Companies with 401k plans are increasingly offering employees a Roth investment option in addition to the regular (tax deductible) 401k. With the Roth option, you don’t receive an income tax deduction and your money grows tax deferred just like your regular 401k investment. However, at retirement, withdrawals from a Roth are tax free, whereas regular 401k withdrawals are taxed as ordinary income. So what’s the best way to go? Is it better to get the tax deduction now and pay taxes during retirement or would you be better off skipping the tax deduction now and having your money come out tax free during retirement?
The key word here is taxes. Even more important is understanding the difference between your marginal tax rate and your effective tax rate.
Your marginal tax rate is the rate being paid on your last dollar of income. For example, if your taxable income is $78,000 and you file a joint tax return, your marginal tax bracket is 25%. This is because, for joint filers, income above $75,301 is taxed at 25%. If you invest $1,000 into your 401k plan, your tax deduction is worth $250 in cold hard cash (tax savings).
Your effective tax rate is the ‘average’ rate you paid on your taxable income. For example, if your taxable income is $78,000, as a joint filer, you’ll owe approximately $11,043 income taxes. $11,403 is 14% of your $78,000 taxable income. This 14% represents your effective income tax rate.
The important distinction is that when deciding to invest, it’s your marginal rate you want to pay attention to. However, during retirement, it’s your expected effective rate that matters. Here’s our rule of thumb: If your marginal tax rate is 25% or higher, we typically recommend the regular IRA…go ahead and take the tax deduction. The reason is that we find many retirees are able to take money out of their retirement accounts at an effective tax rate of 15%. Higher deduction as compared to a lower effective withdrawal tax rate equals a winning tax strategy. Therefore if you’re in the 15% or lower marginal tax rate, we typically recommend investing in a Roth.
Details matter. For example, in our example above, a joint filer with a taxable income of $78,000 who intends to invest $10,000 in her 401k should consider ‘splitting’ her contributions between regular 401k and ROTH 401k contributions. By investing $2,700 in her regular 401k, the tax deduction will reduce her taxable income to $75,300 (and save $675 in taxes) which happens to be the upper threshold for the 15% marginal tax rate. By investing the remaining $7,300 in her Roth 401k, that portion goes in at the 15% rate…no tax deduction but she didn’t want a tax deduction at that lower rate. She preferred to create a retirement fund that would never be subject to income tax.
One important advantage of a Roth is that if you don’t use it during your retirement and you leave it to your spouse or children, they too will not be taxed on withdrawals.
A few final thoughts. The perfect retiree is someone who has accumulated retirement savings in several different types of investment ‘buckets’. If you have money in a personal investment bucket; an IRA (or 401k style) bucket; and a Roth IRA bucket, you are able to significantly control your income taxes from year to year. That’s because you get to choose which buckets (and how much) to draw from for your cash flow needs. For example, we had one client case where, for a particular reason, we didn’t want to pay any income taxes. We have managed to accomplish this goal for over fifteen years by carefully deciding from which buckets to draw his funds.