Marginal vs Effective tax rate explanation.

[Time2]

I picked this up on a forum, "you won’t come out ahead with a Roth, because the Roth 401k contributions are taxed at your marginal tax rate, and regular 401k withdrawals will be taxed at your effective tax rate." I don't necessarily agree with it, but I want more understanding. I do understand, "The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income." and I understand Effective tax rate is income divided by tax paid, or the average tax. So how does this relate to the quoted line. I think the quote is wrong, but willing to learn.

 

[SevenUp]

I picked this up on a forum, "you won’t come out ahead with a Roth, because the Roth 401k contributions are taxed at your marginal tax rate, and regular 401k withdrawals will be taxed at your effective tax rate." I don't necessarily agree with it, but I want more understanding. I do understand, "The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income." and I understand Effective tax rate is income divided by tax paid, or the average tax. So how does this relate to the quoted line. I think the quote is wrong, but willing to learn.

You are correct. The quote is not correct. For example, see Common misconceptions.

 

[Koolau]

I'm no tax expert, but I don't think this is correct. I've never heard it before but YMMV.

ETA Looks like I cross posted with SevenUp.

 

[Gumby]

That quote is wrong. What I think they mean to say is that your Roth contributions are taxed at your marginal rate when you are working and making contributions, while tIRA distributions are taxed at your marginal rate when you are retired and taking distributions. For a lot of people, the marginal rate in retirement will be lower than when working, but certainly not for everyone.

Effective rate has nothing to do with it.

 

[DJRR]

The quote is wrong. You have to compare marginal to marginal or effective to effective. My effective rate is ~ 50% of my marginal rate while working and I expect it to be the same in retirement.

 

[Jerry1]

Effective rate is what you end up with after the decisions you’ve made based on marginal rate.

 

[scrabbler1]

The only time I can see one's marginal rate would not be totally appropriate is if the withdrawals or contributions straddle 2 tax brackets. In that instance, the marginal rate on the first dollar would not be equal to the marginal rate on the last dollar.

Effective tax rate still wouldn't be appropriate.

 

[Time2]

Thanks all, I could not see how it was right, thanks telling me you agree the quote is wrong.

 

[Koolau]

We are here to help. Only just remember that we are strangers on the internet and we are worth only what you pay us.

Best of luck.

 

[DJRR]

Effective tax rate still wouldn't be appropriate.

I think effective rate would be appropriate if Congress enacted significant tax changes without changing the marginal rate. For Ex:

Enacting a wealth tax based on net worth would be a negative for Roth investments v. Traditional.
Reducing the standard deduction or eliminating Schedule A deductions would be a plus for Roth investments vs. Traditional.

 

[jazz4cash]

Thanks all, I could not see how it was right, thanks telling me you agree the quote is wrong.

You gonna go back and set the record straight on that other forum?

I just got flamed on another forum for something similar.

 

[SevenUp]

The only time I can see one's marginal rate would not be totally appropriate is if the withdrawals or contributions straddle 2 tax brackets. In that instance, the marginal rate on the first dollar would not be equal to the marginal rate on the last dollar.

In that case, make separate contribution/withdrawal decisions for the different marginal rates.

You might decide to make traditional contributions while saving 22%, but switch to Roth when down to 12%. Or you might withdraw up to but not over where an IRMAA tier exists.

It's a little trickier when you have to contribute/withdraw in a less desirable zone in order to reach a more desirable zone. In that case you do want to calculate the marginal rate on that chunk (i.e., much more than $1) of money.

Effective tax rate still wouldn't be appropriate.

Agreed, it would not.

 

[Time2]

You gonna go back and set the record straight on that other forum?

I just got flamed on another forum for something similar.

Well ya, the original poster of this 7 years ago, (!) did respond and doubled down. Here's what I just finished responding with, critic me as needed, I might need to go back and correct myself.

"I’ll run through the numbers for you and everyone else. I’ll chose a 48 yr old married couple, with a $29,200 standard deduction and a $120,000 income. Their AGI is, $120,000 -$27,200 = $92,800. The tax would be 10% of the first $23,200, or $2,320 and 12% on, $92,800 - $23,200 = $69,600, or $8,352 of tax. For a total tax of $2,320,+ $8,352 = $10,672. Marginal rate, 12%, Effective rate, 8.7%

Now, if they did a 401k contribution of $10,000, That would reduce their income to $110,000. Their AGI would be $110,000- $27,200 =$82,800, The tax would be 10% of the first $23,200 or $2,320 and 12% on $82,800 - $23,200 = $59,600 or $7,152 of tax. For a total tax of $2,320 + $7152 = $9,472. So by using the 401k they saved, $10,672 - 9472 = $1200. $1200 is 12% of the $10,000 they put into the 401k. This means if they put the $10,000 into a Roth/401k, they would lose the deduction of $1,200. That $1,200 is 12% of $10,000, AND is the Marginal Rate. The $10,000 you put into the Roth/401k was taxed at 12%.

Marginal Tax Rate, 12% Effective rate with 401k, 8.74%

If you disagree, please explain."

 

[SevenUp]

Now, if they did a 401k contribution of $10,000...The $10,000 you put into the Roth/401k was taxed at 12%.

The marginal rate applied to the contribution is usually non-controversial.

How the future withdrawal is taxed is where the controversy lies.

 

[USGrant1962]

The quote actually has some merit, especially for the ER crowd.

For a medium-to-high earner who retires early - say at 55 with 15 years until SS at 70, you are looking at every dollar into an IRA either taxed at a relatively high marginal rate for Roth, or saving a relatively high marginal rate for tIRA. This is because the contribution is on top of medium-to-high salary/wage earnings.

Yet when you withdraw, sans pension or SS, a good chunk of what you withdraw from a tIRA is in the lower tax brackets. If you want to do the math, compare marginal on Roth contributions to effective on tIRA withdrawals for the most accurate comparison. Again, in the case of ER without SS or pension.

The real takeaway is tax diversification has a lot of value for early retirees. Tax deferred saves while working, Roth is tax free on withdrawal but pays maximum marginal rates on contributions, and taxable gets the sweet, sweet LTCG treatment.

 

[SevenUp]

If you want to do the math, compare marginal on Roth contributions to effective on tIRA withdrawals for the most accurate comparison. Again, in the case of ER without SS or pension.

Doesn't work that way, regardless of whether SS or pension is present.

Let's say you have been making tIRA (and/or t401k) contributions in previous years, so you have a balance in those accounts. That's fixed - nothing you can do to change it, and there will be some income (perhaps 4% of the future balance, or whatever withdrawal rate you want) due to that balance.

When you look at making a new contribution, any withdrawal due to that new contribution will come on top of the withdrawal already possible due to previous contributions. In other words, the future income due to the new contribution will be taxed at the future marginal rate when withdrawn.

 

[USGrant1962]

...

When you look at making a new contribution, any withdrawal due to that new contribution will come on top of the withdrawal already possible due to previous contributions. In other words, the future income due to the new contribution will be taxed at the future marginal rate when withdrawn.

You are assuming there is some mandatory withdrawal that is related to your contributions or portfolio size. That is not the case prior to RMDs, and even in RMD-land may not compare to your working tax situation.

You withdraw what you need for spending, the sum of that total withdrawal is taxed at your effective rate. You saved (tIRA) or paid (Roth) at your working marginal rate. Yes, assuming a retirement spending level equal to your working taxable income (a tenuous assumption that favors tIRA over Roth) the last dollars of your Roth/tIRA withdrawals are a wash. The quotation is talking about all the Roth dollars you paid tax on at high rates (on top of you salary) and are withdrawing at low rates - say the first $120K/year MFJ.

 

[SevenUp]

You are assuming there is some mandatory withdrawal that is related to your contributions or portfolio size. That is not the case prior to RMDs, and even in RMD-land may not compare to your working tax situation.

No mandatory withdrawal assumption needed. It's simply that new traditional contributions, when withdrawn, will be taxed on top of what could (or must) be withdrawn without those new contributions. In other words, the marginal tax rate saved by the new contributions should be compared with the marginal tax rate expected for future withdrawals.

You withdraw what you need for spending, the sum of that total withdrawal is taxed at your effective rate.

Yes, the sum is. But that sum isn't derived from a single contribution. Contributions are made year by year, and the direction (traditional vs. Roth) of those contributions can be changed year by year.

You saved (tIRA) or paid (Roth) at your working marginal rate.

Everyone agrees with that.

The quotation is talking about all the Roth dollars you paid tax on at high rates (on top of you salary) and are withdrawing at low rates - say the first $120K/year MFJ.

Is it? Seems "...Roth 401k contributions are taxed at your marginal tax rate, and regular 401k withdrawals will be taxed at your effective tax rate" is exactly the first of the Common misconceptions described there. Comparing marginal now to effective later makes traditional look better (or Roth worse) than reality.

If you were talking with a single filer who expects to have an 18% marginal rate while working this year (say, 12% federal and 6% state), and in retirement pay 22% marginal and 15% effective, would you tell that person
a) use Roth because paying 18% now is better than paying 22% later, or
b) use traditional because saving 18% now is better than paying 15% later?

 

[Texas Proud]

You have to compare marginal with marginal... any other way is not correct...

The question is what is the tax on the next $1... and as long as you do not go into another bracket then that could be $10,000...

So if you have exceeded the 12% bracket then the next $1 is 22%... and that is also for the next $10,000....

Same for saving on taxes...

Effective tax rates do not come into an equation at all... sure, at the end of the day you can look at your new effective compared to your old effective but that should not come into your decision of what to do...

 

[Koolau]

This whole discussion reminds me of the issues I'm discovering after preparing well for early retirement. I AM going to be paying more taxes and I AM going to get caught by the various MAGI "gotchas" as I try to spend down my stash. However you slice it, having an abundance comes with some downsides. BUT having some Roth money available allows me to "titrate" my taxable money. That alone made me lean toward Roth conversion. Lots of other advantages in my opinion.

But, lets face it, none of us is getting out of here untaxed though YMMV.

 

[Gumby]

....

But, lets face it, none of us is getting out of here untaxed though YMMV.

The taxman may occasionally sleep, but he never forgets.

 

[Time2]

But, lets face it, none of us is getting out of here untaxed though YMMV.

Their is one way if you had only known tax law would not change. And that is putting all your money into taxable accounts. This year you could have qualified dividends and LTCG withdrawals of about $121,450k in tax able gains and pay $0 tax (65 or older). Dividends you had received before retirement may have been taxed, but after retirement they would be part of the $121,450k that is taxed at 0%.
My first year retired I sold $160k of Funds, about $106k was LTCGs, I paid $0 tax and since I didn't need $160k, I reinvested $80k or $90k and reset the cost basis. But you are right, I don't know any one that uses only taxable accounts.