roth conversion on a portion of your traditional balance and pay less taxes on the conversion than you deferred by doing pre-tax contributions (assuming that you have sufficient room in the 22% marginal tax bracket). Your investment then gets to recover as a Roth investment and you would pay no additional taxes upon future distribution from the Roth 401k.
mptfan
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by mptfan »

krick wrote: Mon Apr 22, 2019 4:37 pm Am I missing something?
No.
mptfan
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by mptfan »

krick wrote: Mon Apr 22, 2019 5:21 pm
InvisibleAerobar wrote: Mon Apr 22, 2019 4:48 pm but other than that, you are thinking about this a level deeper than your friend is, as you correctly recognize that the first cent of annual distribution from your 401(k) likely will not be in your highest marginal bracket, whereas during contribution is skimmed off the top, so to speak
This was exactly my point but he insists that I am wrong or at least looking at it the wrong way.
You are looking at it the right way. Your friend is wrong. Read The Bogleheads Guide to Retirement Planning, Chapter 10, in particular the section entitled "Third Priority: Tax Deductible Retirement Accounts" beginning on page 154.
Last edited by mptfan on Mon Apr 22, 2019 5:50 pm, edited 1 time in total.
NotWhoYouThink
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by NotWhoYouThink »

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.
First, you probably won't have the same income when you retire. Now you save some of your income, so you won't take money out of your 401k/IRA just to put it in savings, although you will have to take it out eventually through RMDs. But you will be able to manage your income. You won't pay SS on unearned income, but you also (under current law) pay as much tax on dividends and capital gains as you do on ordinary income.
Yup. You're not saving a lot of "future taxes" by taking the deduction now. Plus we don't know whether future taxes will be higher or lower than they are now. And you don't know how much you will withdraw during retirement.
Of course you are not saving future taxes. You are saving current taxes, right now, this year. Future taxes are not certain, but under the current law not all of SS income is taxed, some states don't tax it at all. And again, cap gains and dividends are taxed differently and mostly at lower rates.

If you are in a lower tax rate now, it makes sense to put some money in a Roth IRA. But at 22/24% I'd keep putting it in the 401k and saving tax money now. Odds are your overall money available to spend doing this will be higher.
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celia
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by celia »

krick wrote: Mon Apr 22, 2019 4:37 pm I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.
This very well could be true if you don't have any other sources of income in retirement. But if you will have SS, a pension, rental income, those could increase your tax bracket. However, having a spouse (so filing MJF) in retirement as opposed to filing Single now (if that is the case), would lower your taxes in retirement since MFJ has twice as much room in each tax bracket compared to Singles. The reverse is also true in that if you are contributing to Roth now while MFJ, if you withdraw in retirement and are divorced or widowed, the room in the tax brackets will be half the size as now, making your tax bracket increase.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.
However, tax rates don't stay the same over the long term. There seems to be a major change in income tax laws every 10 years or so, as witnessed at the beginning of 2018. In fact, the 2018 tax laws are temporary, due to expire at the end of 2025 unless Congress moves to make them permanent before then. Right now, we are at historically low tax rates, so this is a good time to contribute to Roths. The other good times to contribute to a Roth are when you are young and/or early in your career, where your income (and tax brackets) are expected to go up in the future.

Besides looking at the tax brackets, I like to look at the dollar value of the taxes in each situation. I would rather pay $x in extra taxes now than a multiple of that later on if I have it in taxable and it is not earmarked for any upcoming need. I know that inflation would adjust the $x if not spent on taxes now and it is more of a mental accounting.
cusetownusa
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by cusetownusa »

mptfan wrote: Mon Apr 22, 2019 5:46 pm
krick wrote: Mon Apr 22, 2019 5:21 pm
InvisibleAerobar wrote: Mon Apr 22, 2019 4:48 pm but other than that, you are thinking about this a level deeper than your friend is, as you correctly recognize that the first cent of annual distribution from your 401(k) likely will not be in your highest marginal bracket, whereas during contribution is skimmed off the top, so to speak
This was exactly my point but he insists that I am wrong or at least looking at it the wrong way.
You are looking at it the right way. Your friend is wrong. Read The Bogleheads Guide to Retirement Planning, Chapter 10, in particular the section entitled "Third Priority: Tax Deductible Retirement Accounts" beginning on page 154.
+1
KlangFool
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by KlangFool »

krick wrote: Mon Apr 22, 2019 4:37 pm
My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.
krick,

That assumption is wrong for almost everyone. Hence, there is no point to discuss further. You should ask your friend why he thinks that is true.

This is the fundamental flaw of most people when they think about this problem.

KlangFool
bradpevans
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by bradpevans »

Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
Will the traditional person owe more than 33,440 in taxes assuming the 152,000 is the sole income for the year?
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Dottie57 »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
I will have less income from my retirement funds but the same or more spendable income. No FICA, pay tax on up to 85% of SS or less, no employee paid benefits, no life ins, no Medicare tax, no contributions to HSA when Medicare is in effect.

401k dollars going in were at 25% marginal — every single cent.

401k dollars coming out in retirement are taxed at 0%, then 12%, then maybe 22%. Then Add on tax of SS at marginal rate.
Thesaints
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Thesaints »

Dottie57 wrote: Mon Apr 22, 2019 6:28 pm I will have less income from my retirement funds but the same or more spendable income. No FICA, pay tax on up to 85% of SS or less, no employee paid benefits, no life ins, no Medicare tax, no contributions to HSA when Medicare is in effect.

401k dollars going in were at 25% marginal — every single cent.

401k dollars coming out in retirement are taxed at 0%, then 12%, then maybe 22%. Then Add on tax of SS at marginal rate.
That's no doubt correct. Unless your much younger and highly-compensated spouse continues to work... :)
decapod10
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
You shouldn't be looking at "taxes paid". You don't care about taxes paid. You care about how much money you have after taxes. In the scenario that @bradpevans lays out, pre-tax 401k is superior to Roth 401k. There are arguments to be made about whether or not this is a realistic scenario (there's social security to consider, RMD's as you mentioned, changing tax codes), but for this specifically pre-tax is clearly better.

Adam:

Current marginal tax bracket: 22%. Contributes $19k to pre-tax 401k. Investments increase 8x, so 401k value is $152k. Adam withdraws all $152k at retirement (edit: in a single year), assume no other income. Assume tax brackets are the same as 2019, ignore the standard deduction (which tilts it even more in favor of pre-tax).

Marginal tax bracket = 22% MFJ
Total tax paid = $25,157
Total take home = $152k - $25,157 = $126,483

Billy:

Current marginal tax bracket: 22%. Wants to contribute to Roth 401k. $19k - 22% = $14,820 after taxes goes into the Roth. Investments increase 8x, so Roth 401k value is $118,560. Billy withdraws all money

Total take home = $118,560

By using pre-tax investments, Adam has saved roughly $8,000. Much more than that if you include the standard deduction.
Last edited by decapod10 on Mon Apr 22, 2019 6:46 pm, edited 1 time in total.
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gilgamesh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

Sometimes tax deferral crosses tax brackets, and at times withdrawals from these accounts can cross tax brackets too. So, it really depends...IMO blanket statements like it’s only marginal tax rate vs marginal or marginal vs effective is just nonsense...

It’s easy to see current tax benefit of deferrals (whether it crosses brackets or not), then see how it meshes with your withdrawal plans....that’s all one can do.

For me personally, it’s marginal tax rate now and in retirement.
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TomatoTomahto
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by TomatoTomahto »

Let’s not forget the many couples who are deferring at MFJ rates but will be withdrawing at single rates, because of death of a spouse.
Last edited by TomatoTomahto on Mon Apr 22, 2019 6:57 pm, edited 1 time in total.
I get the FI part but not the RE part of FIRE.
jacksonm
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by jacksonm »

Operating under Jack Bogle's sage advice that "nobody knows nuthin" I maxed out both my individual Roth and company 401k contributions in the years leading up to retirement.

You can try to predict whether or not you will be in a higher tax bracket when you retire or not but it's all just a guess.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

decapod10 wrote: Mon Apr 22, 2019 6:42 pm
Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
You shouldn't be looking at "taxes paid". You don't care about taxes paid. You care about how much money you have after taxes. In the scenario that @bradpevans lays out, pre-tax 401k is superior to Roth 401k. There are arguments to be made about whether or not this is a realistic scenario (there's social security to consider, RMD's as you mentioned, changing tax codes), but for this specifically pre-tax is clearly better.
I missed the part where he somehow invests less than the full 19,000. I suppose if you can't afford the taxes today, you are better off deferring them in order to invest the extra 22%. Again, I don't see why you wouldn't be able to pay those extra taxes and make ends meet, but I concede the point.
bradpevans
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by bradpevans »

Lee_WSP wrote: Mon Apr 22, 2019 7:45 pm
decapod10 wrote: Mon Apr 22, 2019 6:42 pm
Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
You shouldn't be looking at "taxes paid". You don't care about taxes paid. You care about how much money you have after taxes. In the scenario that @bradpevans lays out, pre-tax 401k is superior to Roth 401k. There are arguments to be made about whether or not this is a realistic scenario (there's social security to consider, RMD's as you mentioned, changing tax codes), but for this specifically pre-tax is clearly better.
I missed the part where he somehow invests less than the full 19,000. I suppose if you can't afford the taxes today, you are better off deferring them in order to invest the extra 22%. Again, I don't see why you wouldn't be able to pay those extra taxes and make ends meet, but I concede the point.

Certainly one could do both.
In my toy example the “take home pay after taxes” is constant (133000 - taxes on 133000)
bradpevans
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by bradpevans »

Lee_WSP wrote: Mon Apr 22, 2019 7:45 pm
decapod10 wrote: Mon Apr 22, 2019 6:42 pm
Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
You shouldn't be looking at "taxes paid". You don't care about taxes paid. You care about how much money you have after taxes. In the scenario that @bradpevans lays out, pre-tax 401k is superior to Roth 401k. There are arguments to be made about whether or not this is a realistic scenario (there's social security to consider, RMD's as you mentioned, changing tax codes), but for this specifically pre-tax is clearly better.
I missed the part where he somehow invests less than the full 19,000. I suppose if you can't afford the taxes today, you are better off deferring them in order to invest the extra 22%. Again, I don't see why you wouldn't be able to pay those extra taxes and make ends meet, but I concede the point.

Certainly one could do both.
In my toy example the “take home pay after taxes” is constant (133000 - taxes on 133000)
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

Lee_WSP wrote: Mon Apr 22, 2019 7:45 pm
decapod10 wrote: Mon Apr 22, 2019 6:42 pm
Lee_WSP wrote: Mon Apr 22, 2019 5:42 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm Suppose I am in the 22% bracket making 152,000 and contribute 19,000 to 401, meaning I owe taxes on 133,000 and live on the rest

Suppose years later the 19,000 has doubled 3 times and become 152,000 and I withdraw it all.

Suppose instead i had gone Roth, meaning I invested 19,000*(0.78)= 14,820 and lived on 133,000 minus taxes

Under the same investments the Roth value is now 118,560 (and no more taxes will be paid)

After paying taxes on the 152000 withdraw, don’t i have more than 118560?
Federal Taxes paid on the ROTH = 4,180
Federal Taxes paid on the full withdrawal = 19,970 (this is assuming the withdraw is the only source of income. The person in this scenario will pay much more in tax as the first 77k was taxed at the two lower brackets)
You shouldn't be looking at "taxes paid". You don't care about taxes paid. You care about how much money you have after taxes. In the scenario that @bradpevans lays out, pre-tax 401k is superior to Roth 401k. There are arguments to be made about whether or not this is a realistic scenario (there's social security to consider, RMD's as you mentioned, changing tax codes), but for this specifically pre-tax is clearly better.
I missed the part where he somehow invests less than the full 19,000. I suppose if you can't afford the taxes today, you are better off deferring them in order to invest the extra 22%. Again, I don't see why you wouldn't be able to pay those extra taxes and make ends meet, but I concede the point.
Well, we're talking about equivalent amounts, then it's not really fair to compare $19k pretax to $19k post tax since that's not really a meaningful comparison. A more fair comparison would be $19k pretax + $5358 minus taxes into a taxable account vs $19k in a Roth. But you're right that Roth accounts have another less obvious advantage, which is that $19k of Roth space is "more" tax advantaged space than $19k of pre-tax space.

By default though, if someone just generically asks the question with no other information, I would say that at 22% marginal I would strongly consider pre-tax. Of course it's much more complicated than that though.

Someone here (KlangFool I think) also made an interesting game theory observation. If you contribute to a pre-tax account, you "lose" when you're retirement income is higher than expected and "win" if your retirement income is lower than expected. If you contribute to a Roth account, you "lose" if your retirement income is lower than expected and "win" if your retirement income is higher than expected. If you're uncertain, this might push you toward pre-tax because you're in a much better position when you "lose" because you actually have too much income, while in the Roth situation you "lose" when you have too little income which is a worse situation to be in.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by MathIsMyWayr »

krick wrote: Mon Apr 22, 2019 4:37 pm I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.
If you are later in your career, then you should have a somewhat clear idea of what your taxable income base will be in retirement such as SS, pension, annuity, and the RMD from the retirement fund saved so far. In your example, the current contribution to a pre-tax 401k is made at the tax bracket of 22%, this contribution will come out at the tax bracket at the top of your taxable income base during retirement. It is not likely, but not impossible, that it may be greater than 22%. In this case, Roth will be more beneficial. If your 401k balance is projected to be $3 MM without further contribution and you are making $150k now, then Roth will be the way to go.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by grayfox »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
What you are missing is RMDs. You think you can limit your withdrawals to stay in 10% or 12% bracket? Think again.

If you choose the Traditional IRA (tIRA), save diligently, invest wisely, and have a little bit of luck you will end up with a large tIRA. Then the year you turn 70-1/2 you will be forced to take huge RMDs that will put you in the top tax bracket, whatever that will be at that time. :oops: Right now the top bracket is 37%. Who knows what it will be decades in the future. Plenty would like to see it at 70%.

You will find yourself in the top tax bracket the rest of your life. And the RMDs just keep getting bigger. But not only will you pay high tax rate, you will have your SS taxed and pay huge medicare B and D premiums and pay whatever else they have that gets phased out for "high income" tax payers.

By putting everything in the TIRA, you are screwing your future 70-year old self. That's elder abuse.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Nate79 »

Another traditional vs Roth discussion...... Search, it's been discussed many times before.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Grogs »

grayfox wrote: Tue Apr 23, 2019 5:42 am
krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
What you are missing is RMDs. You think you can limit your withdrawals to stay in 10% or 12% bracket? Think again.

If you choose the Traditional IRA (tIRA), save diligently, invest wisely, and have a little bit of luck you will end up with a large tIRA. Then the year you turn 70-1/2 you will be forced to take huge RMDs that will put you in the top tax bracket, whatever that will be at that time. :oops: Right now the top bracket is 37%. Who knows what it will be decades in the future. Plenty would like to see it at 70%.

You will find yourself in the top tax bracket the rest of your life. And the RMDs just keep getting bigger. But not only will you pay high tax rate, you will have your SS taxed and pay huge medicare B and D premiums and pay whatever else they have that gets phased out for "high income" tax payers.

By putting everything in the TIRA, you are screwing your future 70-year old self. That's elder abuse.
Is this really a scenario to be worried about? Top tax bracket is $510k+. And that doesn't count 15% of SS, Roth, LTCG rates, etc. Even if I paid 80% EFFECTIVE tax on $510k, I would still be getting more than my current net pay minus investments. I'm certainly not going to lose any sleep over that "nightmare" scenario.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by supersecretname »

Assuming no other income, and leaving aside future unknown tax changes, and all else equal, you are right and friend is wrong.

It’s a point missed by many.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

grayfox wrote: Tue Apr 23, 2019 5:42 am
krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
What you are missing is RMDs. You think you can limit your withdrawals to stay in 10% or 12% bracket? Think again.

If you choose the Traditional IRA (tIRA), save diligently, invest wisely, and have a little bit of luck you will end up with a large tIRA. Then the year you turn 70-1/2 you will be forced to take huge RMDs that will put you in the top tax bracket, whatever that will be at that time. :oops: Right now the top bracket is 37%. Who knows what it will be decades in the future. Plenty would like to see it at 70%.

You will find yourself in the top tax bracket the rest of your life. And the RMDs just keep getting bigger. But not only will you pay high tax rate, you will have your SS taxed and pay huge medicare B and D premiums and pay whatever else they have that gets phased out for "high income" tax payers.

By putting everything in the TIRA, you are screwing your future 70-year old self. That's elder abuse.
This is blown way out of proportion...yeah! RMD is something to consider, but it’s not this.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

Yeah! Leaving money in a Roth 401k when subject to RMD is just giving money away...but that’s an argument for Roth 401k vs Roth IRA during RMD, and I don’t think anyone is doing that.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by MathIsMyWayr »

gilgamesh wrote: Tue Apr 23, 2019 7:53 am
Yeah! Leaving money in a Roth 401k when subject to RMD is just giving money away...but that’s an argument for Roth 401k vs Roth IRA during RMD, and I don’t think anyone is doing that.
If you separate or retire from your employer after age 70 1/2, you are subject to the first RMD on Roth 401(k) even if you want to roll over it to Roth IRA.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by MnD »

krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
You are correct and your friend, along with some of the responses above are wrong and/or suffer from pessimism and illusion of control bias.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

MnD wrote: Tue Apr 23, 2019 8:27 am
krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
You are correct and your friend, along with some of the responses above are wrong and/or suffer from pessimism and illusion of control bias.
I just wanted to point to this....what boglehead wiki says “The main reason to prefer one type of account over the other is the comparison of marginal tax rates. If your marginal tax rate now is higher than your estimated marginal tax rate at retirement, then the traditional account is better; if it is lower, then the Roth account is better“

https://www.bogleheads.org/wiki/Traditional_versus_Roth

I think it depends on your withdrawal strategy and the tax doesn’t have to be marginal or effective...it’s a spectrum, specific to each individual plan/situation.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gasdoc »

gilgamesh wrote: Tue Apr 23, 2019 8:30 am
MnD wrote: Tue Apr 23, 2019 8:27 am
krick wrote: Mon Apr 22, 2019 4:37 pm I was trying to explain to a friend why I contribute to a traditional 401k as opposed to a Roth 401k. He strongly disagrees with my logic and it has me questioning myself.

I explained that every dollar I contribute to my traditional 401k now would have been taxed at my marginal rate of 22%. When I withdraw it from my 401k in retirement, it could be not taxed at all, or taxed at 10%, 12%, or 22%, depending on how much I withdraw. Probably somewhere around 15% on average.

My friend says that if you have the same amount of income while working as you do in retirement, then your effective tax rates are identical and it doesn't make any difference and your tax burden is the same.

Am I missing something?
You are correct and your friend, along with some of the responses above are wrong and/or suffer from pessimism and illusion of control bias.
I just wanted to point to this....what boglehead wiki says “The main reason to prefer one type of account over the other is the comparison of marginal tax rates. If your marginal tax rate now is higher than your estimated marginal tax rate at retirement, then the traditional account is better; if it is lower, then the Roth account is better“

https://www.bogleheads.org/wiki/Traditional_versus_Roth

I think it depends on your withdrawal strategy and the tax doesn’t have to be marginal or effective...it’s a spectrum, specific to each individual plan/situation.
I have mentioned this earlier, but it was not commented on. Above is the bottom line, but consider diversifying since in many cases it may not be clear which is the better route. Earlier, we leaned toward Roth contributions leaving us with more after tax assets. As we get closer to retirement, and we see that our retirement income should be on the low side due to the earlier Roth contributions, we are shifting to pretax contributions. In the end, I think it is valuable to have both types of "buckets" in order to withdraw money strategically. My 2 cents.

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Re: Taxes: marginal rate now vs effective rate in retirement

Post by FrugalProfessor »

You are correct. The relevant trade-off is marginal rate today vs average rate in retirement. I spent the first decade of my investing career thinking that the relevant tradeoff was marginal today vs marginal in retirement, but I was wrong for reasons you mention in your post.

Bloggers like GoCurryCracker & Root of Good have zero average rate in retirement. It's pure arbitrage (with the caveat that tax brackets & rates may change). Both have multi-million dollar portfolios in early retirement and neither pays anything in taxes (https://www.gocurrycracker.com/6-years- ... ee-living/). Further, much of Root of Good's family is on Medicaid despite having a net worth of $2M (he does so by having very low income since he retired early).

I explain this fact more elaborately beginning on page 21 (through 28) of the attached pdf, which is a brain dump of what I've learned about the tax code the past decade (https://www.dropbox.com/s/lv96xgpfp95d3 ... t.pdf?dl=1).
I blog. Taxes are the lowest hanging source of alpha. I eat tax alpha for breakfast.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Dottie57 »

Thesaints wrote: Mon Apr 22, 2019 6:39 pm
Dottie57 wrote: Mon Apr 22, 2019 6:28 pm I will have less income from my retirement funds but the same or more spendable income. No FICA, pay tax on up to 85% of SS or less, no employee paid benefits, no life ins, no Medicare tax, no contributions to HSA when Medicare is in effect.

401k dollars going in were at 25% marginal — every single cent.

401k dollars coming out in retirement are taxed at 0%, then 12%, then maybe 22%. Then Add on tax of SS at marginal rate.
That's no doubt correct. Unless your much younger and highly-compensated spouse continues to work... :)
Yeah. Since I am single, the whole world is. :D
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Spirit Rider »

FrugalProfessor wrote: Tue Apr 23, 2019 9:14 am You are correct. The relevant trade-off is marginal rate today vs average rate in retirement. I spent the first decade of my investing career thinking that the relevant tradeoff was marginal today vs marginal in retirement, but I was wrong for reasons you mention in your post.
No, you were correct your first decade. Go back and read @cherijoh's post from yesterday. Yes, in any given year you have an effective tax rate, but it is irrelevant. This is a persistent myth based on a flawed understanding.

When you are making a determination of current vs. future tax rates to decide whether to make pre-tax or post-tax incremental contributions. The only thing that matters is the marginal tax rate(s) at contribution and the marginal tax rate(s) at withdrawal. Any incremental contribution increases your portfolio and will incrementally increase your withdrawal. Everyone can see the marginal contribution tax rate(s), but it causes an incremental change in the withdrawal which will be subject to incremental withdrawal marginal tax rate(s).
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by krick »

WOW. This blew up.

Trust me, I wasn't trying to start yet another Roth vs Traditional war. I know there are good reasons for choosing either (or a blend of both) and it ultimately depends on your particular circumstances.

My only goal here was to get confirmation that my understanding of the taxation is correct and that my plan is sound for my specific situation. I was genuinely worried that I was missing something critical based on my friend's response.

The comments in this thread did make me consider some things that I hadn't before and I thank each and every one of you for the time you took to reply. I never really thought too much about the differences in taxation due to being married. I'm currently not married and I don't anticipate myself being married in the future but it's definitely something to be aware of when trying to min-max your future finances.

I also wasn't concerned with RMDs because I expect my total portfolio when I retire to be relatively low (under 1 million) and I plan to start building a Roth conversion ladder upon retirement, converting up to the standard deduction each year until all traditional is converted to Roth.

My annual income requirements are also extremely low compared some of the people here. I currently spend less than $30K per year and I don't expect it to increase much in retirement other than for healthcare costs.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Quirkz »

gasdoc wrote: Tue Apr 23, 2019 8:57 am consider diversifying since in many cases it may not be clear which is the better route. Earlier, we leaned toward Roth contributions leaving us with more after tax assets. As we get closer to retirement, and we see that our retirement income should be on the low side due to the earlier Roth contributions, we are shifting to pretax contributions. In the end, I think it is valuable to have both types of "buckets" in order to withdraw money strategically. My 2 cents.
Agreed. This seems key to me. In most basic examples I've become convinced Traditional has a slight edge overall, but the flexibility of a Roth to either pull out some funds early or pull out a one-time lump sum without affecting annual income in retirement are both very valuable, so there seems to be a clear case for having at least some of that available.

Naturally the next question is "how much of each?" which layers guesswork upon guesswork. 50-50? 75-25? 90-10? Especially keeping in mind there seems to be a natural window to convert from Traditional to Roth between retirement and taking SS, I'm leaning toward mostly Traditional and some Roth, but I'm not about to tell someone they're wrong if they do it the other way around.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by KlangFool »

Quirkz wrote: Tue Apr 23, 2019 11:30 am
gasdoc wrote: Tue Apr 23, 2019 8:57 am consider diversifying since in many cases it may not be clear which is the better route. Earlier, we leaned toward Roth contributions leaving us with more after tax assets. As we get closer to retirement, and we see that our retirement income should be on the low side due to the earlier Roth contributions, we are shifting to pretax contributions. In the end, I think it is valuable to have both types of "buckets" in order to withdraw money strategically. My 2 cents.
Agreed. This seems key to me. In most basic examples I've become convinced Traditional has a slight edge overall, but the flexibility of a Roth to either pull out some funds early or pull out a one-time lump sum without affecting annual income in retirement are both very valuable, so there seems to be a clear case for having at least some of that available.

Naturally the next question is "how much of each?" which layers guesswork upon guesswork. 50-50? 75-25? 90-10? Especially keeping in mind there seems to be a natural window to convert from Traditional to Roth between retirement and taking SS, I'm leaning toward mostly Traditional and some Roth, but I'm not about to tell someone they're wrong if they do it the other way around.
Quirkz,

It is very simple.

Max up your Trad. 401K and put the tax savings into Roth IRAs.

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Re: Taxes: marginal rate now vs effective rate in retirement

Post by #Cruncher »

bradpevans wrote: Mon Apr 22, 2019 5:35 pm… the 19,000 has doubled 3 times and become 152,000 and I withdraw it all... Under the same investments the Roth value is now 118,560 … After paying taxes on the 152000 withdraw, don’t i have more than 118560?
This primarily depends on what other taxable income you'd have at the time of the withdrawal. This can be seen with the following example which assumes the only other taxable income is from Social Security. Based on the footnoted assumptions [1], with a SS benefit of $152,118, the after tax income is the same for both the Traditional and Roth routes. [2] For a smaller SS benefit the Traditional would be better than the Roth; for a larger SS benefit it would be worse.

Code: Select all

              -- Nominal $ ---     ---- Real $ ----
               Trad      Roth       Trad      Roth
              ------    ------     ------    ------
Investment    19,000    14,820
Grows to     152,000   118,560     76,000    59,280
Soc Sec      152,118   152,118     76,059    76,059
Tax           33,440         0     16,720         0 [3]
After tax    270,678   270,678    135,339   135,339
  1. Assumptions:
    • The money grows 8-fold over a 35 year period (+6.1% / year) during which the CPI doubles (2% / year).
    • The standard deduction and tax brackets also double. But the SS thresholds do not.
    • Tax brackets and rates are otherwise unchanged from 2019.
    • Taxes are calculated for a joint return with both spouses getting the age 65+ standard deduction.
  2. This is the case whether income and taxes are computed on a nominal or real dollar basis. The "Real $" columns of the little table assume the investment grows 4-fold in real terms (8-fold divided by CPI that doubles). The standard deduction and tax brackets stay at their 2019 levels; but the two SS thresholds (which are not indexed to inflation) are halved.
  3. Here is how the taxes are computed for the Traditional case, on both a Nominal $ and Real $ basis using my Marginal Tax Rates spreadsheet (with tweaks of the standard deduction, tax brackets, and SS thresholds).

    Code: Select all

                                        Nom $    Real $
    Floor: ord income 10% bracket           0         0  
    Floor: ord income 12% bracket      38,800    19,400
    Floor: ord income 22% bracket     157,900    78,950
    Social Security 50% threshhold     32,000    16,000
    Social Security 85% threshhold     44,000    22,000
    
    Non-SS Ordinary Income            152,000    76,000
    Social Security Benefit           152,118    76,059
    SS Relevant Income                228,059   114,029
    50% SS taxable                      6,000     3,000
    85% SS taxable                    123,300    61,650
    Total SS taxable                  129,300    64,650

    Code: Select all

    Adjusted gross income             281,300   140,650
    Std Deduction (both 65+)           54,000    27,000
    Taxable Income                    227,300   113,650
    
    Taxable: ord income 22% bracket    69,400    34,700
    Taxable: ord income 12% bracket   119,100    59,550
    Taxable: ord income 10% bracket    38,800    19,400
    
    Tax: ord income 22% bracket        15,268     7,634
    Tax: ord income 12% bracket        14,292     7,146
    Tax: ord income 10% bracket         3,880     1,940
                                       ------    ------
    Total tax                          33,440    16,720
    For the Roth route taxes are $0 because -- with no other income -- the taxable portion of SS is less than the standard deduction.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by FrugalProfessor »

Spirit Rider wrote: Tue Apr 23, 2019 10:15 am
FrugalProfessor wrote: Tue Apr 23, 2019 9:14 am You are correct. The relevant trade-off is marginal rate today vs average rate in retirement. I spent the first decade of my investing career thinking that the relevant tradeoff was marginal today vs marginal in retirement, but I was wrong for reasons you mention in your post.
No, you were correct your first decade. Go back and read @cherijoh's post from yesterday. Yes, in any given year you have an effective tax rate, but it is irrelevant. This is a persistent myth based on a flawed understanding.

When you are making a determination of current vs. future tax rates to decide whether to make pre-tax or post-tax incremental contributions. The only thing that matters is the marginal tax rate(s) at contribution and the marginal tax rate(s) at withdrawal. Any incremental contribution increases your portfolio and will incrementally increase your withdrawal. Everyone can see the marginal contribution tax rate(s), but it causes an incremental change in the withdrawal which will be subject to incremental withdrawal marginal tax rate(s).
The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:

Assume I'm retired today. Married. $0 of income except for roth conversions (or trad withdrawals). I convert 24,001 from a trad to a roth (or alternatively withdraw that amount from trad assuming I'm of age). No other income. Due to the $24k standard deduction, I owe taxes on $1 of conversions at 10%. In other words, I pay $0.10 in taxes on $24,001 of income. My marginal rate in that example is 10% yet my average rate is 0.10/24001 = 0.00042%.

In the above example, you would be crazy to believe that it's the marginal rate of 10% that matters in retirement. It's the average rate (taxes owed divided by trad withdrawals) that drives the underlying math. By only looking at the marginal (as I mistakenly thought for about a decade), you miss the underlying economics. It's a subtle, but important, difference. It makes trad even more compelling.

Arguments about future changes to tax law (brackets, rates, deductions) are still valid reasons to do roth now, but it still doesn't change the underlying economics of the relevant tradeoff. Marginal rate now vs Average (defined as taxes owed / total income) rate in retirement.
I blog. Taxes are the lowest hanging source of alpha. I eat tax alpha for breakfast.
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