The only certain things in life are death and taxes – Benjamin Franklin
It is crunch time for tax filing with April 18th just a couple of days away. Hopefully, most of you are either done with filing or close to it.
With that said, don’t let Tax Day be the last time you think about your liability. After all, filing is just the result of the decisions and progress you made last year. What are you doing to optimize your taxes going forward?
This can be a broad topic so let’s narrow the scope for the sake of this post: If you have to choose between saving in “pre” or “post” tax shelters, which is the better option? To defer or not to defer, that is the question….
Benefits of the Roth
Many money experts emphasize the importance of maxing out the Roth while you are young. They have reasons for this including:
- Your income is most likely to be less at younger ages which should put you in a lower tax bracket
- Mortgage/Student loans and other deductions are going to be more prevalent in the younger demographics
- Child tax credits are likely to play a larger role
- Taxes are possibly going to be higher in the future
- Last but not least: It forces you to save more. If you are not going to save any money beyond what you put into your Roth IRA, then you are actually contributing more than you would be in traditional IRA when maxing either one out. This is because you must account for the taxes that you paid on the front end for the Roth. (i.e. $6k in after tax money is more like ~$7.3k in pretax dollars)
These are all valid reasons and should be reviewed as part of the retirement planning process. With that said, there are also a lot of assumptions built into these recommendations.
Disclaimer: I am not a tax professional but I will share my interpretation of the federal tax process. Please consult a professional to discuss your specific situation.
The Fundamentals of Federal Tax Rates
The Federal Income Tax system is calculated through tax brackets. A common misconception is that individuals making above one of the thresholds must pay that tax rate for their entire taxable income. This is incorrect. As incomes increase above the threshold for a given tax bracket, only the portion that is above that bracket is taxed at the higher rate. The money below that threshold is actually taxed according to the brackets they fall within.
To illustrate how this actually works, let’s take an example of single tax filer who has a taxable income of $100k. (We used 2021 tax numbers instead of 2022 because we are currently on a flight back from Hawaii and I did not save a copy of the 2022 tax ranges before taking off …It really does not matter because we are only trying to discuss the concept).
At a $100k, this individual will cross into the 24% tax bracket; however, her effective tax rate is much less than that. This is because only $13,625 of her salary is above the $86,375 threshold for 24% ($100,000-$86,375 = $13,625).
This is how the brackets work. Only the money within the range of a bracket is taxed at that assigned amount. Every dollar from $0-$9,950 is taxed at 10%, $9,951 – $40,525 @12%, $40,526 – $86,375 @ 22% etc. for this 2021 scenario. (You will need the current year’s tax rates to do the same math)
Once you have the tax dollars owed for each tax bracket, you can determine the effective tax rate which is essentially a weighted average of the tax brackets.
Note: it is important to understand that this is only reviewing the taxable income. This $100k will be assumed to be after all of her deductions (standard or itemized).
Understanding Tax Liability Today vs Retirement
A common assumption that is made during retirement planning, is that cost of living in retirement will be the same as your income level today. Sometimes, it is even an inflation adjusted version of your income level today. As an example, if you currently earn $100k/year then you “will need $100k/year” in retirement.
In my opinion, this is an ultra-conservative approach and probably does not reflect reality. There are things to consider in your retirement that could be more or less than your current situation.
Health Care Costs :
Many people rely on their current employer for health coverage and fewer companies are providing this as a benefit to their employees. Retirement health care and company pension programs that are quickly disappearing. This cost should be considered in planning, especially if retirement will begin prior to Medicare kicking in. For me, this is probably the most significant cost risk in retirement.
Other costs should drop significantly. Mortgage/Car/student loans and other debts should be paid off. This will directly reduce monthly expenditures when compared with today. Also, kids will most likely (or at least hopefully) be moved out and on their own so there should be a reduced household cost.
Finally, all money from your income that is currently going to savings today (one way or another) should not accounted for in retirement planning because at this point you will be in drawdown mode (i.e., If you are setting aside 20% of your income every month today, you don’t need to account for that in your monthly expenditures in retirement)
Considering all of the above, there is actually a case to be made that retirement cost will actually be significantly less than your income prior to retiring.
This is important to our tax conversation because if you are making a taxable income of $100k/yr today but will only require $50k/yr in retirement, then you will be in a lower tax bracket. (Assuming the tax rates don’t change…More to come on that)
Taxes Always Go Up
There is some belief that it is better to get taxed today instead of tomorrow because future taxes are “most likely to go up”.
This is sometimes referenced based on increases to the top tax brackets a few years ago. The top tax brackets do not tell the whole story. You need to understand how your effective tax rates are trending.
We pulled in the entire history for the federal tax since 1913. During this review, we evaluated the tax implications of several different income ranges from $30k/Yr to $1M/yr. The results do not reflect the sentiment that taxes always go up. In fact, we have been continuing to trend to lower rates.
Note: there was a period in the late 80’s and early 90’s where rates increased for many brackets. As the years progressed, however, the effective tax rates for the $30k, $50k, and $150k incomes dropped back to their lowest levels in decades.
Obviously, taxes could always increase but considering the political sentiment around taxes, it seems likely that one side is going to focus on lowering taxes across the board and the other side only wants to focus on increasing taxes on the upper income brackets.
As long as you are not targeting retiring on a massive income level, then what are the chances that your taxes are really going to dramatically increase?
Also, if you are going to retire with a planned retirement income of over >$200k/yr, the effects of saving in your 401k vs Roth 401k are probably going to be minimal when compared to the remaining money that is required in non-tax sheltered accounts in order to achieve that level of lifestyle.
Don’t Forget 4%
Remember the 4% rule (or 3% for those more conservative). If you want to retire off of a $200k/yr retirement salary, the 4% rule puts you at needing $5M ($6.7M for 3% rule). It will be hard to get there with tax deferred retirement accounts alone.
Every bit counts though. You need to understand where you want to go in order to help you make your decision of Roth vs Traditional.
There is not a “one-size-fits-all” answer to this question.
There are times where you are better off investing to your Roth and post-tax buckets before anything else. This is often when your current income is low and deductions are high. However, there are also times where it makes more sense to focus on pre-tax buckets first in order to reduce your taxes today.
Obviously, there is no crystal ball and taxes could go up but you need to decide where you want to be in retirement so that you can get a feeling for your potential tax liability. This should help you decide if you go with Roth or traditional.
There are also blended options that can be done if you want to hedge your bets. Our favorite one (no surprise) is the Mega Backdoor Roth which allows for 401k pretax and the Mega backdoor Roth portion which is after tax. If the MBDR is not available to you, try doing the traditional 401k and a roth IRA or vise versa if you want tax diversity.
Saving more is always a good option.
Doing your taxes at the end of the year tells you where you have been. How are you considering optimizing tax years going forward?