Taxes: marginal rate now vs effective rate in retirement

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decapod10
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

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.

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).
For any incremental contribution, it's marginal rate now vs marginal rate in retirement, not marginal rate now vs effective rate in retirement. The only time that it's marginal rate now vs effective rate in retirement is if you:

1) have no other sources of retirement income
2) you have $0 in retirement savings

Mainly because in this instance, effective rate and marginal rate are basically the same thing. Once you have a meaningful amount of money in retirement savings, then any additional contribution you need to compare marginal tax rates now vs marginal tax rates at retirement.

For example,

Person A:

Your current marginal rate is 22%. You currently have $0 in retirement savings. At retirement, we'll assume the standard deduction and social security cancel out to make the math easier, and also assume that the tax structure is the same as now and single.

If you contribute $19k to your pre-tax 401k and it grows 3x to $57,000, then you withdraw it all when you retire. In this instance, you are indeed paying the effective tax rate (and also the marginal rate in a sense, though the "marginal rate" crosses over multiple brackets).

Person B:

Keep everything the same, but you have $2,000,000 $666,666 in retirement savings which grows 3x to $2,000,000 at retirement. You plan to withdraw $80,000 per year from that pot of money.

If you contribute $19k to your pre-tax 401k, it grows to 3x to $57k. At retirement, you pull $80,000 from your nest egg as planned. Then, you pull the $57k. For that $57k (which came from your $19k contribution), you are paying the marginal tax rate, not the effective rate.

The problem is, of course, is that it's not so simple. You can game your tax rates in retirement to some extent by changing how much you withdraw from your accounts, so it gets really complicated. But fundamentally it's marginal now vs marginal at retirement. I think a lot of misunderstandings come because people have wildly inaccurate views as to what their retirement income will look like.

Edit: some numbers.
Last edited by decapod10 on Tue Apr 23, 2019 1:33 pm, edited 1 time in total.
Lee_WSP
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm 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.
How does social security affect the math?
Spirit Rider
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Spirit Rider »

FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.
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gilgamesh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.
I think some of us had the wrong idea of what marginal rates were...we thought it was the tax bracket the last dollar withdrawn falls under. Thus we thought there is just one number for the marginal rate. It looks like marginal rates is calculated on the spectrum of tax rates from the first to last and has multiple numbers...That was the reason for the confusion.

Therefore, I think conceptually both were right, it’s just that some of us had the wrong/faulty definition in mind.
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gilgamesh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm
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.
If I am correct, then the above statement is wrong...I don’t know why ‘spirit rider’ didn’t correct that? (Edit: I’m most likely still wrong with this...as otherwise it would have been pointed out - the example was very clear on its presentation....so I don’t know!)

Here, the marginal tax rate is 0% up to $24k and the marginal rate for the last $1 is 10%???
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

Here, the marginal tax rate is 0% up to $24k and the marginal rate for the last $1 is 10%???
Marginal means at the margin. That would be correct, but it's probably just the wrong term to be using to describe the total tax paid on the $24,001 as it is DE minimus.
Spirit Rider
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Spirit Rider »

gilgamesh wrote: Tue Apr 23, 2019 3:54 pm
Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.
I think some of us had the wrong idea of what marginal rates were...we thought it was the tax bracket the last dollar withdrawn falls under. Thus we thought there is just one number for the marginal rate. It looks like marginal rates is calculated on the spectrum of tax rates from the first to last and has multiple numbers...That was the reason for the confusion.

Therefore, I think conceptually both were right, it’s just that some of us had the wrong/faulty definition in mind.
No, marginal tax rates are not the full spectrum of all of the rates that apply to total income. That is the effective tax rates.

However, your marginal tax on a given incremental amount might cross brackets. So the more correct terminology is the marginal rate or rates that apply to an incremental amount. Both your incremental contributions and incremental increases in your withdrawal may be in one tax bracket or straddle two brackets.
decapod10
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

gilgamesh wrote: Tue Apr 23, 2019 4:01 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm
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.
If I am correct, then the above statement is wrong...I don’t know why ‘spirit rider’ didn’t correct that? (Edit: I’m most likely still wrong with this...as otherwise it would have been pointed out - the example was very clear on its presentation....so I don’t know!)

Here, the marginal tax rate is 0% up to $24k and the marginal rate for the last $1 is 10%???
Yes, you are correct. The marginal rate for the $1 is 10%. Any additional amount that would have been invested and withdrawn at this time would therefore be taxed at 10% which is the marginal rate, not at the effective rate, which is 0.00042%. If I withdraw another $1000 because I invested an extra $100 30 years ago, then that $1000 is being taxed at the marginal rate of 10%, not the effective tax rate at 0.00042%. That's why it correct to say marginal rate now vs marginal rates at retirement, it's just so complicated to figure out what the marginal tax rate at retirement will be until you're actually retired.

Of course, the question then becomes, what if I'm drawing an extra $40,000? That amount crosses over the 10% tax bracket into the 12% tax bracket. You're are not paying the effective tax rate which is around 6%. (edit: You are actually paying roughly 11% on that last $40k). One could argue that your marginal tax bracket is 12% and clearly in this case you're not paying 12% on all $40k, but I personally don't take that view. As Kitces says, "A marginal tax rate is the tax rate that will apply to the next marginal – or incremental – amount of income (or deductions). It is calculated by dividing the amount of additional taxes that will be due based on some decision (e.g., to take an IRA withdrawal) by the amount of income involved."

https://www.kitces.com/blog/understandi ... -use-each/

This is a more reasonable definition to me rather than just "my tax bracket." I would argue that the marginal tax rate on that last $40k is 11%.
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gilgamesh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

I was reading that exact article by Kitces, between break at work...still haven’t finished it. I think it’s the confusion in the definition that was the cause of the disagreements.
aristotelian
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by aristotelian »

Folks,
Here is my contribution to the never ending Roth vs Traditional debate. It does not account for the difference between "incremental" vs "effective" rate in retirement so it somewhat favors the 401k. Still, I think it is a pretty good approximation and offers a roadmap for keeping taxes on your 401k low. https://docs.google.com/spreadsheets/d/ ... 1374797127

In short, I generally agree with OP (not his friend). In general, you are going to have less taxable income in retirement than you are during your working years. Most proponents of Roth confuse spending with taxable income, but it is very possible to have above average spending and pay zero tax. viewtopic.php?t=87471

Proponents of Roth bring up some good valid concerns that are worth noting, but they are mostly exceptions. Some of those exceptions might be:
-Disproportionately large 401k such that liquidating it before age 70 will be impossible.
-Working until age 70, preventing Roth conversions at low effective rates.
-Pension, inheritance, or other unexpected source of taxable income that moves you into a higher tax bracket
-Expectation of large increase in salary over time (e.g. student or early career)

Every situation is different but I would still say these are exceptions that largely prove the rule.
penumbra
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by penumbra »

Very helpful thread. Thank you FrugalProfessor for clarifying how this works. It sounds like subsequent posters are coming around to your view, after clarifying the "marginal" terminology. Since most people have eliminated wages after retirement, RMD's fill each tax bracket progressively starting at, or very close to the lowest bracket (I understand SS and dividends may fill the lowest brackets first). Overall, though, for a high earner, deferring taxes into a traditional plan that would have be taxes at the highest bracket, and then withdrawing after retirement with the RMD spread over multiple brackets results in net lower taxes paid. For some years I was regretting overcontributing to a large (high 7 figure 401k) pension plan, but this explanation makes me realize it didn't work out too bad. Had no idea of the math at the time, though! Thanks again.
decapod10
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

penumbra wrote: Tue Apr 23, 2019 5:50 pm Very helpful thread. Thank you FrugalProfessor for clarifying how this works. It sounds like subsequent posters are coming around to your view, after clarifying the "marginal" terminology.
Personally, I disagree with FrugalProfessor's interpretation and agree with Spirit Rider, but I can't speak for others.
Lee_WSP
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

Without actual examples, I cannot make a determination one way or the other. Every person's retirement is different from everyone else's. Some have pensions, others do not. Some are worth hundreds of millions, others have no savings. Some people are in their peak earning years, others are at either end of the bell curve (if it's even a bell curve).

Unless you know with reasonable certainty you're going to be a higher earning tax bracket in a few years, it's hard to definitely say a ROTH is the way to go given the total cost of investing.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by jhawktx »

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 elde 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.
Ugh, another overblown RMD boogeyman post. OP, please ignore this hyperbole unless you will end up with several million $ in tIRA.
bradpevans
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by bradpevans »

Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.

I can see both arguments, so I wonder if it’s a matter of perspective

Incremental dollars in leads to incremental dollars out, hence the marginal rate matters
One more dollar in means taxed at marginal (Roth) or deferred (traditional)
One more dollar out from traditional is taxed at marginal, so marginal rates dictate

If the choice is Roth or traditional then we have:
X dollars taxed down to (1-marginal)*X, eventually doubles but total tax is marginal rate x X

Traditional invests X, eventually doubles to 2X

Absent of other income, withdrawing 2X dollars and paying tax leads to more spendable dollars via traditional
Should other income (SS, pension, cap gains) push all of the 2X dollars into the same marginal rate as while working, then it’s even with the Roth

I view Roth as marginal rates now + zero later
I view traditional as zero now + (some at zero + some at 10% + some at 22% ....)

This makes it hard to beat traditional
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gilgamesh
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

bradpevans wrote: Tue Apr 23, 2019 10:31 pm
Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.

I can see both arguments, so I wonder if it’s a matter of perspective

Incremental dollars in leads to incremental dollars out, hence the marginal rate matters
One more dollar in means taxed at marginal (Roth) or deferred (traditional)
One more dollar out from traditional is taxed at marginal, so marginal rates dictate

If the choice is Roth or traditional then we have:
X dollars taxed down to (1-marginal)*X, eventually doubles but total tax is marginal rate x X

Traditional invests X, eventually doubles to 2X

Absent of other income, withdrawing 2X dollars and paying tax leads to more spendable dollars via traditional
Should other income (SS, pension, cap gains) push all of the 2X dollars into the same marginal rate as while working, then it’s even with the Roth

I view Roth as marginal rates now + zero later
I view traditional as zero now + (some at zero + some at 10% + some at 22% ....)

This makes it hard to beat traditional
I don’t think you read the posts towards the end...you have this view, because you have the wrong definition of marginal rates. I did as well.

Once you know the correct definition, you will see, there is only one way to view this and it is what spirit rider is saying.

This Kitces article is useful to understand marginal tax rates...It is most definitely not what you, I and some others thought it was...by definition, Roth decision or any other decisions of that sort have to utilize marginal tax rates.
https://www.kitces.com/blog/understandi ... -use-each/
grayfox
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by grayfox »

jhawktx wrote: Tue Apr 23, 2019 6:22 pm
Ugh, another overblown RMD boogeyman post. OP, please ignore this hyperbole unless you will end up with several million $ in tIRA.
I agree. If you expect to have a small tIRA at age 70, you will not have to worry about RMDs. Nothing to see here. But why are you so pessimistic and expect only a small nest egg come retirement?

Many Bogleheads did save diligently and invest wisely over many decades and now have multi-million tIRAs with huge RMDs looming. It's not unusual. Why do you think there are so many threads about doing Roth conversions?

Here's some numbers. If you contribute to tIRA from age 25 until age 65, that is 40 years; to age 70 is 45 years. That's a long time to be contributing and compounding. I looked up the contribution limits: for tIRA is $6,000 and 401k is $19,000. So that would be $25,000 per year? Is that right? If you did that for 45 years and got 5% CAGR, you would end up with about $4 million by age 70. 7% return would be about 7 million.

:idea: I think that anyone starting out now that has marketable job skills and can get a decent-paying job, save and invest, and do that for a full working life should easily have multi-million nest-egg. Ask yourself, when you reach retirement age, would you rather have millions in a Roth or tIRA?
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

gilgamesh wrote: Wed Apr 24, 2019 4:53 am
bradpevans wrote: Tue Apr 23, 2019 10:31 pm
Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.

I can see both arguments, so I wonder if it’s a matter of perspective

Incremental dollars in leads to incremental dollars out, hence the marginal rate matters
One more dollar in means taxed at marginal (Roth) or deferred (traditional)
One more dollar out from traditional is taxed at marginal, so marginal rates dictate

If the choice is Roth or traditional then we have:
X dollars taxed down to (1-marginal)*X, eventually doubles but total tax is marginal rate x X

Traditional invests X, eventually doubles to 2X

Absent of other income, withdrawing 2X dollars and paying tax leads to more spendable dollars via traditional
Should other income (SS, pension, cap gains) push all of the 2X dollars into the same marginal rate as while working, then it’s even with the Roth

I view Roth as marginal rates now + zero later
I view traditional as zero now + (some at zero + some at 10% + some at 22% ....)

This makes it hard to beat traditional
I don’t think you read the posts towards the end...you have this view, because you have the wrong definition of marginal rates. I did as well.

Once you know the correct definition, you will see, there is only one way to view this and it is what spirit rider is saying.

This Kitces article is useful to understand marginal tax rates...It is most definitely not what you, I and some others thought it was...by definition, Roth decision or any other decisions of that sort have to utilize marginal tax rates.
https://www.kitces.com/blog/understandi ... -use-each/
If you want to carefully track each dollar, then one should use marginal rates. Determine the tax rate on contribution and the tax rate on withdrawal for each dollar invested. This will give you the most precise information and allow you to adjust whether to invest each dollar in a Traditional or Roth account.

For example, one can say that this dollar invested in a Roth now will be taxed at 22%, but, if invested it in a Traditional account, it would be taxed at 12% when you withdraw it, based on your current portfolio balance. Then, 10 years from now, when your portfolio balance is much higher, you could say that this dollar invested in a a Roth now will be taxed at 22%, but, if invested in a Traditional account, it would be taxed at 25% when you withdraw it (assuming tax rates have changed slightly in 10 years).

On the other hand, for a broad brush analysis in order to make Roth vs Traditional decisions over many years, effective (or average) tax rates are suitable. That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawals.

For example, one could say that all the Roth contributions that you make over the next 5 years will be taxed at 22%, but, if invested in a Traditional account, would be taxed at an effective rate of 10% on withdrawal, because you will have no other sources of taxable income other than Traditional account withdrawals. And, then, when you start drawing SS, your effective rate will increase to 15%, due to SS taxation.

Either of these methods is suitable for making Traditional vs. Roth decisions.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

:sharebeer Thank you very much!
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

rkhusky wrote: Wed Apr 24, 2019 10:32 am
gilgamesh wrote: Wed Apr 24, 2019 4:53 am
bradpevans wrote: Tue Apr 23, 2019 10:31 pm
Spirit Rider wrote: Tue Apr 23, 2019 1:33 pm
FrugalProfessor wrote: Tue Apr 23, 2019 1:21 pm The linked pdf supports my claims. Assuming you didn't read it, here's the argument I make in the pdf:
I did read it.
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
You would be crazy to believe that it's the effective rate that even matters.

You never pay an effective tax rate on incremental dollars, only marginal rates. You still a missing the fundamental fact that incremental contributions result in incremental increase in portfolio value which results in incremental available withdrawal amounts. Those incremental withdrawal amounts are always subject to marginal rates.

I can see both arguments, so I wonder if it’s a matter of perspective

Incremental dollars in leads to incremental dollars out, hence the marginal rate matters
One more dollar in means taxed at marginal (Roth) or deferred (traditional)
One more dollar out from traditional is taxed at marginal, so marginal rates dictate

If the choice is Roth or traditional then we have:
X dollars taxed down to (1-marginal)*X, eventually doubles but total tax is marginal rate x X

Traditional invests X, eventually doubles to 2X

Absent of other income, withdrawing 2X dollars and paying tax leads to more spendable dollars via traditional
Should other income (SS, pension, cap gains) push all of the 2X dollars into the same marginal rate as while working, then it’s even with the Roth

I view Roth as marginal rates now + zero later
I view traditional as zero now + (some at zero + some at 10% + some at 22% ....)

This makes it hard to beat traditional
I don’t think you read the posts towards the end...you have this view, because you have the wrong definition of marginal rates. I did as well.

Once you know the correct definition, you will see, there is only one way to view this and it is what spirit rider is saying.

This Kitces article is useful to understand marginal tax rates...It is most definitely not what you, I and some others thought it was...by definition, Roth decision or any other decisions of that sort have to utilize marginal tax rates.
https://www.kitces.com/blog/understandi ... -use-each/
If you want to carefully track each dollar, then one should use marginal rates. Determine the tax rate on contribution and the tax rate on withdrawal for each dollar invested. This will give you the most precise information and allow you to adjust whether to invest each dollar in a Traditional or Roth account.

For example, one can say that this dollar invested in a Roth now will be taxed at 22%, but, if invested it in a Traditional account, it would be taxed at 12% when you withdraw it, based on your current portfolio balance. Then, 10 years from now, when your portfolio balance is much higher, you could say that this dollar invested in a a Roth now will be taxed at 22%, but, if invested in a Traditional account, it would be taxed at 25% when you withdraw it (assuming tax rates have changed slightly in 10 years).

On the other hand, for a broad brush analysis in order to make Roth vs Traditional decisions over many years, effective (or average) tax rates are suitable. That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawals.

For example, one could say that all the Roth contributions that you make over the next 5 years will be taxed at 22%, but, if invested in a Traditional account, would be taxed at an effective rate of 10% on withdrawal, because you will have no other sources of taxable income other than Traditional account withdrawals. And, then, when you start drawing SS, your effective rate will increase to 15%, due to SS taxation.

Either of these methods is suitable for making Traditional vs. Roth decisions.
Lol!, I could have wrote this exact post a day ago, and then I understood the correct meaning of marginal tax rates.

P.S: Conceptually you are right (and thus I was right prior to yesterday too), but you (and me prior to yesterday) are wrong when we say “On the other hand, for a broad brush analysis in order to make Roth vs Traditional decisions over many years, effective (or average) tax rates are suitable“ - this Statement is the definition of “wrong”...read what spirit rider wrote. I’ve argued with him too -however he is 100% correct.

Then you said “That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawal”...I could have wrote that yesterday too....but, it’s a non-sensical statement. There is no “effective tax rate paid on Roth”? That sentence is gibberish. By definition when you compare taxes for traditional vs Roth it is marginal tax rates...by definition they are.

Kitces article cited above explains all of this.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

gilgamesh wrote: Wed Apr 24, 2019 11:38 am Then you said “That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawal”...I could have wrote that yesterday too....but, it’s a non-sensical statement. There is no “effective tax rate paid on Roth”? That sentence is gibberish. By definition when you compare taxes for traditional vs Roth it is marginal tax rates...by definition they are.
Of course there is an effective rate paid on Roth contributions. If I contribute $6000 to a Roth, all in the 22% tax bracket, then the effective rate on the Roth contribution is 22%. If I contribute $6000 to a Roth, $3000 of which is in the 12% tax bracket and $3000 of which is in the 22% tax bracket, then the effective rate on the Roth contribution is 17%. Elementary mathematics.

Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Spirit Rider »

rkhusky wrote: Wed Apr 24, 2019 12:12 pm
gilgamesh wrote: Wed Apr 24, 2019 11:38 am Then you said “That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawal”...I could have wrote that yesterday too....but, it’s a non-sensical statement. There is no “effective tax rate paid on Roth”? That sentence is gibberish. By definition when you compare taxes for traditional vs Roth it is marginal tax rates...by definition they are.
Of course there is an effective rate paid on Roth contributions. If I contribute $6000 to a Roth, all in the 22% tax bracket, then the effective rate on the Roth contribution is 22%. If I contribute $6000 to a Roth, $3000 of which is in the 12% tax bracket and $3000 of which is in the 22% tax bracket, then the effective rate on the Roth contribution is 17%. Elementary mathematics.

Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
Now you are just playing semantics. The problem with using the term effective rate for this scenario is that it is too easy to be confused with a the total effective tax rate. Whereas, any person with half a clue knows that when someone is referring to a marginal rate that maybe be one marginal rate or straddle two marginal rates. That is the very definition of tax brackets.
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fortfun
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by fortfun »

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?
This guy says ALL 401k and then do Roth conversions later. I plan to retire early and might try this strategy, however, I don't fully understand it yet.
https://www.gocurrycracker.com/never-pay-taxes-again/
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by kaneohe »

Spirit Rider wrote: Wed Apr 24, 2019 12:22 pm
rkhusky wrote: Wed Apr 24, 2019 12:12 pm
gilgamesh wrote: Wed Apr 24, 2019 11:38 am Then you said “That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawal”...I could have wrote that yesterday too....but, it’s a non-sensical statement. There is no “effective tax rate paid on Roth”? That sentence is gibberish. By definition when you compare taxes for traditional vs Roth it is marginal tax rates...by definition they are.
Of course there is an effective rate paid on Roth contributions. If I contribute $6000 to a Roth, all in the 22% tax bracket, then the effective rate on the Roth contribution is 22%. If I contribute $6000 to a Roth, $3000 of which is in the 12% tax bracket and $3000 of which is in the 22% tax bracket, then the effective rate on the Roth contribution is 17%. Elementary mathematics.

Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
Now you are just playing semantics. The problem with using the term effective rate for this scenario is that it is too easy to be confused with a the total effective tax rate. Whereas, any person with half a clue knows that when someone is referring to a marginal rate that maybe be one marginal rate or straddle two marginal rates. That is the very definition of tax brackets.
Perhaps there needs to be a hybrid term added........marginal effective rate.........the term marginal rate suffers from the fact that many definitions use the term "on the next dollar" which may be misleading in the real world. Similarly the term effective rate suffers from the
total average" rate that is often used to define it. In the real world often you are worried about a chunk of income at the margin and not just the next dollar so a single number does not give the best description so perhaps knowing the whole situation is better w/ as many words/numbers used as needed to make the picture complete.
Last edited by kaneohe on Wed Apr 24, 2019 3:59 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 »

rkhusky wrote: Wed Apr 24, 2019 12:12 pm
gilgamesh wrote: Wed Apr 24, 2019 11:38 am Then you said “That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawal”...I could have wrote that yesterday too....but, it’s a non-sensical statement. There is no “effective tax rate paid on Roth”? That sentence is gibberish. By definition when you compare taxes for traditional vs Roth it is marginal tax rates...by definition they are.
Of course there is an effective rate paid on Roth contributions. If I contribute $6000 to a Roth, all in the 22% tax bracket, then the effective rate on the Roth contribution is 22%. If I contribute $6000 to a Roth, $3000 of which is in the 12% tax bracket and $3000 of which is in the 22% tax bracket, then the effective rate on the Roth contribution is 17%. Elementary mathematics.

Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
It’s not just Kitces, it’s boglehead wiki article and the whole accepted financial world. We can’t just make up definitions or contort them to our whim.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Lee_WSP »

Guys,
The only way to accurately calculate how much tax will be owed and which investment vehicle was correct is through hindsight. If retirement is 5 years away, you can get a pretty darned good idea of which route is best as you'll have a pretty darned good idea of what your income streams & expenses will be.

However, if retirement is 30 years away, all these funds will be so commingled that it's just impossible to get an accurate picture of what contribution will be withdrawn at what marginal or effective rate. I mean, what if you get 10 years of top earning social security? What if you decide to spend the last 10 years of your career in the government to collect a pension? What if, what if, what if? The point being, you cannot know something so far into the future. So just keep on saving and do the best you can. If you're in a high bracket now, you can probably safely assume taking the deduction now is a safe choice. If you're in the bottom two brackets, you can also safely assume that going the ROTH is the way to go.

If you're in the middle, I don't know, split the difference. Just make a plan and stick with it. That's the more important thing.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

This is boglehead wiki (https://www.bogleheads.org/wiki/Marginal_tax_rate)....Roth vs traditional here involves 4 marginal savings rate.

.......take a couple making $54K/yr with two young children. In 2016, that puts them in the "15% bracket." Yet, due to various combinations of the saver's and earned income credits, as they increase 401k contributions from $0 to $18,000 their marginal savings rates (calculated a dollar at a time) go through regions of 25%, 46%, 36%, 31%.....
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Spirit Rider »

kaneohe wrote: Wed Apr 24, 2019 12:40 pm Perhaps there needs to be a hybrid term added........marginal effective rate.........the term marginal rate suffers from the fact that many definitions use the term "on the next dollar" which may be misleading in the real world. Similarly the term effective rate suffers from the
total average" rate that is often used to define it. In the real world often you are worried about a chunk of income at the margin and not just the next dollar so a single number does not give the best description so perhaps knowing the whole situation is better w/ as many words/numbers used to make the picture complete.
I'm liking it. Concise, descriptive and with little room for misunderstanding.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by nolesrule »

Lee_WSP wrote: Wed Apr 24, 2019 12:49 pm Guys,
The only way to accurately calculate how much tax will be owed and which investment vehicle was correct is through hindsight. If retirement is 5 years away, you can get a pretty darned good idea of which route is best as you'll have a pretty darned good idea of what your income streams & expenses will be.

However, if retirement is 30 years away, all these funds will be so commingled that it's just impossible to get an accurate picture of what contribution will be withdrawn at what marginal or effective rate. I mean, what if you get 10 years of top earning social security? What if you decide to spend the last 10 years of your career in the government to collect a pension? What if, what if, what if? The point being, you cannot know something so far into the future. So just keep on saving and do the best you can. If you're in a high bracket now, you can probably safely assume taking the deduction now is a safe choice. If you're in the bottom two brackets, you can also safely assume that going the ROTH is the way to go.

If you're in the middle, I don't know, split the difference. Just make a plan and stick with it. That's the more important thing.
You can do a fairly reasonable estimate using a tax estimation spreadsheet like the Personal Finance Toolbox (PFT). Much about taxes with only some exceptions are indexed to inflation. So just look at your pre-tax balance you have now, do a reasonable real return projection for when you expect to start withdrawals on the balance you have now, and then consider how much of that balance will be withdrawn per year. Maybe 3-5%. I use 4%.

I then plug the numbers into the PFT, add in projected SS and pension amounts, some dividends and interest and it spits out an ordinary income marginal rate. The nice thing about the PFT marginal rate estimator is it allows you to put in an increment of whatever size you want and calculates based on change in tax / increment amount. It's not just telling you your brackets.

If that is higher than current marginal rate on money that is being contributed, go Roth. if less, go traditional. If it's the same, I would probably go traditional, and look for opportunities to convert at a lower bracket in the future.

It's not perfect, but it's a reasonable way to estimate marginal rate now vs. later based on assets you have right now, particularly when you are far from retirement.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by ray.james »

I remember a long discussion in 2016 of about f 9-13 pages on marginal vs effective discussion. I did not understand it then. I think I am finally seeing the light. Thanks for the great discussion. I think I have the same misunderstanding as gilgamesh.

I also want too highlight greyfox point. This discussion will become lot more important as tax advantaged saving limits remain as large as they are today. Esp for GenX/Gen Y.
When in doubt, http://www.bogleheads.org/forum/viewtopic.php?f=1&t=79939
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

ray.james wrote: Wed Apr 24, 2019 2:11 pm I remember a long discussion in 2016 of about f 9-13 pages on marginal vs effective discussion. I did not understand it then. I think I am finally seeing the light. Thanks for the great discussion. I think I have the same misunderstanding as gilgamesh.

I also want too highlight greyfox point. This discussion will become lot more important as tax advantaged saving limits remain as large as they are today. Esp for GenX/Gen Y.
I hope you mean ‘had’...There’s no misunderstandings any more....

Roth vs traditional can only be evaluated via marginal tax rate...no ifs ands or buts. The misunderstanding by others (and me, previously) is only due to their wrong understanding of what exactly is marginal tax rates.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

gilgamesh wrote: Wed Apr 24, 2019 12:41 pm
rkhusky wrote: Wed Apr 24, 2019 12:12 pm Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
It’s not just Kitces, it’s boglehead wiki article and the whole accepted financial world. We can’t just make up definitions or contort them to our whim.
Effective rate just means average rate. It is nonsense to say that effective rate can only mean the average rate on one's total income. For instance, there are many total incomes - which one are you using for your definition? AGI, MAGI, Taxable Income, or perhaps the ALI (Adjusted Livesoft Income)?

Please provide references that the Boglehead wiki and the rest of the financial world say that your definition of effective rate is the only definition.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

rkhusky wrote: Wed Apr 24, 2019 3:13 pm
gilgamesh wrote: Wed Apr 24, 2019 12:41 pm
rkhusky wrote: Wed Apr 24, 2019 12:12 pm Just because Kitces calculates the effective tax rate for the total taxes and total income in that particular article, doesn't mean it can't be used in other ways.
It’s not just Kitces, it’s boglehead wiki article and the whole accepted financial world. We can’t just make up definitions or contort them to our whim.
Effective rate just means average rate. It is nonsense to say that effective rate can only mean the average rate on one's total income. For instance, there are many total incomes - which one are you using for your definition? AGI, MAGI, Taxable Income, or perhaps the ALI (Adjusted Livesoft Income)?

Please provide references that the Boglehead wiki and the rest of the financial world say that your definition of effective rate is the only definition.
Edit - I didn’t realize you switched to effective rates there, sorry. I was talking about marginal rates. There is no disagreement on effective rate per se, but only when wrongly used instead of marginal rates.
Last edited by gilgamesh on Wed Apr 24, 2019 3:26 pm, edited 1 time in total.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

Spirit Rider wrote: Wed Apr 24, 2019 12:22 pm Now you are just playing semantics. The problem with using the term effective rate for this scenario is that it is too easy to be confused with a the total effective tax rate. Whereas, any person with half a clue knows that when someone is referring to a marginal rate that maybe be one marginal rate or straddle two marginal rates. That is the very definition of tax brackets.
In my original post, I wrote:
rkhusky wrote: Wed Apr 24, 2019 10:32 am That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawals.
In the part you quoted, I wrote:
rkhusky wrote: Wed Apr 24, 2019 12:12 pm an effective rate paid on Roth contributions
These are clearly different than effective rate on total income. I agree that "effective rate" without any qualifiers is generally taken to be the average rate on all income. But when qualifiers are used, it is perfectly fine to use the term to refer to other average rates.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

kaneohe wrote: Wed Apr 24, 2019 12:40 pm Perhaps there needs to be a hybrid term added........marginal effective rate.........the term marginal rate suffers from the fact that many definitions use the term "on the next dollar" which may be misleading in the real world. Similarly the term effective rate suffers from the
total average" rate that is often used to define it. In the real world often you are worried about a chunk of income at the margin and not just the next dollar so a single number does not give the best description so perhaps knowing the whole situation is better w/ as many words/numbers used to make the picture complete.
Most practitioners don't use next dollar because of discontinuities in the tax code (e.g. child tax credit), which can cause huge marginal rates. Next $100 or next $1000 is better.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by decapod10 »

rkhusky wrote: Wed Apr 24, 2019 3:25 pm
Spirit Rider wrote: Wed Apr 24, 2019 12:22 pm Now you are just playing semantics. The problem with using the term effective rate for this scenario is that it is too easy to be confused with a the total effective tax rate. Whereas, any person with half a clue knows that when someone is referring to a marginal rate that maybe be one marginal rate or straddle two marginal rates. That is the very definition of tax brackets.
In my original post, I wrote:
rkhusky wrote: Wed Apr 24, 2019 10:32 am That is, compare the effective tax rate paid on Roth contributions versus the effective tax rate paid on Traditional withdrawals.
In the part you quoted, I wrote:
rkhusky wrote: Wed Apr 24, 2019 12:12 pm an effective rate paid on Roth contributions
These are clearly different than effective rate on total income. I agree that "effective rate" without any qualifiers is generally taken to be the average rate on all income. But when qualifiers are used, it is perfectly fine to use the term to refer to other average rates.
Well, one thing to point out is that despite the semantics issue, I don’t think that semantics is the problem when we look at Spirit Rider vs FrugalProfessor’s interpretation which tax rates to look at. They have a more fundamental disagreement than just words. FrugalProfessor clearly states that the important consideration when thinking about pre-tax investments is “Marginal rate now vs Average (defined as taxes owed / total income) rate in retirement.”

Clearly FrugalProfessor is talking about total effective tax rate on total income being the number to look at when deciding whether to contribute to pre-tax vs Roth, a concept which both Spirit Rider and I disagreed with.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

“Assume a couple has $80,000 of total income, and deductions include $4,000 of state income taxes and $11,000 of mortgage interest, for total deductions of $15,000 (again ignoring personal exemptions for simplicity). The client’s net taxable income is $80,000 – $15,000 = $65,000, which places them in the 15% tax bracket.

If the couple earned another $20,000 of income, total income would rise to $100,000, and taxable income after deductions would be $85,000. As a result, the couple would actually cross from the 15% tax bracket to the 25% tax bracket.

However, the couple’s marginal tax rate for $20,000 of income is not 15%, nor 25%, but a blended rate. Since the upper threshold for the 15% tax bracket is $70,700 (in 2012), the first $5,700 of the additional income would be taxed at 15%, and the remaining $14,300 would be taxed at 25%, for a total tax increase of $855 + $3,575 = $4,430. This would represent a marginal tax rate of $4,430 (total additional taxes) / $20,000 (total additional income) = 22.15%.

Notably, this means the marginal tax rate of a strategy may depend on the amount of income involved. If this couple had only added $2,000 of income, the tax bracket would have remained 15%, and the marginal tax rate would have been 15%. Because the income increase was $20,000, though, and that resulted in crossing into another tax bracket, the marginal tax rate was 22.15%, which represents a blend of the two brackets across which the income landed.”

https://www.kitces.com/blog/understandi ... -use-each/
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by rkhusky »

gilgamesh wrote: Wed Apr 24, 2019 4:34 pm “Assume a couple has $80,000 of total income, and deductions include $4,000 of state income taxes and $11,000 of mortgage interest, for total deductions of $15,000 (again ignoring personal exemptions for simplicity). The client’s net taxable income is $80,000 – $15,000 = $65,000, which places them in the 15% tax bracket.

If the couple earned another $20,000 of income, total income would rise to $100,000, and taxable income after deductions would be $85,000. As a result, the couple would actually cross from the 15% tax bracket to the 25% tax bracket.

However, the couple’s marginal tax rate for $20,000 of income is not 15%, nor 25%, but a blended rate. Since the upper threshold for the 15% tax bracket is $70,700 (in 2012), the first $5,700 of the additional income would be taxed at 15%, and the remaining $14,300 would be taxed at 25%, for a total tax increase of $855 + $3,575 = $4,430. This would represent a marginal tax rate of $4,430 (total additional taxes) / $20,000 (total additional income) = 22.15%.

Notably, this means the marginal tax rate of a strategy may depend on the amount of income involved. If this couple had only added $2,000 of income, the tax bracket would have remained 15%, and the marginal tax rate would have been 15%. Because the income increase was $20,000, though, and that resulted in crossing into another tax bracket, the marginal tax rate was 22.15%, which represents a blend of the two brackets across which the income landed.”

https://www.kitces.com/blog/understandi ... -use-each/
The 22.15% would be the effective tax rate on the extra $20K income. Marginal tax rates are computed on small additions, like %1 or $100 or $1000. Marginal rates are not calculated on amounts that span tax brackets. Their marginal rate before the $20K addition would be 15%. The marginal rate after the $20K is added is 25% (absent any other tax rate changes). Examining marginal rates would have allowed the couple to perhaps contribute to a Traditional account to bring the marginal rate down to 15% and then contribute the rest to a Roth account.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

rkhusky wrote: Wed Apr 24, 2019 5:58 pm
gilgamesh wrote: Wed Apr 24, 2019 4:34 pm “Assume a couple has $80,000 of total income, and deductions include $4,000 of state income taxes and $11,000 of mortgage interest, for total deductions of $15,000 (again ignoring personal exemptions for simplicity). The client’s net taxable income is $80,000 – $15,000 = $65,000, which places them in the 15% tax bracket.

If the couple earned another $20,000 of income, total income would rise to $100,000, and taxable income after deductions would be $85,000. As a result, the couple would actually cross from the 15% tax bracket to the 25% tax bracket.

However, the couple’s marginal tax rate for $20,000 of income is not 15%, nor 25%, but a blended rate. Since the upper threshold for the 15% tax bracket is $70,700 (in 2012), the first $5,700 of the additional income would be taxed at 15%, and the remaining $14,300 would be taxed at 25%, for a total tax increase of $855 + $3,575 = $4,430. This would represent a marginal tax rate of $4,430 (total additional taxes) / $20,000 (total additional income) = 22.15%.

Notably, this means the marginal tax rate of a strategy may depend on the amount of income involved. If this couple had only added $2,000 of income, the tax bracket would have remained 15%, and the marginal tax rate would have been 15%. Because the income increase was $20,000, though, and that resulted in crossing into another tax bracket, the marginal tax rate was 22.15%, which represents a blend of the two brackets across which the income landed.”

https://www.kitces.com/blog/understandi ... -use-each/
The 22.15% would be the effective tax rate on the extra $20K income. Marginal tax rates are computed on small additions, like %1 or $100 or $1000. Marginal rates are not calculated on amounts that span tax brackets. Their marginal rate before the $20K addition would be 15%. The marginal rate after the $20K is added is 25% (absent any other tax rate changes). Examining marginal rates would have allowed the couple to perhaps contribute to a Traditional account to bring the marginal rate down to 15% and then contribute the rest to a Roth account.
That same Kitces article where I quoted that example is the #1 reference in the Boglehead wiki which discusses the definition of ‘marginal tax rate’...https://www.bogleheads.org/wiki/Marginal_tax_rate

If that example (example 3 of the Kitces article boglehead references) is wrong, then Boglehead wiki should not have that as their #1 reference, or what you think is ’marginal tax rate’ is not it.

This is precisely what I’ve been trying to say...at least, now we are on the same page.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by gilgamesh »

That’s why I said saying “effective tax rate paid on Roth” is gibberish. Doing Roth is an action, taxes paid on that action by definition is ‘marginal tax rate’ for that action...you cannot say it’s ‘effective tax rate’, as by definition it is marginal tax rate.

It doesn’t matter what action it is, and how many tax brackets it crosses (and tax credits it may affect) - by definition the average taxes paid for that action is what’s called ‘marginal tax rate’

I did not know this yesterday, but after spirit rider (and some others) insisted on it, I decided to study the definition carefully... I had the same understanding as you did, until then.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by Tdubs »

bradpevans wrote: Mon Apr 22, 2019 5:35 pm
Plus we don't know whether future taxes will be higher or lower than they are now.
[/quote]

There are many reasons to think taxes will be higher. There are few, if any, to think they will be lower. The odds are not the same, as is implied here.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by willthrill81 »

Another relevant point that hasn't been made yet in this thread is that both during your career and in retirement, not all of your income is necessarily taxed at the same rate. A MFJ couple, assuming 4% withdrawals, needs $600k of assets just to 'fill up' the standard deduction (aka the 0% bracket). They need another $485k to fill up the 10% bracket and another $1,488,750 to fill up the 12% bracket. So until you're on track to have over $2.5 million by the time you reach retirement and your current marginal tax bracket is above 12%, tax-deferred is the way to go. The two significant exceptions to this is are (1) you believe that your marginal tax bracket will go even higher in the future and you want to 'lock in' your current marginal tax rate via Roth contributions and/or (2) you believe that you will be making substantial withdrawals as a single taxpayer rather than MFJ.

Based on our income alone, we are currently in the 22% bracket and likely will be until I retire. As such, we are heavily using tax-deferred accounts, enough that it brings us back down into the 12% bracket. Starting next year, our plan is to make Roth conversions of a rollover IRA to Roth to the top of the 12% bracket, locking in the tax rate of that money at 12%. If our investments do really well, we could potentially have some withdrawals taxed at 22% in retirement, but if we do, that will be a first-world problem that we will gladly deal with. :D
Last edited by willthrill81 on Wed Apr 24, 2019 6:54 pm, edited 2 times in total.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by willthrill81 »

Tdubs wrote: Wed Apr 24, 2019 6:49 pm
bradpevans wrote: Mon Apr 22, 2019 5:35 pm
Plus we don't know whether future taxes will be higher or lower than they are now.
There are many reasons to think taxes will be higher. There are few, if any, to think they will be lower. The odds are not the same, as is implied here.
Many said the same thing two years ago, yet here we are.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by TravelforFun »

gilgamesh wrote: Tue Apr 23, 2019 7:36 am
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.
Not out of proportion. A lot of BHs have large tax deferred accounts, dividends, rental income, etc. Plus SS and RMD and hence, face high marginal tax rates.

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

Post by willthrill81 »

TravelforFun wrote: Wed Apr 24, 2019 7:25 pm
gilgamesh wrote: Tue Apr 23, 2019 7:36 am
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.
Not out of proportion. A lot of BHs have large tax deferred accounts, dividends, rental income, etc. Plus SS and RMD and hence, face high marginal tax rates.

TravelforFun
But grayfox's analysis seems to assume that your portfolio will grow at a rate equal to or greater than your RMDs. This might happen, but it might not. If it doesn't, then your tax-deferred balance will go down as the RMD percentage goes up. Schwab's RMD calculator visually demonstrates this very well.

Unless you are/were both a very egregious saver who wants to be the richest person in the cemetery, RMDs are not normally a true problem. In many instances where people complain about them, they are either confusing RMDs with retirement spending.
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FiveK
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by FiveK »

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.
If this is the first 401k contribution you have ever made, then you are correct. Otherwise you are not correct.

Your friend misses the point entirely. ;)

That's the short version. Background below, one step at a time. No sense in discussing later steps until we are in agreement on the earlier ones. All returns are "real" and using 2019 tax brackets for all calculations.

As others have mentioned, see the wiki for the useful definition of marginal tax rate: "It is calculated by dividing the amount of additional taxes that will be due (or reduced) by the amount of income involved." Whatever bracket boundaries and tiers are crossed, or phaseouts in play, etc., that simple division gives you the marginal rate of interest.

1. So far so good?

When you analyze a financial choice, you want to know what happens as a result of that choice. It's easy to see that a traditional contribution saves you some amount of tax for some amount of contribution. Divide the change in tax by the amount of contribution (per the wiki definition) and you have the marginal tax saving rate for that contribution.

Here is where your friend misses the point because he is talking about effective rates. The amount of tax you pay on the Adjusted Gross Income remaining after your traditional contribution is irrelevant.

2. So far so good?

Now come the "not intuitively obvious" part: what happens to your withdrawal later as a result of the choice to make a traditional contribution now. Start by imagining how much tax you would pay in retirement if you stopped (or never started) making traditional contributions now.

You might have a pension, or SS benefits, or interest, or dividends, or other "unavoidable" income. "Unavoidable" is in quotes because, yes, one could defer SS and/or pension, invest in non-interest and non-dividend paying ways, etc. So let's assume all those are zero.

There is another retirement income source: withdrawals from your taxable, Roth, and traditional accounts. Let's assume no taxable or Roth accounts, so we are left with withdrawals from traditional accounts as the only income. Let's further assume that withdrawals are made using some fraction, let's say 4%, of the traditional balance.

3. So far so good? All assumptions OK?

This takes us back to "If this is the first 401k contribution you have ever made, then you are correct." If you have no money in traditional accounts, then withdrawals based on your very first contribution will indeed start filling the standard deduction, then the lowest bracket, etc.

But if, based on previous years' contributions, you expect your traditional balance to be $1300K at withdrawal, you will have $52K income whether you make another contribution or not. If single you owe the IRS $4615.

4. So far so good?

Now you have to estimate the amount to which your next traditional contribution will grow. Let's say you put in $19K and expect it to quadruple (e.g., ~8% return for 18 years). Now you will have $1326K at withdrawal and $55,040 income, and you owe the IRS $5283. Your marginal rate on that withdrawal is (5283 - 4615)/(55040 - 52000) = 22%.

Your effective tax rate is 5283/55040 = 9.6%.

5. So far so good?

Now the critical issue: what do you do if your current marginal tax saving rate is 18% (e.g., 12% federal and 6% state) and you expect to pay only federal tax in retirement due to moving to a no income tax state?

Following the advice of those who tell you to compare marginal now to effective later will cost you 4% because you will be paying 22% instead of 18%.

Following the advice of those who tell you to compare marginal now to marginal later will limit your tax rate to 18%.

The choice is yours.

All clear? If not, at which step do we need to review?
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by MikeG62 »

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 friend is failing to realize (as you have pointed out) that your 401k contributions will receive a tax benefit at your marginal rate (i.e., highest rate in each year) whereas your withdrawals will be taxed at your average rate (again for the reason you indicate - some at 10%, some at 12% maybe some at 22%). Assuming tax rates do not change, it is hard to imagine the tax you would pay in retirement (on the same level of income) being equal to the tax you saved (deferred) while contributing to your 401k.

Also, you may well be able to do Roth conversions between the time you retire and begin taking your RMD’s. These conversions may also be done into the lower tax brackets like the 12% tax rate (again likely lower than your marginal rate when the contributions were made to your 401k).
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FiveK
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by FiveK »

MikeG62 wrote: Wed Apr 24, 2019 7:49 pm ...whereas your withdrawals will be taxed at your average rate (again for the reason you indicate - some at 10%, some at 12% maybe some at 22%).
Sure would be nice if we could choose to take different income streams and file separate returns (e.g., a separate return for withdrawals based on each year of traditional contributions) but the IRS doesn't allow that.

Withdrawals based on subsequent contributions are taxed on top of withdrawals based on previous contributions - in other words, at marginal rates.
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by kaneohe »

FiveK wrote: Wed Apr 24, 2019 7:55 pm ........................................................................
Withdrawals based on subsequent contributions are taxed on top of withdrawals based on previous contributions - in other words, at marginal rates.
I can see that this is true for RMDs. It is less obvious to me if the withdrawal is pre-RMD .
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Re: Taxes: marginal rate now vs effective rate in retirement

Post by FiveK »

kaneohe wrote: Wed Apr 24, 2019 8:03 pm
FiveK wrote: Wed Apr 24, 2019 7:55 pm ........................................................................
Withdrawals based on subsequent contributions are taxed on top of withdrawals based on previous contributions - in other words, at marginal rates.
I can see that this is true for RMDs. It is less obvious to me if the withdrawal is pre-RMD .
Let's say you are single and expect to have $1.3 million in traditional accounts at retirement, some time in the future, whether you make another traditional contribution or not. How much tax do you expect to pay on annual withdrawals (not RMDs necessarily, just money to spend)?

If you do decide to make another traditional contribution, such that you now expect more than $1.3 million in traditional accounts at retirement, how much more will you be able to withdraw and how much more tax will you have to pay?

If you won't withdraw any extra, despite having a higher balance, the question then passes to "what marginal rate do you expect your heirs to pay on their inherited IRAs?"
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