By Dr. James M. Dahle, WCI Founder
Tax-deferred accounts are frequently derided by three types of people:
- Those trying to sell whole life insurance as an awesome investment because you can borrow against its value (just like your car, home, or investment portfolio) tax-free, but not interest-free.
- Those who have a serious fear of dramatic increases in future tax rates, and
- Those who simply don't understand how tax brackets work.
When Not to Use a Tax-Deferred Account
Although the Roth (tax-free) versus traditional (tax-deferred) 401(k)/403(b)/457(b) contribution question can be quite complex (especially since the right answer depends on variables that are unknown and unknowable), the rule of thumb is to use tax-deferred accounts as much as possible during your peak earnings years and tax-free accounts in all other years. For a typical doctor, those other years include the following:
- Pre-med years
- Medical school
- Residency
- Fellowship
- The year you leave training
- Sabbaticals
- Extended maternity/paternity leave
- Working part-time at any point in the career
Filling the Brackets
The key principle to help you understand WHY the rule of thumb is usually correct is a concept I call “Filling the Brackets.” People who don't understand how the tax code works sometimes worry about being “bumped up into the next tax bracket.” That's stupid. While there are a few rare places in the tax code where having slightly more income really does dramatically increase your tax burden, for the most part when you make more money, only the additional money made is subject to being taxed at the higher rate. Thus, your effective tax rate (total tax paid/total income earned) is typically significantly less than your marginal tax rate (the % of the next dollar earned that goes to the tax man.)
Let's use an example to demonstrate just how powerful a tax-deferred account can be. Let's imagine a doctor who didn't start saving for retirement until mid-career. She used a 401(k) and put $50K in it per year for 15 years from age 47 to age 62. It earned 5% real (and we'll use real [after-inflation] numbers, the 2019 tax brackets, and a 0% state income tax rate throughout this post) and thus added up to
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=FV(5%,15,-50000,0,1) = $1,132,875
She is single and was earning $350,000 during her career, so her federal tax rate was 35% throughout her peak earnings years. She has no pension, no rental properties, and is delaying Social Security to age 70 like a good white coat investor. So her only source of taxable income when she retires at age 62 is that 401(k).
She decides she is going to withdraw 4% per year. That would normally be adjusted up with inflation each year, but we're using real numbers so we don't have to make an adjustment there. So when she put her money into the account, she saved 35% on taxes on it.
Now, what happens when she withdraws the money? What tax rate does she pay on it? Well, let's assume her only deduction is the standard deduction. She is withdrawing 4% * $1,132,875 = $45,315 per year
- The first $12,200 she withdraws comes out at 0%. That's the standard deduction. Save at 35%, pay at 0%. Very much a winning combination.
- The next $9,700 comes out at 10% for a total of $970 in federal tax. Save at 35%, pay at 10%. Pretty sweet deal.
- The next $45,315 – $9,700 – $12,200 = $23,415 comes out at 12% for a total of $2,810. Save at 35%, pay at 12%. Still awesome.
What is her effective tax rate? It's ($970 + $2,810)/$45,315 = 8.4%. Save at 35% and pay at 8.4%. That's a heck of a deal. This is why maxing out tax-deferred retirement accounts is such a good idea. You get to save money at your marginal tax rate when you contribute the money.
It grows tax-protected for decades–no taxes due on dividends, distributed gains, or gains from exchanging funds. In most states, it also provides powerful asset protection and estate planning benefits. Then, when you withdraw the money, you get to use it to fill up the brackets, usually providing an effective tax rate lower than the rate at which you saved the money during your peak earnings years.
In fact, the worse of a saver you are, the better a deal that a tax-deferred account becomes. If the doctor in our example only had a $300K IRA, her 4% withdrawal would have been completely tax-free.
Here's an illustration from my book, The White Coat Investor's Financial Boot Camp. It illustrates just how beneficial a tax-deferred contribution can be, as a result of filling the brackets.
Increased Tax Rates Don't Change the Basic Formula
Let's now talk about what would happen if tax rates DID increase dramatically in the future. Before we get into this, there are some people out there who have some crazy ideas about future tax rates.
If you truly, in your heart of hearts, believe that tax rates are going to DOUBLE in the future (i.e. the 12% bracket becomes the 24% bracket and the 37% bracket becomes the 74% bracket) then yes, you should be doing Roth contributions and Roth conversions as much as possible now.
However, let's get real for a minute. The reason most of these wackos think rates are going to double is usually based on the federal debt. There are three reasons that even if the country and their elected representatives decide to do something about the federal debt, doubling tax rates is a very unlikely solution. There are simply better ways to deal with it.
- The federal debt issue isn't about the absolute size of the debt, but the percentage of GDP that it represents. While relatively high right now compared to historical figures (although it was higher in WWII), it isn't ridiculously high. It's basically the equivalent of a family with a mortgage the size of their gross income–very much affordable.
- Raising taxes is VERY unpopular, particularly when done to the middle class. Go ahead, try to name 51 senators who will vote to raise taxes. Go ahead. I'll wait. Now try to name 51 who will vote to DOUBLE tax rates. Case closed.
- Inflation is a stealth tax. It basically steadily erodes the value of everything you earn and own. But you know what a great hedge against inflation is? Nominal debt. As inflation increases, that debt becomes easier and easier to pay. Now, some of the federal debt IS indexed to inflation (TIPS) but it's only about 8% of the debt, so on a real basis, inflation reduces the national debt. Inflating the debt away is far more viable politically than doubling tax rates.
So let's get real. Let's assume EVERY tax bracket goes up 5% RIGHT AS OUR DOCTOR RETIRES and run the numbers again. 5% is a DRAMATIC increase. That is MUCH different than reversing the Trump tax cuts, where the largest change was reducing the top bracket from 39.6% to 37%. We're basically talking about a change twice that big in the opposite direction.
- The first $12,200 she withdraws comes out at 0%. That's the standard deduction. Save at 35%, pay at 0%. Very much a winning combination.
- The next $9,700 comes out at 15% for a total of $1,455 in federal tax. Save at 35%, pay at 15%. Still a great deal.
- The next $45,315 – $9,700 – $12,200 = $23,415 comes out at 17% for a total of $3,981. Save at 35%, pay at 17%. Still a big difference there.
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What is her effective tax rate? It's ($1,455 + $3,981)/$45,315 = 12%. Save at 35% and pay at 12%, even after a dramatic tax increase. Certainly, the “solution” to this problem offered by whole life salesmen is wrong. Not only do you end up paying for unnecessary insurance and get a low returning investment, but you miss out on this huge tax arbitrage.
What About Other Retirement Income?
The best argument AGAINST using a tax-deferred account is not the fear mongering done by those with little knowledge of financial history or who are trying to sell you insurance-based investing products like whole life insurance. The best argument is that most people, particularly super-savers which we will deal with next, will have other sources of taxable income in retirement. These sources include pensions, Social Security, rental income from real estate properties, royalties, dividends, capital gains distributions, and interest.
The critics are absolutely right–the more of these you have, the less beneficial a tax-deferred account is going to be. However, it would be very rare that going 100% Roth with your retirement accounts (if it were even allowed, since the match and other employer contributions are always tax-deferred) would be the right move. Let's run some numbers again, then I'll discuss each of these sources of income.
Let's assume that our doc not only is going to take $45,315 from that 401(k), but also is going to receive $30,000 in Social Security (85% of which will be taxable), $10,000 a year from a rental property, $10,000 a year from bond interest, and $10,000 per year in qualified dividends/long-term capital gains. Her gross income is going to go way up (from $45,315 to $105,315). Her tax bill will also rise at an even faster rate than her income. But as you will see, she still benefits from filling the brackets.
How much taxable income does she now have? Well, the $45,315, 85% of the $30K in SS ($25,500), the rental income (let's assume half of it is covered be depreciation, so $5,000 there), and $10,000 in interest for a total of 85,815 taxed at her marginal interest rate and another $10,000 at the qualified dividend/LTCG rate. We'll first look at the ordinary income.
- The first $12,200 she withdraws comes out at 0%. That's the standard deduction.
- The next $9,700 comes out at 10% for a total of $970 in federal tax. So far so good.
- The next $29,775 comes out at 12% for a total of $3,573. Not too bad.
- The last 85,815 – $29,775- $9,700 – $12,200 = $34,130 comes out at 22% for a total of 7,509.
- Add 15% * $10,000 = $1,500 for the qualified dividends.
Build a big enough nest egg, and you can just chill like this kid
Total tax bill is $970 + $3,573 + $7,509 + $1,500 = $13,552. Given her total income of $105,315, that's a 12.9% effective tax rate, dramatically lower than what was saved by contributing to the 401(k). Although to be fair, the real calculation is
($34,130 * 22% + ($45,315-$34,130)*12%)/45,315 = 19.6%
Obviously saving at 35% and paying at 19.6% is a still a pretty awesome deal. Certainly one shouldn't do Roth 401(k) contributions just because they'll have some Social Security, rental, interest, and dividend income. They'll need to have A LOT of other income, like nearly as much as they were earning during their peak earnings years.
Let's go through the various sources of income that could fill lower brackets and make a few comments about each one.
6 Sources of Income to Fill Lower Brackets
#1 Social Security
This one will be an issue for most people eventually, but since the right move for the vast majority of those noodling on this tax-free versus tax-deferred decision is to delay to age 70, it probably isn't an issue for a number of years. If you retire at 55 and don't take Social Security until 70, that's 15 years that you can use withdrawals from tax-deferred retirement accounts (and maybe even Roth conversions) to fill the lower brackets. Don't worry about the Age 59 1/2 Rule, since early retirement is one of the exceptions to paying the penalty on early withdrawals so long as you follow the Substantially Equal Periodic Payments (SEPP) rule.
Another issue with Social Security is that all of it isn't taxed. In fact, for a very low earner, very little of it is taxed. But most readers of this blog, and particularly those thinking about Roth versus traditional 401(k) contributions, should expect to pay taxes on the maximum 85% of it. Still, 15% of it is tax-free.
#2 Pensions
Pension payments fill the lower brackets, so if you're expecting one or more pensions, particularly large ones, then Roth contributions are relatively more favorable.
Imagine a two military doc couple, for instance. They might enjoy a relatively low marginal tax rate during their working years because they are likely residents of a tax-free state, a significant chunk of their pay consists of tax-free allowances, and their salary is on the low side for physicians.
Then in retirement, they could enjoy a combined pension ranging from $84K to $136K. Even for a married couple, that pension alone will fill the 0%, 10%, 12%, and a decent chunk of the 22% brackets. This is one of the reasons why almost every military member should be making Roth TSP instead of tax-deferred TSP contributions. But what percentage of docs are expecting a pension, especially a large one? I'd guess fewer than 5%.
#3 Rental Income
Here's another big one. If you have a ton of rental income, then Roth contributions and conversions can make a lot of sense because the rental income fills the lower brackets.
However, there are a few considerations. First, one or two small rental properties aren't going to fill enough brackets to make a difference. Imagine a paid-off $100K cap rate 6 rental property. That's only going to kick out $6K in income, and that's assuming it is already fully depreciated. It would take four of those just to fill the “0% bracket” for a married couple. But if you've got a dozen doors under management and they're mostly paid off or a million or two in real estate funds or syndicated properties, then that might fill two or three of the lower brackets. Bear in mind that depreciation and large mortgages may very well reduce the amount of taxable income there dramatically such that you lose very little of the lower bracket space to your rental income.
#4 Royalties
This one technically belongs on the list, but let's be honest here. Most of us don't have a lot of royalty income now and probably won't have much in retirement either. I do have a substantial amount of royalty income from my book, but as time goes on, fewer and fewer people buy it and if I wasn't constantly plugging it on a blog and a podcast, very few would buy it. But sure, if for some reason you've got $200K in indefinite royalty income, then you probably want to do more Roth contributions and conversions than someone who doesn't.
#5 Qualified Dividends
Qualified dividends and long term capital gains enjoy their own favorable tax brackets. The 2019 qualified dividend/LTCG brackets are as follows:
Remember the incomes in the table aren't JUST the dividends/capital gains, but your entire taxable income. But still, most doctors in retirement are going to have their qualified dividends and LTCGs taxed at 15%, and some may even slip a few into the 0% tax bracket. You would have to be a REALLY successful investor to have $434K+ (in today's dollars) in taxable retirement income.
However, I don't really consider dividends and LTCGs to be filling the brackets and forcing tax-deferred retirement account withdrawals to be taken in higher brackets since they're on a completely different tax bracket scale. I view your dividend/LTCG taxes as being added AFTER you have applied the ordinary income tax brackets to those withdrawals.
Besides, all those tax losses you've created from tax loss harvesting over the years (especially if combined with the practice of donating appreciated shares to charity) reduce that income even further (and may even reduce your taxable ordinary income up to $3,000 per year.)
Don't forget that, depending on your basis, a large part of the value of the shares you sell may not be taxable at all. Just like a Roth IRA or bank account withdrawal, that is money that doesn't even show up in this equation.
#6 Bond Interest
If you have a ton of taxable bond interest, that could also fill some of the lower tax brackets. However, given that bond funds are currently only yielding 3-4%, you'll need a lot of money in taxable bonds for this to really fill up much of a bracket. Even $500K in taxable bonds is only going to kick out $15-20K in taxable interest. You can also use muni bonds and not pay federal (+/- state) income tax on that income at all.
What About Super Savers?
Another group of people that ought to at least think about doing more Roth contributions and conversions during peak earnings years are super savers. By super savers, I mean people who save a large percentage of their income, like 30-50%+ and yet still work a full or nearly full career. These folks not only max out retirement accounts, but usually have a significantly sized taxable account and maybe even rental properties.
The good news for these folks is that they've won the game. I mean, the worst case scenario for these folks is that they pay a little more tax than they need to. It's not that they won't have all the money they ever need to spend in retirement — with plenty left over to ruin their kids and maybe even their grandkids. On the other end of the spectrum, we have people who have not saved enough or have barely saved enough. The less you save, the more useful a tax-deferred account is. So it makes sense that as you save more, the less useful a tax-deferred savings account becomes. The withdrawals plus other income simply get you much closer to what your peak earnings marginal tax rate was. In fact, if you really save a ton, you could even theoretically pay at a higher marginal rate in retirement than you saved during your peak earnings years, especially if tax rates rise a bit.
Another important effect to understand is that if you are also investing in a taxable account, then if your contribution tax rate and your withdrawal tax rate are equal, you would be better off using a Roth account. The reason for that is easily seen if you adjust everything for taxes. If the government really owns 1/3 of your tax-deferred money, then a $1M IRA + $333K in a taxable account is precisely equal to a $1M Roth IRA. But as time goes by, the Roth IRA becomes more valuable because all of its growth is protected from tax drag, whereas only part of an IRA + taxable combination account is protected from tax drag.
Let's run some numbers to show just how much of a super saver you can be and still not have to worry about this.
Super Saver Scenario
Let's say a couple of super savers earn about $300,000 together and save half of it, 1/4 in tax-deferred accounts and 1/4 in a taxable account and do that for 35 years. They're in the 32% tax bracket during their peak earnings years. Their investments earned 5% real over that time period. We'll assume a little tax drag on the taxable account. After 35 years, they've got a $6.8M IRA and a $6M taxable account of which half is basis. If they decide to spend 4% of each account, their income looks like this:
- $40K from Social Security
- $272K from the IRA
- $120K from the taxable account at qualified dividend/LTCG rates
- $120K basis from the taxable account
Total spendable cash each year: $552K
Total taxable income: $432K
How much do they pay in tax?
- The first $24,400 is taxed at 0% due to the standard deduction.
- The next $16K is taxed at 10%, for $1,600. That is all from Social Security and has filled up the 0% and most of the 10% bracket. There's still a little room in the 10% bracket for that IRA withdrawal though.
- $3,400 of the IRA withdrawal is taxed at 10%, for $340.
- The next $59,550 (all IRA withdrawal) is taxed at 12%, for $7,146.
- The next $89,450 (all IRA withdrawal) is taxed at 22%, for $19,679
- The last $119,200 (all IRA withdrawal is taxed at 24%, for $28,606.
- The $120K dividends/gains from the taxable account is all taxed at 15% for $18,000 in tax due.
- The $120K of basis incurs no tax burden.
Total tax paid on that $432K in taxable income and $552K in spending cash is $73,771, 17% and 13% respectively. But the important question is what is that IRA withdrawal taxed at? Remember they saved 32% on the money going in.
$340 + $7,146 + $19,679 + 28,606 = $55,771
$55,771/$272,000 = 20.5%.
So even these super savers come out way ahead by using a tax-deferred account during their peak earnings years. Even if tax rates increased 5% across the board they're STILL going to only pay $69,469 on that withdrawal, or 25.5%.
A Change in State Tax Rates
One other way that using a Roth 401(k) during peak earning years can help is if you spend your career in an income-tax free state (such as Alaska, Washington, Nevada, Texas, Florida, South Dakota, Tennessee, or New Hampshire) and then retire to a high tax state such as California, New Jersey, or New York. You could be adding 7-10% to your withdrawal tax rate and that could push you into a situation where you're paying more at withdrawal than at contribution. But even that probably has to be combined with one or two of the other three factors: increased tax rates, significant other income in retirement, and super-saver tendencies. I think this is a pretty rare situation. Most people stay put in retirement and those who move tend to move to lower income tax states than where they spent their career (i.e., New York to Florida, Illinois to Texas, Minnesota to Arizona, Montana to Nevada).
Careful with Spouse Life Expectancy
Another factor to be aware of, especially if your spouse is much older or sicker than you, is that once your spouse dies you go from using married tax brackets to single tax brackets. If that's just a couple of years at the end of your life, no big deal. If that's your last 20 years, you may have wished you had done more Roth contributions or conversions. For example, a married couple with $250K in taxable income is in the 24% bracket, but a single person with the same income is in the 35% bracket.
The year your spouse dies may also be a good year for a big conversion too.
Beware the 199A Deduction
If you are self-employed and qualify for the 199A deduction, be careful using tax-deferred employer contributions as they reduce your ordinary business income that your 199A deduction is calculated from. You may be better off making Mega Backdoor Roth IRA contributions instead like we are this year.
Drawing Conclusions
As you can see, the rule of thumb to use a tax-deferred account during peak earnings years is persistent despite numerous factors that would seem to reverse it. That leads me to believe that when someone is arguing for Roth 401(k) contributions or Roth conversions during peak earning years they are either:
- Ignorant, or
- Trying to sell you something
There are at least two well-known people in my local area making this argument on the radio or in their books. No surprise that both of them make their living by selling cash value life insurance. I've also had a fair number do it in the comments section of this blog. Each time I challenge them to actually run the numbers themselves. They never seem to want to do so. They either change tactics and start arguing for some other benefit of whole life insurance, or (more likely) launch into ad hominem attacks. As you now know because you've run the numbers, it's unlikely that this rule of thumb is going to be wrong for any but a tiny percentage of investors. In fact, it's probably more likely that the other rule of thumb (invest in a tax-free account during non-peak earnings years) is wrong, but that's a post for another time.
What do you think? Did you understand the concept of filling the brackets before this post? Have you been mistakenly making Roth 401(k) contributions? Which type of account do you contribute to and why? Do you think whole life selling agents actually believe they're helping you reduce your taxes and reach your goals when they say you should avoid using your tax-deferred accounts and buy whole life insurance instead? Comment below!
Thanks for this! This is our current main decision re actually Roth conversions rather than TSP Roth (think I have settled that I will not be better off doing Roth TSP) in our pre/ semi retirement years now. I will relook the numbers next lower income year and decide how realistic a fear “higher tax bracket when RMD kicks in” is for us, and any actual/likely benefit to our heirs of Roth IRAs / whether we’re likely to leave them anything as we get closer to that time frame. Hopefully I will be of adequate sound mind to calculate and decide and correctly implement those options- sadly never an absolute given- so I will review it THIS year when time permits to guide our future planning.
As a single doc and high income earner I am in the 37% tax bracket and for me it makes sense to do tax deferred as much as possible. The only money I put in the Roth space is because of backdoor Conversions as my contribution is post tax with no deduction allowed.
I am definitely going to find myself using up a lot of the valuable lower tax brackets (1st world problems) because of the passive income machine I have created. Right now it is already approaching 6 figures and by the time I’m done I’m hoping to top $125k/yr for my pre-retirement assets. Thanks for providing numbers for a similar situation as it still favors tax deferred contributions now.
Way too many assumptions in this to think any of it will be realistic. Preretirement income of 350k to living on 45k is a huge reach. Also the top marginal bracket today is far below the historical average.
Living on $45K is not the same thing as having a taxable income of $45K.
But I agree everyone’s situation is different, so make your own assumptions and run the numbers for your situation.
I think you should take a look at the historical averages before opining that today’s top bracket is “far below” them:
http://dailydoseofexcel.com/archives/2009/04/16/historical-us-tax-rates/
As you can see at the chart there, the top marginal tax rate was higher for about 8 years around WWI and from 1930 to 1986. Prior to 1913 there WAS no income tax (so any average of our country’s top rates has to include 0% for the first 140 years or so.) It was lower in the 20s and 80s too.
Also, the top rate can be a little bit deceiving. For example,
https://taxfoundation.org/us-federal-individual-income-tax-rates-history-1913-2013-nominal-and-inflation-adjusted-brackets/
Yes, in 1979 the top tax bracket was 70%, but you didn’t hit that until a taxable income of $215,400 (MFS). If you adjust that for inflation, it’s the equivalent of $801,700. Our top bracket today starts at just $612,350.
In 1943 the top rate was even higher– 88%. But that started at $200K of taxable income. That’s the equivalent of >$3M today in taxable income.
Those 70%+ tax rates that get thrown around all the time are also insanely deceiving, as there were TONs of loopholes back then (like, nuts), which were closed in exchange for the lower rates… Effective tax rates back then were nowhere near those numbers.
They probably ought to do that again. Close more loopholes, lower the brackets.
Wife of a KP physician here. He will have a decent pension. Don’t live in CA- so the pension is reasonable to live in for us (about $7k/month), sounds like we actually SHOULD be looking at ROTH contributions during peak earning years? Due to a practice mess during 2008 and then joining KP soon after, the 401k got a late start. Its not that big for a ~50-ish MD. We’re working on that, but now I’m questioning whether we should be doing ROTH instead.
Maybe. Add ~$40K from SS to $84K from the pension, subtract a standard deduction and you’re still going to start (and probably finish) withdrawing from that 401(k) in the 22% bracket. If your marginal rate is 32% or higher now, I would argue you’re probably still better off with tax-deferred contributions.
Thanks- obviously would likely defer the SS income til 70. We still have 10 years to add to the 401k, have to have 20 years in to get full pension, and he got a late start.😖
As a KP doc in CA, I was thinking the same thing. Perhaps Roth contributions are better. Still a good 20+ years from retirement from KP but if I make it, will have half my salary at time of retirement (roughly). Don’t know what it’ll be at that point but likely at least 150k per year but likely more unless salaries plateau. Even deferring SS, it will fill up most/all the lower brackets, esp if I add other potential income sources by that time, ie rental etc.
If you calculate Kaiser’s pension in addition to their Keogh plan (which as I understand is basically a tax deferred plan like a 401K anyway – and contribute the max of $38K/yr to this), then yes I agree, it seems that afterwards, maxing out a Roth is the way to go? But I’d like to hear what others think.
Certainly doing all that for a few decades will give you a big old tax-deferred account. And certainly most docs should be doing a backdoor Roth IRA. But I have no idea what you are actually asking.
Seems like you are doing marginal rate comparison vs effective rate. Marginal rate during contribution period vs effective rate during withdrawal. You need to show calculations with effective rate vs effective rate. You aren’t paying 35% effective rate on income during your earning years either.
Hope you meant marginal rate vs. marginal rate, because that is what will matter. See other discussion in this thread, https://www.bogleheads.org/wiki/Traditional_versus_Roth, etc.
If you want to get technical, it’s marginal rates versus marginal rates.
In practice for many doctors who may put in $50K a yer and then take out $120K a year, it’s often something like 35% vs 0%, 10%, 12%, and 22%.
And when you’re using multiple marginal rates like that, it may be more accurate to say “effective rate”.
There are two issues:
1) Nomenclature. The rate in question is “(change in tax)/(change in income).” It’s not “change in tax for the next $1 of income,” nor is it “(total tax)/(total income)” which some would insist are the only calculations that define marginal and effective respectively.
2) Reality. One hopes the doctor planning to remove $120K/yr already has a large traditional balance that would support such a withdrawal, whether a $50K contribution is made this year or not. Making a $50K contribution this year might allow that doctor to withdraw, say, $124K/yr instead. It’s the tax rate on that extra $4K/yr in the future that matters, compared with the tax rate that the $50K will save this year.
1. It’s not clear to me what you are referring to.
2. If a doctor contributes $50K/year to a tax-deferred account, a $120K withdrawal per year in retirement should not be an issue, even without adjusting for inflation. Run the numbers:
=(FV(5%,30,-50000,0))*4% = $132,877.70
1. The words “marginal” and “effective” are not unambiguous. As long as there is agreement that the appropriate calculation for the traditional vs. Roth choice is “(change in tax)/(change in income)” then call it what you will, just define it that way. Some call that the “effective marginal” rate, which either clarifies or muddies things, depending on one’s perspective.
2. No argument with the math of a Future Value calculation. Doing the same calculation but for 29 years gives $124,465. If in the 30th year no traditional contribution or withdrawal is made but the balance continues to grow at 5%/yr, the withdrawal after 30 years would be $130,878. Some amount of tax would be due on that $130,878, filling whatever brackets it fills.
The choice in the 30th year then depends not at all on brackets below whatever taxable income a gross income of $130,878 fills. The choice in the 30th year depends on the tax rate incurred by the extra $2000 the $50000 traditional contribution would allow (and the tax rate saved by the $50000).
Does that make sense?
1. Fair enough
2. I can’t remember if I put a 0 or a 1 as the last factor (contribute at the beginning or the end of the year) but I’m assuming that’s the only difference.
2. I think “0” for “end of year” but that’s irrelevant. You could use “1” for “beginning of year” and the specific numbers would change but the point remains.
The point is that going into the 30th year, you know the lower brackets for retirement are already filled by the amount you expect to withdraw, based on contributions in years 1-29 and growth.
You’ll pay tax on at least that amount, regardless of how much and to what account you contribute in year 30.
OK so far?
When you look at year 30’s contribution, you should look at the tax rate you’ll pay on the EXTRA withdrawal you can do if you make a traditional contribution. In other words, the (extra tax)/(extra withdrawal).
The extra withdrawal never gets a sniff at the 0%, 10% , etc., brackets because those will have been filled in any case.
Of course, if one is saving 35% on a traditional contribution, comparing that to 22% or 24% marginal in retirement gives the same answer as if one used the effective (total tax)/(total income) rate: make the traditional contribution.
Does that make sense?
It’s odd having a conversation in this format (one back and forth a day) while having 50 others by email and on other posts. I confess I’m having a hard time even recalling what we’re talking about every time I come back.
It’s not clear to me why someone would be taking traditional IRA withdrawals while making traditional IRA contributions. Why wouldn’t one live on what would have been contributed?
But yes, one fills the brackets with taxable income, whatever that source of taxable income might be. Whether it’s from IRA withdrawals, Roth conversions, Social Security (at least the taxable portion), real estate rents, or a salary from a part-time job.
Another great post which reminds me again it’s easy to overestimate retirement effective tax rates even for super savers. My Roth conversion problem is mostly over since I’ve never had a job that qualified for a 401K or equivalent and converted my Traditional IRA to Roth to enable “backdoor” Roth conversions but this also means that 90% of my savings are in taxable accounts. I find that the dividend income is a problem from the perspective of adding to taxes each year and it’s not just the 20% maximum for qualified dividends but the additional 3.8% ACA tax for qualified (even before state taxes) and the full earned income tax bracket for nonqualified dividends from some of the stocks within international index funds (especially that factor-rich small cap, value international stock category). I feel like those will continue to fill the tax brackets quickly in retirement but that is a minor quibble to the excellent point you make about how unlikely it is that our retirement tax bracket will even approach what we experience during our peak saving years.
If you’re still paying the 3.8% tax in retirement, you really knocked it out of the park. Good job. 🙂
Truly one of your finest posts yet. Thanks for doing so much of this homework for us, Doc.
My understanding is that the top marginal tax rate was over 60% for like 50 years in this country… why wouldn’t we go back there?
Important to differentiate marginal vs effective rates when comparing eras. This is because of changes in the deduction schemes within the tax code.
For example, in the 1950s, when the top marginal rate was 91%, the average effective rate through this time was around 42%
In 1986, the top marginal rate was 50% while the effective rate was 33.1%
in 2016, the top marginal rate was 39.6%, while the effective rate was 26.9%.
So the effective tax rate differences between different era is not as staggering as the marginal rates would suggest.
You want me to explain the mental gyrations of a future Congress?
Seriously though, if you believe that is going to happen, then sure, convert everything to Roth now.
Well, I was hoping for something a little more nuanced than “i just don’t think they will” since it is what your entire argument depends on. To me there is pretty clearly a non-zero chance that the tax rates will return to historical levels and so it makes sense to at very least diversify between tax deferred and Roth in order to insure against that very real possibility
You’re expecting nuance out of a prediction about future tax rates? Would you like me to do interest rates and stock market performance too? Seriously, I don’t know what the future holds. My crystal ball is just as cloudy as yours.
I do Backdoor Roth IRAs every year and now am doing Mega Backdoor Roth IRAs with another $93K a year. So that’s $105K a year going into Roth accounts. In addition, about $70K is going into tax-deferred accounts. Another $7K into an HSA and a 7 figure amount in to taxable. I think we’re plenty diversified. We already have hundreds of thousands in Roth accounts because we’ve been doing his and her Roth IRAs for the last 15 years.
But I get a 42% (37% fed + 5% state) deduction for anything that goes into a tax-deferred account. I think it’s unlikely that I’ll be withdrawing at that rate in the future, so I’m not doing any Roth conversions. I think most of my withdrawals will come out at less than 30%. So even if tax rates go up 5% (maybe even 10%) absolute, I’m still better off with tax-deferred if I can do them at 42%.
I don’t know your tax situation, but make the best projections you can, take reasonable assumptions, and do what the numbers suggest you should.
But before deciding tax rates will return to their 1930-1980 levels, consider what is special about those 50 years? Why not have tax rates return to their 1920 levels or 1870 levels or 1990 levels or whatever? Why pick the time when tax rates were highest to be “historical levels?”
Thanks for running so many scenarios! This was a very illuminating post. I’ll have a choice soon whether to elect for a Roth 401(k) or a tax deferred 401(k), on top of a Keogh which is tax deferred. I was planning to do the Roth 401(k) to “hedge my bets,” but that may not be the best option after all.
Much to ponder here. Many thanks.
— TDD
While “hedging your bets” would provide some insurance there, it’s entirely possible that insurance will have a cost. Only you can decide if that is something you should pay to insure against.
Thanks for the clear articulation! One more scenario to consider is when only one spouse retires, so there is still meaningful earned income filling the buckets…but not at the 2 earner level. I’m looking to do mega Backdoor ROTH 401(k) (first time allowed this year), and then start some ROTH conversions to top off bracket going forward (2020 and beyond) after I retire later this year. If nothing else, it provides a little bit of tax diversification and will limit future RMDs bumping me well beyond those levels…
That mostly just increases the cost of the pre-Social Security Roth conversions even if it makes Roth 401(k) contributions slightly better than they would otherwise be. Could still be the wrong move with one spouse working.
Exactly- must run the numbers to compare different scenarios and test assumptions…thanks again for highlighting the variables.
Great post and important concept. Many people mistakenly compare their marginal rate when working to their expected marginal rate in retirement, when they should be looking at their current marginal rate versus their expected future *effective* rate. For high-income professionals, that effective rate in retirement is likely to be lower even if overall tax brackets move higher. It’s still really complicated, though, especially for self-employed folks who now get the Section 199A deduction. Even with the Section 199A deduction, though, the muted benefit of dodging taxes now (with a traditional pre-tax contribution) is still often better than dodging taxes later (with a Roth contribution). Our byzantine tax code sure makes financial planning more complicated, huh?
Unfortunately, the mistake is comparing marginal now vs. effective later. Sure would be nice if the tax code worked that way, but it doesn’t.
The pension example makes it relatively easy to see: if a pension fill all the low brackets, withdrawals come on top and are thus subject to marginal, not effective, rates.
A little less obvious, but nonetheless true, is that withdrawals based on previous years’ contributions also provide a base on top of which withdrawals based on new contributions are taken. As years go by, and new decisions must be made, it’s the marginal rate to which any new contribution will be subjected at withdrawal that matters.
Not sure I understand what you’re saying. At withdrawal, a dollar doesn’t care if it was contributed in 1975, 2005, or yesterday. Nor does it care if it was a contribution or a gain.
For someone no longer contributing, looking at the average tax rate on all traditional withdrawals and comparing that to the average of all tax rates saved by traditional contributions, is a reasonable way to determine how well, on average, one did at choosing traditional vs. Roth.
But for the person still able to contribute, each new contribution should be judged on the marginal rate saved vs. the marginal rate that will be paid due to the extra withdrawal made possible by the new contribution.
E.g., if you could save 28% now (perhaps 24% fed and 4% state) and expect to pay 32% marginal but 20% effective at withdrawal, would you
– contribute to traditional because 28% > 20%, or
– contribute to Roth because 28% < 32%?
Yes, great point. I think it’s borderline pedantic but accurate to say it’s marginal versus marginal. If I’m 50 and already have $1m in pre-tax savings, that money might grow and create an RMD at age 70.5 of ~$100,000. This might be on top of perhaps $40,000 in social security income. It makes sense then to evaluate your next pre-tax vs post-tax decision at age 51 as your marginal rate then versus the marginal rate of the incremental RMD on top of the $140,000. All that being said, for most folks it pencils out better to save pre-tax in prime earnings years. Every situation is unique and there’s no one-size-fits-all advice. This has been a great article and thread to think about different scenarios.
Ahh…I see what you’re saying now. I think your statement is accurate, but VERY hard to predict that, of course. It is the right way to think about it though.
Perhaps not much harder to predict marginal than effective – both require a clear crystal ball. 😉
Also, other income such as a pension, inherited IRA, rentals, Social Security, taxable interest and dividends, etc., increases the marginal rate of traditional withdrawals.
Doesn’t affect the fact that for most, traditional contributions will work best. But for the not insignificant population fortunate enough to be in that situation, it’s better to use Roth when the withdrawal marginal rate appears to exceed (even meet) the contribution marginal rate.
See https://www.bogleheads.org/wiki/Traditional_versus_Roth and https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 for more.
Sorry for reviving an old post but I have been search for an answer/thoughts on this.
First, let me say that for most doctors/investors likely you are completely right. When looking at taxes, wouldn’t time in the market also contribute substantially? I mean, specifically if you are starting out, Roth seems to make more sense due to the doubling effect as every dollar that goes in is already taxed so the earnings can pile up and contribute substantially. For instance, $56,000 in a Roth for 30yrs, at 7.2% (for easy math) would be worth $450k and could have been taxed at 24%, so $73684 for that 450k vs the tax deferred option also 56k tax deferred, now worth 450k) when you withdraw the 450k it is taxed at 20% effective and cost 90k to spend it and the taxable account would get the $17684 and assuming either lower return investment or higher but taxable along the way return, will estimate a 100k value still subject to tax on capital gains or distributions at at least 10% it starts to be a bit more of a wash.
The thing nobody really mentions is the 450k costs the same 73,684 but actual taxes paid are closer to $100-150k vs $17,684 and while you shouldn’t let the tail wag the dog, that is substantial).
And of course, it doesn’t take long before people start skipping out on investing that money saved on taxes and start putting it towards something else. If the dollar spends less time in the market then the traditional is going to pick up any tax benefits and the investment has less time to catch up. Conversely, the dollars are more secure in the Roth account because you know how much it has cost and you don’t know how much the other money will cost.
I honestly, think with only somewhat disciplined savings I will definitely be in the same bracket or a higher one in retirement with fewer deductions (except maybe charitable giving). My personal plan is to stick to contributing as much as I am able to my Roth accounts in the early years and as I think between match and traditional contributions (those already made and the ones I will make to my traditional only 457b and the ones I will make when I get closer to my break even point) to make sure that I fill up the brackets and then have Roth for my “spending money.” And after I typed all of this out, I don’t think we disagree, I just find the 17k vs 100k tax contribution, though in theory the same amount of money, is enormous. I think I have more flexibility during my earning years to handle a tax burden than I may in retirement. Though it does make you wonder what will happen to government when a huge chunk of Millenials with massive Roth Contributions hit retirement age. And many will have been frugal high earners thereby hitting the tax revenues even harder. If they don’t spend all of their money, the deficit may be huge.
I think this post is for you:
https://www.whitecoatinvestor.com/supersavers-and-the-roth-vs-tax-deferred-401k-dilemma/
Bob, you might also want to look at https://www.bogleheads.org/wiki/Traditional_versus_Roth, particularly the “Calculations” and “Common misconceptions” sections.
WCI – when I took Taxes in business school (a good one), we were taught to compare marginal rates to marginal. And to assume that rates will go up in the future. My two cents.
Well, I don’t know when you were in business school, but are rates higher or lower now than then? I’ll bet their lower, so that second “cent” wasn’t very useful to you.
As far as the first one, you are technically comparing marginal to marginal. But you have to do it for every dollar contributed and withdrawn, not just the last one. The last dollar contributed and the first one withdrawn have a dramatic difference in tax rate for the typical doc. The more you contribute/withdraw, the smaller the difference becomes.
The spousal life expectancy issue is a significant one. If there is a 10 year or longer gap between the time that one spouse passes away and the time that the other spouse passes, the situation could favor significantly more Roth contributions than otherwise. It’s difficult to model this, but my rule-of-thumb is that if the anticipated after-tax difference between tax-deferred and Roth contributions is not substantial, at least 10%, go with Roth contributions.
Agreed that it can be a big deal. I’ll have to noodle on your 10% rule of thumb though.
10% might be a little high, but if the stretch IRA is eliminated as pending legislation seems to indicate that it will (both the House’s and Senate’s versions do, although the Senate’s allows the first $400k to be stretched), that could also lead to the Roth becoming more favorable. And of course, Roth contributions/conversions are a hedge against tax rates going up in the future, something that a lot of folks are concerned about, whether justified or not.
Great post WCI.
There’s a growing middle band of physicians these days that dont get past the newly expanded 24% bracket even before taking their deductions 345k yearly— W2 primary care docs mostly fall here and coupled with pretty good legacy pensions.
Pile on top of that the 2025 tax brackets sunset. For those who experienced the last sunset, that can really make the math scenario interesting.
So if one earns 345k and doesn’t anticipate a significant drop in spending habits so 40% drop and straight line income revenue taxation ….one can find themselves at the same tax bracket and maybe even higher is the sunset occurs and brackets reset higher.
This is where Roth comes into sharper focus along with the RMD discussion too.
Remember that you can earn a lot less in retirement and still have the same spending habits/lifestyle. Think of all the expenses you won’t have in retirement- retirement savings, college savings, payroll taxes, life insurance premiums, disability insurance premiums, work expenses, commuting expenses, child related expenses etc.
But yes, if you’re in a low bracket now and are confident you will withdraw that money at a higher rate later, then Roth is the way to go. I would argue that’s a pretty small group of doctors, even taking into account the situation you describe.
Just presenting the other not so extreme side. I don’t think the spread is as wide as exampled.
I can’t imagine a 450K earner suddenly dropping expense to 192k income support levels. They may have less kid support, but suspicion is if you’re used to spending on the kids, that won’t spot with the grandkids. AND retirement spending can very easily ramp up. We anticipate more travel and not-on-shoestring in our golden years before infirmity.
A 40%+ drop is quite a lot IMHO to anticipate budget changes. There’s ‘beach bum’ bare bones basic daily expenses, but I would be remiss to think that’s the general spending habits of most 450k earners as demonstrated.
You can’t imagine it? How many examples do you need? PoF, me, the guy profiled earlier this month making $1.8M and spending $76K etc.
At any rate, what matters isn’t what MOST people will spend, but what YOU will spend. If you plan to be spending $400K in retirement, then make your decisions accordingly.
My monthly income/budget varies by 40% every month so I don’t think that’s a particularly difficult thing to work around. But I don’t spend anywhere near 60% of my income.
You know that you and PoF are not 1 or even probably closer to 2 standard deviations outside the norm, right? Like points guy and other travel hackers, what you guys do are aspirational examples, not the norm which many can nor will do.
Cutting expenses from working to retirement or varying them by 40% month to month at any time are not sound financial planning expectations or budgeting goals imho.
Medscape recently posted salaries reflect more in the 200-350k range than not and with a decent chance post retirement surpassing 102k….you’re looking at a 2% spread plus the pretax earning boost. Assuming no tax bracket reset.
At that point, one may very well look at Roth for a tax free environment and if a high net worth or side income that runs into RMD forced distributions, Roth considerations really do come into play
I agree if your retirement income is going to be similar to your pre-retirement income that you should probably favor Roth contributions. I disagree that is a common situation for doctors. 50% of doctors in their 60s have a net worth under $2M. You think they’re going to have the same income? Give me a break.
For those 50% docs referenced with less than $2M, if they fall into your standard scenario stated of $400K earnings preretirement, anticipated $100K post retirement, and have $2M savings — they have a lot more issues than talking about Roth vs Traditional savings.
Agreed. But it’s not uncommon.
>>50% of doctors in their 60s have a net worth under $2M
I realize this is a big reason you blog, but those are staggering numbers, and quite sad.
The Wealthy Accountant had an almost exact opposite post about this topic today with his argument being the tax deduction today on a traditional contribution isn’t worth as much as a full Roth contribution would be in 40 years.
A comment from Leo on the Wealthy Accountant post linked back to this WCI post as a counterpoint.
The Wealthy Accountant article was interesting too. It likens the tax deferred retirement account as a “loan” from the government, with annualized interest of some percent, based off your income, payable when you withdraw in retirement.
For a 30% tax bracket with $10,000 contribution (so 30% savings going in, 15% rate coming out), he modeled a situation where the interest rate from the government equates to about 5%.
If your employer matches your contribution, this brings the “government loan” interest rate down to about 3%, making it still a pretty good deal.
It’s an interesting way of looking at it, at least.
But now my brain hurts and I need to drink more coffee.
— TDD
I think that’s an incorrect way to look at it, especially if it gives you the wrong answer like it appears to be doing (haven’t read the post, just your comments on it).
So where was his error or how were his assumptions different?
First I’ve heard the anyone discuss the issue with increasing state tax rates. Been thinking a lot about that as we’re currently working in TX but plan to move to CA or OR for the long-term within 5 years. Has caused me to change my thinking away from maxing out the 401(k)+CBP and toward just socking away money in a taxable savings account.
Why? Well, I saved like hell to pretax in residency and first-year attending and now have ~$300K in pretax, which isn’t enough to FIRE but is a good start if (bad-case scenario) I can’t add any more to it but also manage not to touch it for 20 years.
The bigger issue is we’re currently renting and our goal is to buy free and clear on the west coast and we have very little in taxable currently. And given that whatever we do in TX we won’t have quite enough to FIRE the way we want after we move, assuming I keep a 1099 job out there with my same 401(k)+CBP space available, seems it’s best to wait to max out pretax until we get hit with (eg) that 10% CA state income tax.
If we did it the other way around, ie kept socking away our max of ~$150K/y to pretax in TX at the expense of ~$50–100K/y extra in pretax and then tried to max out taxable in CA, then we’d lose 10% of all the money we would have been saving in CA for our CA house. Seems to work out much better mathematically to save up for the house first then finish maxing out retirement in CA.
I do plan to keep putting enough in pretax in TX that we stay at the top of the 24% bracket, both because 32% is a big jump up and I don’t want to deal with the 199A phase-out.
Anything I’m missing here? It’s against your conventional wisdom for sure but I guess we’re pretty unconventional.
That was mentioned in the post. If you’re moving from Texas to California for retirement, that’s one more factor that could make Roth 401(k) contributions the right option for you. But the answer almost never is invest in taxable. Just invest in Roth or in tax-deferred if you have to (but do a Roth conversion of that money just before leaving). See more details here:
https://www.whitecoatinvestor.com/early-retirees-max-out-retirement-accounts/
Of course, money that isn’t for retirement (like a house downpayment) can be and usually should be saved in a taxable account.
Why did you save pre-tax as a resident? That’s a great time for Roth savings.
I saved both pretax (403(b)) and the standard ~$5K/y Roth as a resident, but unfortunately my residency did not offer a Roth 403(b) option, so my Roth savings potential was limited.
I did set up my custom VG 401(k) so it has a Roth 401(k) contribution option, but I haven’t actually used it yet. We’re hoping to be at ~24% total income taxes for the long-term in CA (15% federal + ~8–10% CA), and we’re currently in the 24% federal tax bracket in TX, so I suspect that putting retirement in 401(k) vs Roth 401(k) at this point will make no difference. Right now, as we have very little in our taxable savings account, I’d rather have the security of a large taxable emergency + housing fund than spend that money on Roth conversions.
Agree that I have no reason to invest in taxable with $150K/y potential pretax space to play with. Taxable is for spending money.
Great article… thanks for putting in the effort and for the concise, genuine input.
I’ve been consider some Roth contributions this year. My concern is that tax brackets will fall back into what they were pre-Trump tax changes. What do you think about this scenario?
Savings plan is to have $2.5M at retirement… which at 4% withdrawal rate become an annual withdrawal of $100k
If I assume pre-2018 tax brackets during retirement, my current tax bracket (24%) will be preferred to my marginal tax rate in retirement (25%) once my retirement income exceeds $75,900. (I omitted both standard deduction and tax from Social Security from simplicity… as they nearly cancel each other out).
I know it’s not a big difference, but wouldn’t this scenario favor some Roth contributions? Thoughts?
That scenario was discussed in the post. I think it’s entirely possible for that to happen, maybe even likely. But it won’t change what most people shoul do.
Bear in mind a significant chunk of that $100K withdrawal may be basis or LTCGs from a taxable account, which enjoy much lower tax rates.
Sir Jim,
You are the best. Really admire your commitment to responding to so many comments.
You’ve convinced me to make tax-deferred contributions this year instead of Roth. You’ve convinced me… for now 😁
Wonderful post, as always…
My dad started as a stockbroker in the 70s and he said at that time retirement accounts over 1mil were given a premium tax. Additionally, I believe they will do away with the stretch IRA as we are about to have an unprecedented amount of money transferred from the boomers to gen x and millennials. It is hard for me to believe the gubment isn’t going to get their chubby hands all over it. There are many ways for us to get taxed– and there is a lot of money in pre-tax retirement accounts.
I agree though, trying to guess how the gubment will “get us” is not overly helpful. They could just as easily decide to tax Roth accounts for the “evil” rich people who saved too much.
That’s actually one argument people make for tax-deferred >>> Roth- at least you’re getting a guaranteed upfront tax break.
Jim,
The social security benefit for your super saver couple is a little low. Assuming your SuperSaver physician couple are retired at 70 after 35 years of high income, their benefit is likely > 70K. A pension and any interest income will not help the situation. An IRA of 6.8M is likely to push this couple into a higher and higher tax bracket over time. If they live in a high tax state like CA, their taxes are likely going to go through the roof. Also they will likely pay the highest premium for part B Medicare. They will also leave their heirs with quite a tax problem. I know that they could afford to paid these high taxes but what is the point of this exercise anyway? Utilizing tax deferred accounts in peak earning years makes sense but I would advise that physicians not let their IRAs go above 2M going into retirement. Roth conversions, QCD and QLACs can help lower the RMDs.
Best to use your own numbers when running the numbers. If a couple actually makes maximum SS contributions for 35 years and they each use their own benefit and they both wait until 70, you’re probably right that it could be much higher than my example. But if one or both of them doesn’t work 35 years, doesn’t make maximum contributions each of those years, doesn’t wait until 70, or ends up claiming half of the spousal benefit instead, it’ll be significantly less. I think that is probably much more common than the former, so I think my estimate is reasonable.
I think most docs will pay the highest Part B premium, so that can be ignored.
If their heirs don’t want to have “quite a tax problem” they can simply give all the money to charity. That’s a dumb argument. If these docs are so wealthy, it’s better for their heirs to pay the taxes.
I wish most docs had a $2M IRA going into retirement. That would be wonderful. In reality, 25% of doctors in their 60s aren’t even millionaires, and that includes their house. Only 50% of docs in their 60s have a net worth over $2M. I bet less than 10% have a $2M tax-deferred account. Sure, they tend to cluster on websites like this one, but let’s not kid ourselves that an RMD problem is a common issue.
The lowest Medicare part B premium is $135.50 per month on a MAGI of <$170K (joint returns). The highest Medicare part B premium is $460.50/month for a MAGIs above $750,000.00 per year (married joint returns). I think that most physicians can keep their yearly adjusted gross incomes below $750,000.
Is that right? I thought the cutoffs were at a much lower income level. Let me Google for a second here…..
Looks like you’re right. My apologies.
https://www.ssa.gov/pubs/EN-05-10536.pdf
This is my “predicament” exactly. We are a two-physician couple in our mid-50s. Our estimated SS benefit is around 66-70k/year, and I’ll have an 80-100k pension, depending on when I retire from academic medicine. We’ve grown our tax-deferred accounts to about 2.2M, and future value calculations project this to grow to roughly 4.5-5M by the time we retire. I was thinking about doing Roth conversions when I cut back to 1/2 time in about 5 years.
I think you’ll definitely want to do some conversions eventually. I think you may also be a good candidate for Roth 401(k) contributions. Big SS payment, big pension, big IRA. Congratulations, you’re a super saver.
Interesting article, I am lower income (for this community). I will have to run the numbers now that the wife has gotten a few significant raises. Our tax bracket change probably won’t be as dramatic as several of the examples here. Perhaps staying the same or only decreasing 2% (24 to 22).
Thanks for the great post!
I believe it’s important to point out that tax deferred only makes sense if you are saving/investing the tax break. Otherwise you’re just saving less than someone using a Roth. 19k in a traditional is not equivalent to 19k in a Roth. I’m pro Roth because of the tax free compounded interest and no required minimum age distribution.
That is a good point. $19K in a Roth is more money after-tax than $19K in a tax-deferred account and one must compare apples to apples. That’s why if your tax rate in retirement is the same (or even close) and you’re maxing out your retirement accounts, you’re better off with Roth because then all of your money is in a tax protected account instead of some of it being in a taxable account. That tax drag of investing in taxable has an effect over the years. But the difference between contribution and withdrawal rates is so large for most docs that it more than makes up for that issue.
Hi! Great content, I love this post. However, can you clarify your example under the subheading “fililng the brackets”? You stated that she put 50k in her 401k each year. I’m trying to wrap my head around this as I thought the maximum per year was 19,000? Could you please clarify?
Thank you!
The maximum employee contribution is $19K/year for those under 50. The maximum employee + employer contribution per plan is $56K. If you are the employee and the employer, you get to put $56K in there.
Hope that helps.
Great post, Jim! Great real life examples. Thank you for putting so much thought and effort into this. You are never going to convince some people, no matter how many scenarios you run. If they want to pay max taxes during their peak earning years, I say have at it. The future is completely unknown. High earners paying the max tax might delay future tax hikes for the rest of us! I also have the numbers of Northwestern Mutual and Lincoln National Life reps that keep hounding me if they are looking for a referral.
My work just started offering Roth 401k 2 years ago so I’ve been putting all my 401 k money to kick it up since I’ve never been eligible for a Roth. I am 50. I have plenty deductions right now for a tax refund. Can I do this for a few years then go back to regular 401k?
Your tax refund should have nothing to do with this decision. If you really want some Roth funds, be sure to do a personal and spousal Backdoor Roth IRA each year. That’s $14K ($7K each) a year for 50+ year olds. The Roth vs traditional 401(k) is a totally separate decision. If you just want “tax diversification” no matter what it costs, then sure, do your plan. But otherwise, take a look at the cost.
Thanks for the advice. The only concern I have about the back door IRA is that you need to get all of your money and all your IRAs out every year. I’m not sure that’s possible given some of the investments I have.
I’m not sure either as you haven’t told me what you have as far as accounts and investments. If you tell me, maybe I can come up with a solution and maybe there is no good one.
Really great post that covers some areas of this topic that I had not considered before. Thanks! Consider expanding this into a series.
Also, could you please clarify the following excerpt from the super savers section and maybe provide a more explicit example for this particular scenario:
“Another important effect to understand is that if you are also investing in a taxable account, then if your contribution tax rate and your withdrawal tax rate are equal, you would be better off using a Roth account. ”
I believe this has to do with the fact that Roth contributions effectively get more dollars into tax-protected accounts.
$19k into Roth is the equivalent of putting $19k into tax-deferred PLUS investing the tax savings (so maybe another $6k in taxable since you’ve maxed your 401k). But the advantage now, is that the Roth option has the benefit of having 100% of that money grow tax protected instead of just 70% of it or so.
Or at least that’s what makes sense to me… thoughts?
Yes, that’s my understanding as well. This long article is still my favorite explanation of all this; made it finally click for me:
https://www.madfientist.com/how-to-access-retirement-funds-early/
Search for “here’s a graph” to see the main point. And note that assuming a low enough bracket (and some other stuff) at withdrawal time, pretax money does even better than Roth, as in addition you’re investing the money you would have otherwise paid as tax for the privilege of Rothing.
Your reasoning is correct. That’s why when your tax rate at contribution and withdrawal is the same or very close) you’re better off with Roth.
The strategy of comparing marginal vs. effective is simply wrong.
It would be correct if one had to make a career long decision of traditional vs. Roth. But tax law doesn’t require that.
If one reaches a point at which, even with no further traditional contribution, the expected marginal rate on withdrawals exceeds the current marginal rate, using Roth becomes advisable. Yes, it does require a very large traditional balance to reach high marginal rates using a 4%/yr withdrawal as the only income, e.g., $8.6 million for MFJ to reach the 32% bracket. But lower earners may reach this situation more easily.
Remember that withdrawals based on previous years’ contributions fill lower brackets just as well as pensions do.
If both the expected withdrawal effective and marginal rates are below the current marginal rate, then either strategy leads to same conclusion. But the correct approach is “marginal vs. marginal” not “marginal vs. effective.”
Do we have a disagreement? I’m not seeing it.
Yes, it’s always marginal you should look at, but you must look at it for every dollar. In general, all of your dollars at contribution are in your highest tax bracket. At withdrawal, many of them are not.
Re: At withdrawal, many of them are not.
That statement is true.
Consider the situation where one already expects $1 million in traditional accounts at retirement, plans a 4%/yr withdrawal rate, and that will be the only income. That $40K/yr is indeed subject to a variety of tax rates, but it comes from past contributions. Nothing can be done about those: those choices are past and gone.
Now consider an additional contribution being made this year. For that one (and any future ones) there remains a choice: don’t contribute to traditional and remain with $40K/yr subject to tax, or do contribute to traditional and expect ($40K + $X)/yr subject to tax.
That $X is subject to tax at whatever marginal rates are in effect, starting with $40K income.
Comparing “marginal vs. effective” tilts the scale incorrectly in favor of traditional. As noted, if both the marginal and effective withdrawal tax rates are below the contribution tax rate, one gets “use traditional” as the answer either way. But why not give people the correct strategy that works for all situations?