Many middle- and high-income workers with substantial savings in tax-deferred retirement accounts assume that they’ll be in a higher tax bracket in retirement, especially when factoring in anticipated Social Security benefits.
This assumption is a big source of “Roth hype,” according to Cody Garrett, the financial advisor and author, and it’s bolstered by the likelihood of future tax increases.
While some workers who accumulate big nest eggs will move into a higher tax bracket in retirement and should favor contributions to Roth-style accounts, Garrett said, it’s not a universal truth.
Instead, careful tax analysis is needed to determine the right balance between pre- and post-tax contributions to retirement accounts, Garrett notes. For many mass affluent savers, the math shows that traditional accounts remain superior from a tax-mitigation perspective.
He explores this dynamic in a recent post on LinkedIn and expanded on the idea in written comments shared with ThinkAdvisor.
The standard method to assess tax clarity is to compare current tax rates with anticipated rates. This works well, Garrett says, but only when the exercise factors in the difference between marginal and effective (or average) tax rates.
Marginal vs. Effective Tax Rate
Marginal tax rate, as Garrett details, is the tax rate applied to an individual's last or next dollar of income.
The United States has a progressive tax system, with income taxed at increasing rates. These rates are commonly called “tax brackets,” and taxpayers' marginal tax rate is the rate associated with their highest tax bracket.
To determine a marginal tax rate, taxpayers need to calculate their total taxable income after deductions and determine their filing status. They then need to refer to federal income tax brackets for their filing status to find the highest bracket their income falls into. The rate for that bracket defines their “marginal tax rate.”
The “effective” or “average” tax, on the other hand, is defined as the amount of tax a person pays divided by total income. For households with a total income of $100,000 that pay taxes of $15,000, the average tax rate is 15%.
As framed in a guide published by the Tax Policy Center, average tax rates are best thought of as a measure of a household’s real tax burden; that is, how taxes affect the household’s ability to consume.
Marginal rates, meanwhile, measure the degree to which taxes affect household (or business) economic incentives, such as whether to work more, save more, accept more risk in investment portfolios, or change what they buy.
Putting It Into Practice
With this framework, Garrett’s post highlights a single taxpayer earning $100,000 and contributing $20,000 to a 401(k). After this contribution, plus FICA taxes of 6.2% for Social Security and 1.45% for Medicare, the taxpayer’s annual spending including income taxes is $72,350.
If the worker contributes this amount to a traditional 401(k), the taxpayer will exclude the $20,000 contribution from income within the 22% federal marginal tax bracket. That seems like a good deal from a tax-management perspective, but is it really? The answer comes from weighing their future average tax rate.
If this worker retires and lives off the traditional retirement account, even distributing $100,000 per year, the effective income tax rate will be 13.2%. This equates to a roughly $13,170 tax liability on a $100,000 distribution.
“So they deferred those traditional retirement account contributions at 22% and later included them in income at only 13.2%,” Garrett said. “That's a win!”
To reach an effective income tax rate in retirement of 22%, the taxpayer would need to distribute at least $283,600 from a traditional retirement account.
“What are the chances that a worker spending $72,350 will spend more than $220,000 per year when they're retired?” Garrett asked. “My post shows the power of traditional pre-tax retirement account contributions for most workers, even in the 22% and 24% marginal tax brackets.”
Despite this tax math, many workers and advisors choose Roth contributions at work.
“This is usually the wrong decision, driven by faulty assumptions regarding how retirees create taxable income,” Garrett said. “It’s naturally rare for a retiree to have more income than they did while working for a living.”
© Touchpoint Markets, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.