https://www.bogleheads.org/w/api.php?action=feedcontributions&user=Fyre4ce&feedformat=atomBogleheads - User contributions [en]2021-04-19T10:37:43ZUser contributionsMediaWiki 1.35.2https://www.bogleheads.org/w/index.php?title=Non-deductible_traditional_IRA&diff=72032Non-deductible traditional IRA2021-02-17T18:34:49Z<p>Fyre4ce: Reformatted table, added asset protection</p>
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<div>{{US|reason=irrelevant}}<br />
A '''non-deductible Traditional IRA''' results whenever contributions to a [[Traditional IRA]] (tIRA) are not deducted on the taxpayer's tax return. It is not a separate type of account; rather, it is a ''feature'' of a Traditional IRA that contributions can be deducted from income (subject to income limitations) or not deducted, at the option of the investor. Non-deductible and deductible Traditional IRA contributions, and [[Roth IRA]] contributions, share the same annual limit of $6,000 per year, or $7,000 per year for those 50 and over (as of 2020). Due to the availability of the [[Backdoor Roth IRA]], appropriate situations for non-deductible Traditional IRA investments are very limited; see [[#Appropriate uses|appropriate uses]].<br />
<br />
==Comparisons with other accounts==<br />
<br />
The following table summarizes the differences between the three types of individual IRA investments and a taxable account:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Account/Contribution !! Contributions !! Growth !! Withdrawals<br />
|-<br />
| '''Deductible Traditional IRA''' || Pre-tax (tax-deductible) || Tax-deferred || Fully taxed<br />
|-<br />
| '''Non-Deductible Traditional IRA''' || After-tax || Tax-deferred || Growth is fully taxed; return of basis is tax-free<br />
|-<br />
| '''Roth IRA''' || After-tax || Tax-free || Tax-free<br />
|-<br />
| '''Taxable Account''' || After-tax || Interest, dividends, and distributions are taxed || Capital gains are taxed; return of basis is tax-free<br />
|}<br />
<br />
===Roth IRA===<br />
<br />
A [[Roth IRA]] will always be as good or better than a non-deductible Traditional IRA. In both cases contributions are after-tax, but all future growth and withdrawals from a Roth IRA are tax-free, whereas the withdrawal of growth from a non-deductible Traditional IRA is taxable as income. A Roth IRA and Traditional IRA share the same annual contribution limit. A Roth IRA has an income limit for contribution, whereas a non-deductible Traditional IRA does not. This income limit can be circumvented with the [[Backdoor Roth IRA]].<br />
<br />
===Deductible Traditional IRA===<br />
<br />
If you are eligible to deduct contributions to a Traditional IRA (subject to the [[Traditional_IRA#Contribution_and_income_limits|income limits]]), it is almost always better to do so. Deducting the contributions is effectively an interest-free loan from the government. Only in unusual situations where marginal tax rates are very low today and will be much higher at withdrawal would it make sense to elect not to deduct contributions, but in these situations a Roth IRA should be available and would be a better alternative.<br />
<br />
===Taxable account===<br />
<br />
A [[Taxable account|taxable account]] has key similarities to a non-deductible Traditional IRA: contributions are made after-tax, and upon withdrawal, growth is taxable, whereas basis is returned tax-free. Any yield (interest, dividends, capital gains distributions) from investments within a taxable account are taxable in the year they are earned, whereas a Traditional IRA is fully tax-deferred. However, a taxable account has several important advantages. [[Qualified dividend|Qualified dividends]] and long-term capital gains are taxed at a reduced rate (as low as 0%) compared to ordinary income. Taxable accounts also have no contribution limits and no withdrawal restrictions; a Traditional IRA is a retirement account with a low annual contribution limit, and withdrawals prior to age 59.5 are assessed a 10% penalty, if certain exceptions don’t apply. The following table summarizes the differences between a non-deductible Traditional IRA and a taxable account.<br />
<br />
{| class="wikitable"<br />
|+ style="text-align: center;" | '''Comparison Between Non-Deductible Traditional IRA and Taxable Account'''<br />
|-<br />
! scope="col" style="width: 100pt;" | <br />
! scope="col" style="width: 450pt;" | '''Non-Deductible Traditional IRA'''<br />
! scope="col" style="width: 500pt;" | '''Taxable Account'''<br />
! scope="col" style="width: 150pt;" | '''Advantage'''<br />
|-<br />
| '''Contribution Limit'''||$6,000 ($7,000 for age >=50) combined for all Traditional IRAs and [[Roth IRA|Roth IRAs]]||No contribution limits||Taxable account<ref>a lower contribution limit wouldn't be a good reason to ''not'' invest money first into a non-deductible Traditional IRA, and any excess into a taxable account, if the non-deductible Traditional IRA was otherwise the preferred account</ref><br />
|-<br />
| '''Withdrawal Restrictions'''||Withdrawals prior to age 59.5 are assessed a 10% penalty, with several exceptions. [[IRA distribution tables|Required Minimum Distributions (RMDs)]] begin at age 72||No withdrawal restrictions. No [[IRA distribution tables|RMDs]].||Taxable Account<br />
|-<br />
| '''Taxation of Growth'''||Growth is fully tax-deferred until withdrawal||Interest, dividends, and capital gains are taxable in the year they are earned. Gains can be [[Tax gain harvesting|harvested]].||Non-deductible Traditional IRA<br />
|-<br />
| '''Deduction of Losses'''||Losses are non-deductible||[[Tax loss harvesting|Losses are deductible]] against other capital gains, and up to $3,000 of other income. Non-deductible capital losses carry over to future years||Taxable account<br />
|-<br />
| '''Tax Rates'''||Withdrawn growth is taxed as ordinary income||[[Qualified dividend|Qualified dividends]] and long-term (>1 year) capital gains are taxed at reduced rate, as low as 0%. Interest, non-qualified dividends, and short-term gains are taxed as ordinary income. Gains subject to [[ACA net investment income tax|NIIT]]||Taxable account<br />
|-<br />
| '''Charitable Donations'''||[[Qualified charitable distributions|Qualified Charitable Distributions (QCDs)]] are tax-free to you and the charity||[[Donating appreciated securities|Appreciated shares can be donated]] directly to a charity and incur no capital gains tax||Tie<br />
|-<br />
| '''[[Asset protection|Asset Protection]]'''||IRA's receive [[Asset_protection#Investing_in_an_IRA|federal protection from bankruptcy]] and [http://www.thetaxadviser.com/content/dam/tta/issues/2014/jan/stateirachart.pdf state-level protection from creditors], which varies widely by the state||No special asset protection||Non-deductible Traditional IRA<br />
|-<br />
| '''Estate Planning'''||Heirs inherit Traditional IRA with basis; withdrawals of growth are taxable. Can be made into a [[Stretch IRA]].||Cost basis [[Step-up in basis|steps up]] at death; heirs receive account tax-free.||Taxable account<br />
|}<br />
<br />
==Appropriate uses==<br />
<br />
Non-deductible Traditional IRA contributions are the first step in making [[Backdoor Roth IRA]] contributions, and are most commonly used for this strategy.<br />
<br />
The availability of the Backdoor Roth IRA usually makes long-term investments in a non-deductible Traditional IRA inappropriate. They are appropriate only if ALL the following conditions apply:<br />
<br />
# Your income and participation in a retirement plan at work makes you ineligible for [https://www.irs.gov/retirement-plans/ira-deduction-limits deductible] Traditional IRA and Roth IRA [https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits contributions]. <br />
# You have Traditional IRAs, SEP-IRAs, and/or SIMPLE IRAs with a large total pre-tax balance that can’t be disposed of:<br />
## You don’t have a [[401(k)]] or other [[Employer retirement plans overview|employer retirement account]] that will accept a [[Rollover|rollover]] from your Traditional IRA (or the fees and investment options from the 401k are too poor for this to be advisable)<br />
## You are unable or unwilling to start a business and open a [[Solo 401(k) plan|Solo 401(k)]] that can accept the Traditional IRA as a rollover. See [https://www.bogleheads.org/forum/viewtopic.php?t=281551 this thread] in the forum for a discussion of legal requirements for opening a Solo 401(k).<br>A large pre-tax balance may cause more tax than desirable when using the [[Backdoor Roth]] process due to the [[Backdoor_Roth#Cautions|pro-rata rule]].<br />
# You plan on investing in [[Tax-efficient fund placement|tax in-efficient]] investments that would favor a non-deductible Traditional IRA over a [[Taxable account|taxable account]]; see [[#Comparison to taxable account|below]]<br />
# You plan on holding the investment for a long enough time (decades) for the difference in performance, compared to a taxable account, to be significant<br />
# The long-term performance advantage outweighs the superior liquidity of a taxable account<br />
# You are confident you will spend the money during your lifetime, as opposed to leaving it as part of your estate<br />
<br />
==Performance==<br />
<br />
Evaluating the performance of a non-deductible Traditional IRA is straightforward; the non-deductible basis stays constant, and the value grows according to the investment's rate of return. Upon withdrawal, the difference between the value and the basis is taxed as ordinary income. Variables are defined as follows:<br />
<br />
<math><br />
\begin{align}<br />
t & = \text{time} \\<br />
V(t) & = \text{investment value at time t} \\<br />
B & = \text{non-deductible basis} \\<br />
r & = \text{overall rate of return} \\<br />
tr_{w} & = \text{tax rate on withdrawals} \\<br />
\end{align}<br />
</math><br />
<br />
If the investment compounds continuously, the value of the investment at any future time ''t'' can be written as follows. The formula uses exponentials of base ''e'' <math>\approx</math> 2.71828.<br />
<br />
<math><br />
\begin{align}<br />
V(t) & = V(0) \cdot e^{(r \cdot t)} <br />
\end{align}<br />
</math><br />
<br />
For periodic (for example, annual) compounding, the investment value is as follows. When analyzing a periodic compounding investment, make sure the period on the rates of growth matches the compounding period. For example, a monthly compounding investment with an annual rate of return of 8% would have a periodic return of ~0.667% (8% / 12). Time should also have the units of number of compounding periods, eg. number of months. <br />
<br />
<math><br />
\begin{align}<br />
V(t) & = V(0) \cdot (1 + r)^{t} <br />
\end{align}<br />
</math><br />
<br />
Finally, the after-tax value of the account is:<br />
<br />
<math><br />
\begin{align}<br />
\text{after-tax value} = V(t) - \left ( V(t) - B \right ) \cdot tr_{w} <br />
\end{align}<br />
</math><br />
<br />
===Example table===<br />
<br />
You want to invest $6,000 of pre-tax earnings in a mutual fund and plan to sell it after 30 years. Your federal marginal tax rate is 24% on ordinary income and 15% on qualified dividends and long-term capital gains. The mutual fund has an expected total return of 9%, with capital appreciation of 7% and a dividend yield of 2%, with the latter 100% qualified. The balances and bases (where appropriate) for a deductible Traditional IRA, Roth IRA, non-deductible Traditional IRA, and a taxable account are shown in the table below:<br />
<br />
A spreadsheet that can reproduce the table is on the 'Non-ded. IRA' tab of the [https://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/ Case Study Spreadsheet]<ref name ="MrMoney">[http://forum.mrmoneymustache.com/forum-information-faqs/case-study-spreadsheet-updates/ The MMM Case Study Spreadsheet], [http://forum.mrmoneymustache.com/index.php The Mr. Money Mustache Community], viewed Apr. 14, 2018.</ref> One may enter different assumptions there to see how results change.<br />
<br />
{| class="wikitable collapsible autocollapse"<br />
! !! Deductible tIRA !! Roth IRA !! Non-Deductible tIRA !! Non-Deductible tIRA Basis !! Taxable !! Taxable Basis<br />
|-<br />
! Initial<br />
| $6,000.00 || $4,560.00 || $4,560.00 || $4,560.00 || $4,560.00 || $4,560.00<br />
|-<br />
! 1<br />
| $6,540.00 || $4,970.40 || $4,970.40 || $4,560.00 || $4,956.72 || $4,637.52<br />
|-<br />
! 2<br />
| $7,128.60 || $5,417.74 || $5,417.74 || $4,560.00 || $5,387.95 || $4,721.78<br />
|-<br />
! 3<br />
| $7,770.17 || $5,905.33 || $5,905.33 || $4,560.00 || $5,856.71 || $4,813.38<br />
|-<br />
! 4<br />
| $8,469.49 || $6,436.81 || $6,436.81 || $4,560.00 || $6,366.24 || $4,912.94<br />
|-<br />
! 5<br />
| $9,231.74 || $7,016.13 || $7,016.13 || $4,560.00 || $6,920.10 || $5,021.17<br />
|-<br />
! 6<br />
| $10,062.60 || $7,647.58 || $7,647.58 || $4,560.00 || $7,522.15 || $5,138.81<br />
|-<br />
! 7<br />
| $10,968.23 || $8,335.86 || $8,335.86 || $4,560.00 || $8,176.58 || $5,266.69<br />
|-<br />
! 8<br />
| $11,955.38 || $9,086.09 || $9,086.09 || $4,560.00 || $8,887.94 || $5,405.69<br />
|-<br />
! 9<br />
| $13,031.36 || $9,903.83 || $9,903.83 || $4,560.00 || $9,661.19 || $5,556.78<br />
|-<br />
! 10<br />
| $14,204.18 || $10,795.18 || $10,795.18 || $4,560.00 || $10,501.72 || $5,721.03<br />
|-<br />
! 11<br />
| $15,482.56 || $11,766.74 || $11,766.74 || $4,560.00 || $11,415.37 || $5,899.55<br />
|-<br />
! 12<br />
| $16,875.99 || $12,825.75 || $12,825.75 || $4,560.00 || $12,408.50 || $6,093.62<br />
|-<br />
! 13<br />
| $18,394.83 || $13,980.07 || $13,980.07 || $4,560.00 || $13,488.04 || $6,304.56<br />
|-<br />
! 14<br />
| $20,050.36 || $15,238.28 || $15,238.28 || $4,560.00 || $14,661.50 || $6,533.86<br />
|-<br />
! 15<br />
| $21,854.89 || $16,609.72 || $16,609.72 || $4,560.00 || $15,937.05 || $6,783.10<br />
|-<br />
! 16<br />
| $23,821.84 || $18,104.59 || $18,104.59 || $4,560.00 || $17,323.58 || $7,054.03<br />
|-<br />
! 17<br />
| $25,965.80 || $19,734.01 || $19,734.01 || $4,560.00 || $18,830.73 || $7,348.53<br />
|-<br />
! 18<br />
| $28,302.72 || $21,510.07 || $21,510.07 || $4,560.00 || $20,469.00 || $7,668.66<br />
|-<br />
! 19<br />
| $30,849.97 || $23,445.98 || $23,445.98 || $4,560.00 || $22,249.80 || $8,016.63<br />
|-<br />
! 20<br />
| $33,626.46 || $25,556.11 || $25,556.11 || $4,560.00 || $24,185.54 || $8,394.87<br />
|-<br />
! 21<br />
| $36,652.85 || $27,856.16 || $27,856.16 || $4,560.00 || $26,289.68 || $8,806.03<br />
|-<br />
! 22<br />
| $39,951.60 || $30,363.22 || $30,363.22 || $4,560.00 || $28,576.88 || $9,252.95<br />
|-<br />
! 23<br />
| $43,547.25 || $33,095.91 || $33,095.91 || $4,560.00 || $31,063.07 || $9,738.76<br />
|-<br />
! 24<br />
| $47,466.50 || $36,074.54 || $36,074.54 || $4,560.00 || $33,765.56 || $10,266.83<br />
|-<br />
! 25<br />
| $51,738.48 || $39,321.25 || $39,321.25 || $4,560.00 || $36,703.16 || $10,840.85<br />
|-<br />
! 26<br />
| $56,394.95 || $42,860.16 || $42,860.16 || $4,560.00 || $39,896.33 || $11,464.80<br />
|-<br />
! 27<br />
| $61,470.49 || $46,717.57 || $46,717.57 || $4,560.00 || $43,367.31 || $12,143.04<br />
|-<br />
! 28<br />
| $67,002.84 || $50,922.16 || $50,922.16 || $4,560.00 || $47,140.27 || $12,880.28<br />
|-<br />
! 29<br />
| $73,033.09 || $55,505.15 || $55,505.15 || $4,560.00 || $51,241.47 || $13,681.67<br />
|-<br />
! 30<br />
| $79,606.07 || $60,500.61 || $60,500.61 || $4,560.00 || $55,699.48 || $14,552.77<br />
|-<br />
! After-Tax<br />
| $60,500.61 || $60,500.61 || $47,074.87 || - || $49,527.48 || -<br />
|}<br />
<br />
===Comparison between non-deductible tIRA and taxable accounts===<br />
<br />
The following analysis looks at four investments over a span of up to 40 years in a non-deductible Traditional IRA (ND tIRA) and a [[Taxable account|taxable account]]. The investor is assumed to have a [[Marginal tax rate|marginal tax rate]] of 24% for ordinary income and 15% for [[Qualified dividend|qualified dividends]] and long-term capital gains. The investor contributes $6,000 after-tax per year for up to 40 years. <br />
<br />
[[File:NDTIRAvsTaxable fullsize.png|400px|thumb|right|Non-Deductible Traditional IRA Advantage versus Taxable Account]]<br />
<br />
The following conclusions can be reached by analyzing the performance of a taxable account compared to a non-deductible Traditional IRA:<br />
<br />
* [[Tax-efficient fund placement|Tax efficient]] investments, such as [[Index fund|passive stock funds]], perform better in a taxable account<br />
* Tax inefficient investments, such as [[Corporate bonds|corporate bonds]] and [[Real estate investment trust|REITs]], perform better in a non-deductible Traditional IRA<br />
* The performance advantage for a non-deductible Traditional IRA is greater over a longer period of time, and when [[Marginal tax rate|marginal tax rates]] are higher<br />
<br />
====Stock fund====<br />
<br />
* Total Return: 9%<br />
* Yield: 2%<br />
* Qualified Yield: 90%<br />
<br />
{| class="wikitable collapsible autocollapse" style="text-align:right"<br />
! Year !! Taxable Balance !! Taxable Basis !! Taxable After-Tax !! ND tIRA Balance !! ND tIRA Basis !! ND tIRA After-Tax !! ND tIRA Advantage<br />
|-<br />
! 0<br />
| $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || 0.00%<br />
|-<br />
! 1<br />
| $12,580.92 || $12,100.92 || $12,508.92 || $12,600.00 || $12,000.00 || $12,456.00 || -0.42%<br />
|-<br />
! 2<br />
| $19,799.00 || $18,312.53 || $19,576.03 || $19,860.00 || $18,000.00 || $19,413.60 || -0.83%<br />
|-<br />
! 3<br />
| $27,715.94 || $24,645.55 || $27,255.39 || $27,846.00 || $24,000.00 || $26,922.96 || -1.22%<br />
|-<br />
! 4<br />
| $36,399.40 || $31,111.73 || $35,606.25 || $36,630.60 || $30,000.00 || $35,039.26 || -1.59%<br />
|-<br />
! 5<br />
| $45,923.59 || $37,723.97 || $44,693.65 || $46,293.66 || $36,000.00 || $43,823.18 || -1.95%<br />
|-<br />
! 6<br />
| $56,369.91 || $44,496.41 || $54,588.89 || $56,923.03 || $42,000.00 || $53,341.50 || -2.29%<br />
|-<br />
! 7<br />
| $67,827.65 || $51,444.55 || $65,370.18 || $68,615.33 || $48,000.00 || $63,667.65 || -2.60%<br />
|-<br />
! 8<br />
| $80,394.72 || $58,585.41 || $77,123.33 || $81,476.86 || $54,000.00 || $74,882.41 || -2.91%<br />
|-<br />
! 9<br />
| $94,178.54 || $65,937.65 || $89,942.41 || $95,624.55 || $60,000.00 || $87,074.66 || -3.19%<br />
|-<br />
! 10<br />
| $109,296.91 || $73,521.73 || $103,930.63 || $111,187.00 || $66,000.00 || $100,342.12 || -3.45%<br />
|-<br />
! 11<br />
| $125,879.03 || $81,360.10 || $119,201.19 || $128,305.70 || $72,000.00 || $114,792.33 || -3.70%<br />
|-<br />
! 12<br />
| $144,066.64 || $89,477.39 || $135,878.25 || $147,136.27 || $78,000.00 || $130,543.57 || -3.93%<br />
|-<br />
! 13<br />
| $164,015.17 || $97,900.59 || $154,097.98 || $167,849.90 || $84,000.00 || $147,725.92 || -4.14%<br />
|-<br />
! 14<br />
| $185,895.12 || $106,659.33 || $174,009.75 || $190,634.89 || $90,000.00 || $166,482.52 || -4.33%<br />
|-<br />
! 15<br />
| $209,893.49 || $115,786.08 || $195,777.38 || $215,698.38 || $96,000.00 || $186,970.77 || -4.50%<br />
|-<br />
! 16<br />
| $236,215.37 || $125,316.49 || $219,580.54 || $243,268.22 || $102,000.00 || $209,363.84 || -4.65%<br />
|-<br />
! 17<br />
| $265,085.75 || $135,289.63 || $245,616.33 || $273,595.04 || $108,000.00 || $233,852.23 || -4.79%<br />
|-<br />
! 18<br />
| $296,751.35 || $145,748.38 || $274,100.90 || $306,954.54 || $114,000.00 || $260,645.45 || -4.91%<br />
|-<br />
! 19<br />
| $331,482.81 || $156,739.73 || $305,271.35 || $343,650.00 || $120,000.00 || $289,974.00 || -5.01%<br />
|-<br />
! 20<br />
| $369,576.98 || $168,315.27 || $339,387.72 || $384,015.00 || $126,000.00 || $322,091.40 || -5.10%<br />
|-<br />
! 21<br />
| $411,359.42 || $180,531.56 || $376,735.24 || $428,416.50 || $132,000.00 || $357,276.54 || -5.17%<br />
|-<br />
! 22<br />
| $457,187.24 || $193,450.62 || $417,626.75 || $477,258.15 || $138,000.00 || $395,836.19 || -5.22%<br />
|-<br />
! 23<br />
| $507,452.11 || $207,140.51 || $462,405.37 || $530,983.96 || $144,000.00 || $438,107.81 || -5.25%<br />
|-<br />
! 24<br />
| $562,583.62 || $221,675.86 || $511,447.46 || $590,082.36 || $150,000.00 || $484,462.59 || -5.28%<br />
|-<br />
! 25<br />
| $623,052.97 || $237,138.51 || $565,165.80 || $655,090.59 || $156,000.00 || $535,308.85 || -5.28%<br />
|-<br />
! 26<br />
| $689,376.96 || $253,618.27 || $624,013.16 || $726,599.65 || $162,000.00 || $591,095.74 || -5.28%<br />
|-<br />
! 27<br />
| $762,122.44 || $271,213.59 || $688,486.11 || $805,259.62 || $168,000.00 || $652,317.31 || -5.25%<br />
|-<br />
! 28<br />
| $841,911.13 || $290,032.49 || $759,129.33 || $891,785.58 || $174,000.00 || $719,517.04 || -5.22%<br />
|-<br />
! 29<br />
| $929,424.97 || $310,193.43 || $836,540.24 || $986,964.14 || $180,000.00 || $793,292.74 || -5.17%<br />
|-<br />
! 30<br />
| $1,025,411.89 || $331,826.36 || $921,374.06 || $1,091,660.55 || $186,000.00 || $874,302.02 || -5.11%<br />
|-<br />
! 31<br />
| $1,130,692.27 || $355,073.79 || $1,014,349.50 || $1,206,826.60 || $192,000.00 || $963,268.22 || -5.04%<br />
|-<br />
! 32<br />
| $1,246,165.90 || $380,092.03 || $1,116,254.82 || $1,333,509.27 || $198,000.00 || $1,060,987.04 || -4.95%<br />
|-<br />
! 33<br />
| $1,372,819.68 || $407,052.54 || $1,227,954.61 || $1,472,860.19 || $204,000.00 || $1,168,333.75 || -4.86%<br />
|-<br />
! 34<br />
| $1,511,736.08 || $436,143.37 || $1,350,397.18 || $1,626,146.21 || $210,000.00 || $1,286,271.12 || -4.75%<br />
|-<br />
! 35<br />
| $1,664,102.37 || $467,570.77 || $1,484,622.63 || $1,794,760.83 || $216,000.00 || $1,415,858.23 || -4.63%<br />
|-<br />
! 36<br />
| $1,831,220.76 || $501,560.97 || $1,631,771.79 || $1,980,236.92 || $222,000.00 || $1,558,260.06 || -4.51%<br />
|-<br />
! 37<br />
| $2,014,519.56 || $538,362.10 || $1,793,095.94 || $2,184,260.61 || $228,000.00 || $1,714,758.06 || -4.37%<br />
|-<br />
! 38<br />
| $2,215,565.34 || $578,246.32 || $1,969,967.49 || $2,408,686.67 || $234,000.00 || $1,886,761.87 || -4.22%<br />
|-<br />
! 39<br />
| $2,436,076.37 || $621,512.13 || $2,163,891.74 || $2,655,555.33 || $240,000.00 || $2,075,822.05 || -4.07%<br />
|-<br />
! 40<br />
| $2,677,937.29 || $668,486.94 || $2,376,519.74 || $2,927,110.87 || $246,000.00 || $2,283,644.26 || -3.91%<br />
|}<br />
<br />
====50/50 stock/bond blend====<br />
<br />
* Total Return: 7%<br />
* Yield: 3%<br />
* Qualified Yield: 30%<br />
<br />
{| class="wikitable collapsible autocollapse" style="text-align:right"<br />
! Year !! Taxable Balance !! Taxable Basis !! Taxable After-Tax !! ND tIRA Balance !! ND tIRA Basis !! ND tIRA After-Tax !! ND tIRA Advantage<br />
|-<br />
! 0<br />
| $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || 0.00%<br />
|-<br />
! 1<br />
| $12,381.66 || $12,141.66 || $12,345.66 || $12,420.00 || $12,000.00 || $12,319.20 || -0.21%<br />
|-<br />
! 2<br />
| $19,169.26 || $18,433.99 || $19,058.97 || $19,289.40 || $18,000.00 || $18,979.94 || -0.41%<br />
|-<br />
! 3<br />
| $26,388.61 || $24,886.58 || $26,163.31 || $26,639.66 || $24,000.00 || $26,006.14 || -0.60%<br />
|-<br />
! 4<br />
| $34,067.19 || $31,509.61 || $33,683.56 || $34,504.43 || $30,000.00 || $33,423.37 || -0.77%<br />
|-<br />
! 5<br />
| $42,234.21 || $38,313.94 || $41,646.17 || $42,919.74 || $36,000.00 || $41,259.01 || -0.93%<br />
|-<br />
! 6<br />
| $50,920.73 || $45,311.09 || $50,079.28 || $51,924.13 || $42,000.00 || $49,542.34 || -1.07%<br />
|-<br />
! 7<br />
| $60,159.79 || $52,513.33 || $59,012.82 || $61,558.82 || $48,000.00 || $58,304.70 || -1.20%<br />
|-<br />
! 8<br />
| $69,986.56 || $59,933.70 || $68,478.63 || $71,867.93 || $54,000.00 || $67,579.63 || -1.31%<br />
|-<br />
! 9<br />
| $80,438.40 || $67,586.08 || $78,510.55 || $82,898.69 || $60,000.00 || $77,403.00 || -1.41%<br />
|-<br />
! 10<br />
| $91,555.09 || $75,485.23 || $89,144.61 || $94,701.60 || $66,000.00 || $87,813.21 || -1.49%<br />
|-<br />
! 11<br />
| $103,378.91 || $83,646.85 || $100,419.10 || $107,330.71 || $72,000.00 || $98,851.34 || -1.56%<br />
|-<br />
! 12<br />
| $115,954.84 || $92,087.62 || $112,374.76 || $120,843.86 || $78,000.00 || $110,561.33 || -1.61%<br />
|-<br />
! 13<br />
| $129,330.73 || $100,825.32 || $125,054.92 || $135,302.93 || $84,000.00 || $122,990.22 || -1.65%<br />
|-<br />
! 14<br />
| $143,557.46 || $109,878.82 || $138,505.66 || $150,774.13 || $90,000.00 || $136,188.34 || -1.67%<br />
|-<br />
! 15<br />
| $158,689.15 || $119,268.21 || $152,776.01 || $167,328.32 || $96,000.00 || $150,209.52 || -1.68%<br />
|-<br />
! 16<br />
| $174,783.36 || $129,014.86 || $167,918.09 || $185,041.30 || $102,000.00 || $165,111.39 || -1.67%<br />
|-<br />
! 17<br />
| $191,901.33 || $139,141.49 || $183,987.36 || $203,994.20 || $108,000.00 || $180,955.59 || -1.65%<br />
|-<br />
! 18<br />
| $210,108.18 || $149,672.28 || $201,042.79 || $224,273.79 || $114,000.00 || $197,808.08 || -1.61%<br />
|-<br />
! 19<br />
| $229,473.16 || $160,632.94 || $219,147.12 || $245,972.95 || $120,000.00 || $215,739.44 || -1.55%<br />
|-<br />
! 20<br />
| $250,069.94 || $172,050.80 || $238,367.07 || $269,191.06 || $126,000.00 || $234,825.21 || -1.49%<br />
|-<br />
! 21<br />
| $271,976.89 || $183,954.95 || $258,773.60 || $294,034.43 || $132,000.00 || $255,146.17 || -1.40%<br />
|-<br />
! 22<br />
| $295,277.34 || $196,376.33 || $280,442.19 || $320,616.85 || $138,000.00 || $276,788.80 || -1.30%<br />
|-<br />
! 23<br />
| $320,059.94 || $209,347.82 || $303,453.12 || $349,060.02 || $144,000.00 || $299,845.62 || -1.19%<br />
|-<br />
! 24<br />
| $346,418.95 || $222,904.44 || $327,891.77 || $379,494.23 || $150,000.00 || $324,415.61 || -1.06%<br />
|-<br />
! 25<br />
| $374,454.66 || $237,083.39 || $353,848.97 || $412,058.82 || $156,000.00 || $350,604.70 || -0.92%<br />
|-<br />
! 26<br />
| $404,273.72 || $251,924.26 || $381,421.30 || $446,902.94 || $162,000.00 || $378,526.23 || -0.76%<br />
|-<br />
! 27<br />
| $435,989.57 || $267,469.17 || $410,711.51 || $484,186.15 || $168,000.00 || $408,301.47 || -0.59%<br />
|-<br />
! 28<br />
| $469,722.87 || $283,762.88 || $441,828.87 || $524,079.18 || $174,000.00 || $440,060.17 || -0.40%<br />
|-<br />
! 29<br />
| $505,601.94 || $300,853.04 || $474,889.60 || $566,764.72 || $180,000.00 || $473,941.19 || -0.20%<br />
|-<br />
! 30<br />
| $543,763.28 || $318,790.30 || $510,017.33 || $612,438.25 || $186,000.00 || $510,093.07 || 0.01%<br />
|-<br />
! 31<br />
| $584,352.06 || $337,628.55 || $547,343.53 || $661,308.93 || $192,000.00 || $548,674.78 || 0.24%<br />
|-<br />
! 32<br />
| $627,522.69 || $357,425.10 || $587,008.05 || $713,600.55 || $198,000.00 || $589,856.42 || 0.49%<br />
|-<br />
! 33<br />
| $673,439.41 || $378,240.91 || $629,159.64 || $769,552.59 || $204,000.00 || $633,819.97 || 0.74%<br />
|-<br />
! 34<br />
| $722,276.89 || $400,140.82 || $673,956.48 || $829,421.27 || $210,000.00 || $680,760.17 || 1.01%<br />
|-<br />
! 35<br />
| $774,220.92 || $423,193.78 || $721,566.85 || $893,480.76 || $216,000.00 || $730,885.38 || 1.29%<br />
|-<br />
! 36<br />
| $829,469.12 || $447,473.13 || $772,169.72 || $962,024.41 || $222,000.00 || $784,418.55 || 1.59%<br />
|-<br />
! 37<br />
| $888,231.65 || $473,056.90 || $825,955.44 || $1,035,366.12 || $228,000.00 || $841,598.25 || 1.89%<br />
|-<br />
! 38<br />
| $950,732.06 || $500,028.05 || $883,126.46 || $1,113,841.75 || $234,000.00 || $902,679.73 || 2.21%<br />
|-<br />
! 39<br />
| $1,017,208.13 || $528,474.83 || $943,898.14 || $1,197,810.67 || $240,000.00 || $967,936.11 || 2.55%<br />
|-<br />
! 40<br />
| $1,087,912.74 || $558,491.11 || $1,008,499.50 || $1,287,657.42 || $246,000.00 || $1,037,659.64 || 2.89%<br />
|}<br />
<br />
====Corporate bond fund====<br />
<br />
* Total Return: 4%<br />
* Yield: 4%<br />
* Qualified Yield: 0%<br />
<br />
{| class="wikitable collapsible autocollapse" style="text-align:right"<br />
! Year !! Taxable Balance !! Taxable Basis !! Taxable After-Tax !! ND tIRA Balance !! ND tIRA Basis !! ND tIRA After-Tax !! ND tIRA Advantage<br />
|-<br />
! 0<br />
| $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || 0.00%<br />
|-<br />
! 1<br />
| $12,182.40 || $12,182.40 || $12,182.40 || $12,240.00 || $12,000.00 || $12,182.40 || 0.00%<br />
|-<br />
! 2<br />
| $18,552.74 || $18,552.74 || $18,552.74 || $18,729.60 || $18,000.00 || $18,554.50 || 0.01%<br />
|-<br />
! 3<br />
| $25,116.75 || $25,116.75 || $25,116.75 || $25,478.78 || $24,000.00 || $25,123.88 || 0.03%<br />
|-<br />
! 4<br />
| $31,880.30 || $31,880.30 || $31,880.30 || $32,497.94 || $30,000.00 || $31,898.43 || 0.06%<br />
|-<br />
! 5<br />
| $38,849.46 || $38,849.46 || $38,849.46 || $39,797.85 || $36,000.00 || $38,886.37 || 0.10%<br />
|-<br />
! 6<br />
| $46,030.48 || $46,030.48 || $46,030.48 || $47,389.77 || $42,000.00 || $46,096.22 || 0.14%<br />
|-<br />
! 7<br />
| $53,429.81 || $53,429.81 || $53,429.81 || $55,285.36 || $48,000.00 || $53,536.87 || 0.20%<br />
|-<br />
! 8<br />
| $61,054.07 || $61,054.07 || $61,054.07 || $63,496.77 || $54,000.00 || $61,217.55 || 0.27%<br />
|-<br />
! 9<br />
| $68,910.12 || $68,910.12 || $68,910.12 || $72,036.64 || $60,000.00 || $69,147.85 || 0.34%<br />
|-<br />
! 10<br />
| $77,004.99 || $77,004.99 || $77,004.99 || $80,918.11 || $66,000.00 || $77,337.76 || 0.43%<br />
|-<br />
! 11<br />
| $85,345.94 || $85,345.94 || $85,345.94 || $90,154.83 || $72,000.00 || $85,797.67 || 0.53%<br />
|-<br />
! 12<br />
| $93,940.45 || $93,940.45 || $93,940.45 || $99,761.03 || $78,000.00 || $94,538.38 || 0.64%<br />
|-<br />
! 13<br />
| $102,796.24 || $102,796.24 || $102,796.24 || $109,751.47 || $84,000.00 || $103,571.12 || 0.75%<br />
|-<br />
! 14<br />
| $111,921.25 || $111,921.25 || $111,921.25 || $120,141.53 || $90,000.00 || $112,907.56 || 0.88%<br />
|-<br />
! 15<br />
| $121,323.66 || $121,323.66 || $121,323.66 || $130,947.19 || $96,000.00 || $122,559.86 || 1.02%<br />
|-<br />
! 16<br />
| $131,011.90 || $131,011.90 || $131,011.90 || $142,185.07 || $102,000.00 || $132,540.66 || 1.17%<br />
|-<br />
! 17<br />
| $140,994.66 || $140,994.66 || $140,994.66 || $153,872.48 || $108,000.00 || $142,863.08 || 1.33%<br />
|-<br />
! 18<br />
| $151,280.89 || $151,280.89 || $151,280.89 || $166,027.38 || $114,000.00 || $153,540.81 || 1.49%<br />
|-<br />
! 19<br />
| $161,879.83 || $161,879.83 || $161,879.83 || $178,668.47 || $120,000.00 || $164,588.04 || 1.67%<br />
|-<br />
! 20<br />
| $172,800.98 || $172,800.98 || $172,800.98 || $191,815.21 || $126,000.00 || $176,019.56 || 1.86%<br />
|-<br />
! 21<br />
| $184,054.13 || $184,054.13 || $184,054.13 || $205,487.82 || $132,000.00 || $187,850.74 || 2.06%<br />
|-<br />
! 22<br />
| $195,649.38 || $195,649.38 || $195,649.38 || $219,707.33 || $138,000.00 || $200,097.57 || 2.27%<br />
|-<br />
! 23<br />
| $207,597.12 || $207,597.12 || $207,597.12 || $234,495.62 || $144,000.00 || $212,776.67 || 2.50%<br />
|-<br />
! 24<br />
| $219,908.07 || $219,908.07 || $219,908.07 || $249,875.45 || $150,000.00 || $225,905.34 || 2.73%<br />
|-<br />
! 25<br />
| $232,593.27 || $232,593.27 || $232,593.27 || $265,870.47 || $156,000.00 || $239,501.56 || 2.97%<br />
|-<br />
! 26<br />
| $245,664.11 || $245,664.11 || $245,664.11 || $282,505.29 || $162,000.00 || $253,584.02 || 3.22%<br />
|-<br />
! 27<br />
| $259,132.30 || $259,132.30 || $259,132.30 || $299,805.50 || $168,000.00 || $268,172.18 || 3.49%<br />
|-<br />
! 28<br />
| $273,009.92 || $273,009.92 || $273,009.92 || $317,797.72 || $174,000.00 || $283,286.27 || 3.76%<br />
|-<br />
! 29<br />
| $287,309.42 || $287,309.42 || $287,309.42 || $336,509.63 || $180,000.00 || $298,947.32 || 4.05%<br />
|-<br />
! 30<br />
| $302,043.63 || $302,043.63 || $302,043.63 || $355,970.01 || $186,000.00 || $315,177.21 || 4.35%<br />
|-<br />
! 31<br />
| $317,225.76 || $317,225.76 || $317,225.76 || $376,208.81 || $192,000.00 || $331,998.70 || 4.66%<br />
|-<br />
! 32<br />
| $332,869.42 || $332,869.42 || $332,869.42 || $397,257.16 || $198,000.00 || $349,435.45 || 4.98%<br />
|-<br />
! 33<br />
| $348,988.65 || $348,988.65 || $348,988.65 || $419,147.45 || $204,000.00 || $367,512.06 || 5.31%<br />
|-<br />
! 34<br />
| $365,597.90 || $365,597.90 || $365,597.90 || $441,913.35 || $210,000.00 || $386,254.15 || 5.65%<br />
|-<br />
! 35<br />
| $382,712.08 || $382,712.08 || $382,712.08 || $465,589.88 || $216,000.00 || $405,688.31 || 6.00%<br />
|-<br />
! 36<br />
| $400,346.53 || $400,346.53 || $400,346.53 || $490,213.48 || $222,000.00 || $425,842.24 || 6.37%<br />
|-<br />
! 37<br />
| $418,517.06 || $418,517.06 || $418,517.06 || $515,822.02 || $228,000.00 || $446,744.73 || 6.74%<br />
|-<br />
! 38<br />
| $437,239.98 || $437,239.98 || $437,239.98 || $542,454.90 || $234,000.00 || $468,425.72 || 7.13%<br />
|-<br />
! 39<br />
| $456,532.08 || $456,532.08 || $456,532.08 || $570,153.09 || $240,000.00 || $490,916.35 || 7.53%<br />
|-<br />
! 40<br />
| $476,410.65 || $476,410.65 || $476,410.65 || $598,959.22 || $246,000.00 || $514,249.01 || 7.94%<br />
|}<br />
<br />
====REIT====<br />
<br />
* Total Return: 6%<br />
* Yield: 6%<br />
* Qualified Yield: 0%<br />
<br />
{| class="wikitable collapsible autocollapse" style="text-align:right"<br />
! Year !! Taxable Balance !! Taxable Basis !! Taxable After-Tax !! ND tIRA Balance !! ND tIRA Basis !! ND tIRA After-Tax !! ND tIRA Advantage<br />
|-<br />
! 0<br />
| $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || $6,000.00 || 0.00%<br />
|-<br />
! 1<br />
| $12,273.60 || $12,273.60 || $12,273.60 || $12,360.00 || $12,000.00 || $12,273.60 || 0.00%<br />
|-<br />
! 2<br />
| $18,833.28 || $18,833.28 || $18,833.28 || $19,101.60 || $18,000.00 || $18,837.22 || 0.02%<br />
|-<br />
! 3<br />
| $25,692.07 || $25,692.07 || $25,692.07 || $26,247.70 || $24,000.00 || $25,708.25 || 0.06%<br />
|-<br />
! 4<br />
| $32,863.63 || $32,863.63 || $32,863.63 || $33,822.56 || $30,000.00 || $32,905.14 || 0.13%<br />
|-<br />
! 5<br />
| $40,362.21 || $40,362.21 || $40,362.21 || $41,851.91 || $36,000.00 || $40,447.45 || 0.21%<br />
|-<br />
! 6<br />
| $48,202.73 || $48,202.73 || $48,202.73 || $50,363.03 || $42,000.00 || $48,355.90 || 0.32%<br />
|-<br />
! 7<br />
| $56,400.78 || $56,400.78 || $56,400.78 || $59,384.81 || $48,000.00 || $56,652.45 || 0.45%<br />
|-<br />
! 8<br />
| $64,972.65 || $64,972.65 || $64,972.65 || $68,947.90 || $54,000.00 || $65,360.40 || 0.60%<br />
|-<br />
! 9<br />
| $73,935.40 || $73,935.40 || $73,935.40 || $79,084.77 || $60,000.00 || $74,504.42 || 0.77%<br />
|-<br />
! 10<br />
| $83,306.86 || $83,306.86 || $83,306.86 || $89,829.86 || $66,000.00 || $84,110.69 || 0.96%<br />
|-<br />
! 11<br />
| $93,105.65 || $93,105.65 || $93,105.65 || $101,219.65 || $72,000.00 || $94,206.93 || 1.18%<br />
|-<br />
! 12<br />
| $103,351.27 || $103,351.27 || $103,351.27 || $113,292.83 || $78,000.00 || $104,822.55 || 1.42%<br />
|-<br />
! 13<br />
| $114,064.09 || $114,064.09 || $114,064.09 || $126,090.40 || $84,000.00 || $115,988.70 || 1.69%<br />
|-<br />
! 14<br />
| $125,265.41 || $125,265.41 || $125,265.41 || $139,655.82 || $90,000.00 || $127,738.42 || 1.97%<br />
|-<br />
! 15<br />
| $136,977.51 || $136,977.51 || $136,977.51 || $154,035.17 || $96,000.00 || $140,106.73 || 2.28%<br />
|-<br />
! 16<br />
| $149,223.69 || $149,223.69 || $149,223.69 || $169,277.28 || $102,000.00 || $153,130.73 || 2.62%<br />
|-<br />
! 17<br />
| $162,028.29 || $162,028.29 || $162,028.29 || $185,433.92 || $108,000.00 || $166,849.78 || 2.98%<br />
|-<br />
! 18<br />
| $175,416.78 || $175,416.78 || $175,416.78 || $202,559.95 || $114,000.00 || $181,305.56 || 3.36%<br />
|-<br />
! 19<br />
| $189,415.78 || $189,415.78 || $189,415.78 || $220,713.55 || $120,000.00 || $196,542.30 || 3.76%<br />
|-<br />
! 20<br />
| $204,053.14 || $204,053.14 || $204,053.14 || $239,956.36 || $126,000.00 || $212,606.83 || 4.19%<br />
|-<br />
! 21<br />
| $219,357.96 || $219,357.96 || $219,357.96 || $260,353.74 || $132,000.00 || $229,548.84 || 4.65%<br />
|-<br />
! 22<br />
| $235,360.69 || $235,360.69 || $235,360.69 || $281,974.97 || $138,000.00 || $247,420.97 || 5.12%<br />
|-<br />
! 23<br />
| $252,093.13 || $252,093.13 || $252,093.13 || $304,893.46 || $144,000.00 || $266,279.03 || 5.63%<br />
|-<br />
! 24<br />
| $269,588.58 || $269,588.58 || $269,588.58 || $329,187.07 || $150,000.00 || $286,182.17 || 6.16%<br />
|-<br />
! 25<br />
| $287,881.82 || $287,881.82 || $287,881.82 || $354,938.30 || $156,000.00 || $307,193.11 || 6.71%<br />
|-<br />
! 26<br />
| $307,009.23 || $307,009.23 || $307,009.23 || $382,234.59 || $162,000.00 || $329,378.29 || 7.29%<br />
|-<br />
! 27<br />
| $327,008.85 || $327,008.85 || $327,008.85 || $411,168.67 || $168,000.00 || $352,808.19 || 7.89%<br />
|-<br />
! 28<br />
| $347,920.46 || $347,920.46 || $347,920.46 || $441,838.79 || $174,000.00 || $377,557.48 || 8.52%<br />
|-<br />
! 29<br />
| $369,785.63 || $369,785.63 || $369,785.63 || $474,349.12 || $180,000.00 || $403,705.33 || 9.17%<br />
|-<br />
! 30<br />
| $392,647.85 || $392,647.85 || $392,647.85 || $508,810.06 || $186,000.00 || $431,335.65 || 9.85%<br />
|-<br />
! 31<br />
| $416,552.59 || $416,552.59 || $416,552.59 || $545,338.67 || $192,000.00 || $460,537.39 || 10.56%<br />
|-<br />
! 32<br />
| $441,547.39 || $441,547.39 || $441,547.39 || $584,058.99 || $198,000.00 || $491,404.83 || 11.29%<br />
|-<br />
! 33<br />
| $467,681.95 || $467,681.95 || $467,681.95 || $625,102.53 || $204,000.00 || $524,037.92 || 12.05%<br />
|-<br />
! 34<br />
| $495,008.25 || $495,008.25 || $495,008.25 || $668,608.68 || $210,000.00 || $558,542.60 || 12.84%<br />
|-<br />
! 35<br />
| $523,580.63 || $523,580.63 || $523,580.63 || $714,725.20 || $216,000.00 || $595,031.15 || 13.65%<br />
|-<br />
! 36<br />
| $553,455.90 || $553,455.90 || $553,455.90 || $763,608.71 || $222,000.00 || $633,622.62 || 14.48%<br />
|-<br />
! 37<br />
| $584,693.49 || $584,693.49 || $584,693.49 || $815,425.23 || $228,000.00 || $674,443.18 || 15.35%<br />
|-<br />
! 38<br />
| $617,355.52 || $617,355.52 || $617,355.52 || $870,350.75 || $234,000.00 || $717,626.57 || 16.24%<br />
|-<br />
! 39<br />
| $651,506.93 || $651,506.93 || $651,506.93 || $928,571.79 || $240,000.00 || $763,314.56 || 17.16%<br />
|-<br />
! 40<br />
| $687,215.64 || $687,215.64 || $687,215.64 || $990,286.10 || $246,000.00 || $811,657.44 || 18.11%<br />
|}<br />
<br />
==References==<br />
{{Reflist|30em}}<br />
<br />
==External links==<br />
*[https://www.irs.gov/publications/p590a/ Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)]<br />
*[https://www.irs.gov/publications/p590b/ Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)]<br />
*[http://www.irs.gov/pub/irs-pdf/f8606.pdf Form 8606 Nondeductible IRAs]<br />
*[http://www.irs.gov/instructions/i8606/index.html Instructions for Form 8606 Nondeductible IRAs]<br />
*[https://personal.vanguard.com/us/whatweoffer/ira/whichira?Link=facet Traditional vs Roth]<br />
*[https://www.fidelity.com/building-savings/learn-about-iras/required-minimum-distributions/qcds Qualified Charitable Distributions (QCDs)]<br />
*{{Forum post| t = 300681| title = Proposed new Required Minimum Distribution (RMD) wiki page | author = fyre4ce | date = Jan 14, 2020}}. Includes discussion of non-deductible traditional IRA.<br />
<br />
{{Bogleheads retirement planning start-up kit}}<br />
{{Retirement accounts}}<br />
{{Managing your IRA}}<br />
<br />
[[Category: IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71936User:Fyre4ce/Traditional versus Roth2021-02-10T19:13:23Z<p>Fyre4ce: Rewording suggested in discussion forum</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision of whether to use a '''traditional''' (pre-tax) or a '''Roth''' tax structure. Preference for one tax structure or the other is fundamentally a [https://www.investopedia.com/terms/t/tax-planning.asp tax planning] question. You must make this decision when your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you (or your heirs, if you are [[#Estate_planning|estate planning]]) more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement.<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between your [[#Calculating_marginal_tax_rate_now|known marginal tax rate now]] vs. an [[#Estimating_future_marginal_tax_rate|estimated marginal tax rate at withdrawal]]. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower than the estimate. <br />
<br />
For those who can't or won't make a reasonable estimate of future tax rates, traditional is likely the better choice, because it's best for most people most of the time. For those reluctant to save for retirement at all, either traditional or Roth or any mix is almost always a better choice than saving outside retirement accounts. In addition to providing more future income after taxes, traditional and Roth accounts also offer other benefits such as [[Asset protection|asset protection]] and [[Estate planning|estate planning]].<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Typical cases==<br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have sources of significant taxable income in retirement (pensions, royalties, real estate income not sheltered by depreciation, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.)<br />
* Investors who expect a [[#Social_Security_benefits|spike in Social Security taxation]] to give them a significantly higher marginal tax rate in retirement than they have now; this affects primarily investors in the 12% bracket<br />
* Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
==Common misconceptions==<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Establish a baseline plan for how long you will work, how much income you expect to earn, when you expect to retire, and when you expect to begin receiving Social Security and any other guaranteed income. Certain careers are characterized by long periods of low-income training followed by much higher earnings, and these changes should likely be included. If you're not sure, assuming that your current income continues to a typical retirement age is reasonable. If you think there's a chance your income could drop or disappear, assuming no future income could be reasonable.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#Typical_cases|Typical cases]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]]<br />
# Estimate any guaranteed retirement income (a pension, rental properties, royalties, etc.)<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your traditional IRA withdrawals, then the traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement,<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref> and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a traditional 401(k) but not a Roth 401(k), then you must use traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to traditional accounts. For example, contributing the full $19,500 to a traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a traditional or Roth account. The IRS contribution limits do not distinguish between traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [[Traditional versus Roth examples]].<br />
<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=Managing_a_windfall&diff=71584Managing a windfall2021-01-28T01:19:23Z<p>Fyre4ce: Added to annual tax update category</p>
<hr />
<div>A '''windfall''', in personal finance, is defined as a significant amount of money that a person gets unexpectedly. Windfalls can range in magnitude from small additions to an individual's wealth to large fortunes. Since small and large windfalls, both of which are addressed below, can mean huge changes in a recipient's life, psychological and emotional factors<ref group="note"> A wide range of responses can accompany a financial windfall. Persons who have experienced financial windfalls have shared that they’ve experienced some or many of the following emotions as they adjusted to their new circumstances.<br />
<br />
{| <br />
|+ '''Emotional reactions to windfalls '''Source: [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events], NEFE <br />
| style="width: 30%" |<br />
*Elation <br />
*Fear of loss of money<br />
*Fear of a change in relationships with others<br />
*Anxiety<br />
*Paralysis<br />
*Inability to see the money as a gift or an advantage<br />
*Not knowing what to do with the money<br />
|style="width: 30%"|<br />
*Depression<br />
*Resistance<br />
*Anger<br />
*Grief<br />
*Distrust<br />
*Numbness<br />
*Isolation<br />
|style="width: 30%"|<br />
*Feelings of unworthiness<br />
*Resentment<br />
*Lack of confidence<br />
*Guilt<br />
*Desire to give it all away<br />
*Intimidated<br />
*Lack of identify<br />
*Sense of loss<br />
|}<br />
</ref> are often the most important factors determining outcomes. The National Endowment for Financial Education advises windfall recipients to take the following course of action.<ref name="NEFE">[http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events], NEFE </ref><br />
<br />
Do nothing rash. Set aside one year's living expenses and place the rest of the windfall into low risk investments (FDIC insured accounts, money market funds, treasury bills) for one year. As it may take as long as five years for the windfall recipient to adjust to a new life, this pause provides a chance for emotions to cool, helps avoid impulsive behavior, and, if warranted, allows the recipient time to put together a team of professional advisers. Then, create a detailed plan to meet your highest priority financial goals, and track your progress over the years. <br />
{{Notice|"Most financial practitioners agree that well over 50 percent [of windfalls] are lost in a relatively short period of time. NBC News reported that more than 70 percent of lottery winners exhaust their fortunes within three years." -''Larimore, Lindauer, and LeBoeuf (2006). The Bogleheads' Guide to Investing. Chapter 15, p.180: Wiley. ISBN 978-0471730330.''}}<br />
<br />
==Common sources of windfalls==<br />
Windfalls come in many forms. Here are some common types:<br />
<br />
* '''Legal settlements''' : Settlements include personal injury settlements, settlements involving workers compensation and settlements of employment discrimination. Settlements are taken as either a lump sum or, alternately, as a structured settlement of annuity payments.<br />
* '''Inheritances''': These can often involve retirement accounts and assets held in trust.<br />
* '''Gifts''': These can range from annual gift exclusions up to the lifetime estate taxation credit limit.<br />
* '''Lottery winnings''': Taken as a series of payments; or as the sales value of payments exchanged for a lump sum.<br />
* '''Insurance settlements''': These can be in the form of death benefits received as either a lump sum or annuity; as pre-death cash surrender values; or as life settlements, the sale of a life insurance policy by the owner to a third party in exchange for a lump sum.<br />
* '''Retirement lump sums''': Usually taken in lieu of a lifetime series of annuity payments<br />
* '''Sudden increases in income''': These can come in the form of bonus payments; stock options; or cashing shares in an IPO.<br />
<br />
While not being external sources of new wealth, other common sources of receiving large lump sums include the following:<ref name="Guide">Larimore, Lindauer, and LeBoeuf (2006). ''The Bogleheads' Guide to Investing''. Chapter 15: Wiley. ISBN 978-0471730330. </ref><br />
* A real estate sale<br />
* The sale of a business<br />
* Widowhood and divorce<br />
<br />
Sales of businesses and real estate involve the conversion of an illiquid asset into large sums of fungible cash. Death and divorce not only cause dislocation and trauma, but often result in suddenly thrusting an individual who has had little or no interest or no experience in investing, into the position of managing family wealth.<br />
<br />
==Size of a windfall==<br />
<br />
Windfall sizes vary dramatically. A small windfall might bring you a step closer to your financial goals, a bigger one may make you financially independent, and an enormous windfall might be more money than you ever imagined spending. Windfall size is somewhat relative to your income and assets; what would be a life-changing amount of money for one person might be only accelerate someone else's mortgage payoff by a few years. Some thresholds are more absolute, such as the federal estate tax exemption ($11.7M for singles and $23.4M for married couples as of 2021<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Estate tax], IRS</ref>); financial planners generally agree that additional planning is necessary with assets above this level.<br />
<br />
This wiki page will intends to provide guidance for windfalls that are ''relatively'' large compared to one's income and assets, enough to entail significant lifestyle changes and the need for additional planning. The guidance presented is intended to apply to a wide variety of windfall types, sources, and absolute sizes. Readers are encouraged to consider the guidance that applies to their individual situation.<br />
<br />
==Common pitfalls==<br />
<br />
Among windfall recipients, common errors of commission include:<ref> [http://www.stephenlnelson.com/WindfallFinancialPlanning.htm Financial Planning for a Windfall in Wealth: Lotteries, Stock Options, Inheritances and Other Surprises], Stephen L. Nelson, CPA, PLLC. </ref><br />
<br />
* quitting one's job prematurely<br />
* buying extravagantly priced automobiles or properties, or engaging in other expensive consumption spending<br />
* feeling overconfident about one's business or investing acumen, resulting in jumping into new high risk investments (such as hedge funds) or as an "angel" investor in start-up companies<br />
* falling prey to overcomplicated estate and investment management schemes. Be on the alert for people who may be trying to exploit you or take advantage of your new wealth. It’s important to recognize that you can be a target for all kinds of financial schemes. <br />
* by being too generous to family, friends, and charities<br />
<br />
Common errors of omission include failing to:<br />
<br />
* pay the legally required taxes<br />
* choose risk-appropriate investments and earn a reasonable return on invested capital<br />
* utilize appropriate accounts such as retirement plans<br />
* engage with the right professionals<br />
* set up the appropriate plans, including estate plans<br />
<br />
==Preparing==<br />
<br />
These initial steps will help put you in a position to manage a life-changing amount of money: <br />
<br />
===Take your time===<br />
<br />
Finance authorities are in agreement that avoiding immediate impulse decisions is key to prudent management of the windfall situation. Among the recommendations for this period are the following:<br />
* Tell as few people as possible. Unfortunately, even those close to you may become resentful or solicit you for gifts when they hear about your windfall. You can always tell people later on when you've had time to consider the effect that information may have on your relationships. <br />
* Set aside six months to one year's worth of expenses in a transaction account such as your checking account. Place the remaining windfall assets in separate accounts holding secure low-risk savings vehicles, such as FDIC guaranteed bank accounts and [[Certificate of Deposit|CD]]s, [[Money Markets|money market funds]], and [[Treasury bill|treasury bills]]. <br />
* Use this period of time to begin resolving emotional, family, and social issues. Different sources of windfall, such as the death of a loved one, may have powerful emotional consequences that you should focus on addressing, while spending minimal time worrying about finances. Coming to terms with your emotions will allow you to make better financial decisions.<ref group="note"> The emotional and social issues surrounding windfalls are explored in greater detail in the following links:<br />
* [http://www.amydomini.com/howview How You View Yourself], Amy Domini, Sharon Rich, and Dennis Pearne: Excerpted from ''The Challenges of Wealth'' (Homewood, Ill.: Dow Jones Irwin, 1988), a book on the psychology of wealth.<br />
* [http://www.bankrate.com/finance/personal-finance/4-steps-to-profit-from-a-windfall-1.aspx 4 steps to profit from a financial windfall] examines emotional issues involving individual behavior, family dynamics, and inheritance.<br />
* [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events] is a good general guide.<br />
* [http://www4.gsb.columbia.edu/filemgr?file_id=7217585 Entrepreneurs: Life after Exit] examines issues involved in selling businesses.</ref> <br />
* Hire a competent and unbiased tax professional, such as Certified Public Accountant (CPA), if you don't already have one. Estimated taxes may need to be filed. Complex tax issues may surround distributions from retirement plans, inheritances, and lottery winnings, as well as the exercise of stock options. If you're not sure if your windfall has tax consequences, many tax professionals will be willing to give you a free consultation, and prefer someone who doesn't sell investment products.<br />
* If you have more complex finance issues that should not wait at least 6-12 months, skip ahead to the ''[[#Get_help|Get help]]'' step and pay a fair hourly rate for consultation from a fiduciary financial advisor, preferably one with a CFP or CFA certification. Urgent financial issues include needing to decide whether to receive a lump sum or annuity stream; having a large amount of high-interest debt; or facing imminent eviction, foreclosure, or collection action due to delinquent debts. The focus of the consultation should just be resolving your urgent issues, not necessarily developing a complete financial plan or investing capital. The goal isn't to begin putting your money to work, but rather to reduce stress and distractions by stabilizing your financial situation. Only make the minimum payments that will allow you to focus on the future, and don't redirect payments from paid-off debts to more spending.<br />
<br />
====Lump sum vs. annuity====<br />
{{Main|Lump sum vs pension}}<br />
<br />
The choice of a lump sum or a stream of payments can be a complex one with many influencing factors, such as your financial goals, expected investment performance, taxes, inflation protection, life expectancy, estate planning goals, financial health of the annuity provider, and others. If you are at all unsure of the best course of action, a consultation with a fee-only fiduciary financial advisor would be extremely valuable. However, most windfall recipients should lean strongly toward choosing the annuity, for these reasons:<br />
<br />
* The windfall is much less likely to be squandered: a lump sum can be squandered by just one bad financial decision, whereas squandering an annuity would require a series of many bad choices, and not learning from prior mistakes.<br />
* The most common reason to choose a lump sum is the expectation of a higher rate of return than the effective rate of return of the annuity. However, most windfall recipients are investment novices who are less likely to reliably generate high returns from their investments. This makes the protection of principal plus guaranteed return of the annuity more attractive in comparison.<br />
* Windfall recipients have less ''need'' to earn a high return, so the guaranteed return of the annuity is more likely to be adequate to support a comfortable and prosperous lifestyle.<br />
<br />
Note that this reasoning is very similar to why windfall recipients should [[#Debts|pay off existing debts and avoid taking on new ones]]. These are in addition to any more general reasons that may apply, such as tax savings.<br />
<br />
===Think about goals===<br />
<br />
Begin to think about long term goals, with more focus on the life you would like to create and (for now) less focus about how to achieve it. Some ideas for goals that may be meaningful:<br />
<br />
* Retiring, either in the short or long term<br />
* Cutting back hours at work, and/or dropping less desirable shifts/jobs<br />
* Changing jobs<br />
* Starting a business<br />
* Going back to school, either to pursue a new career or just for enjoyment<br />
* Saving money for benefit of a loved one ([[529 plan]] for education, trust fund, helping pay for a wedding or house down payment, etc.)<br />
* Moving to another city, or country<br />
* Paying off debts<br />
* Certain consumer purchases<br />
* Purchasing real estate<br />
* Traveling<br />
* Taking up a new hobby<br />
* Growing your family<br />
* Donating to charity<br />
* Volunteering your time<br />
<br />
Even a very large windfall will likely not be enough to fully fund all or even most of these goals, so it's important to prioritize your goals, both in terms of overall priority, and the time it will take you to reach them. Many financial novices are surprised how ''little'' of a windfall they are actually able to spend immediately. For example, a $1M windfall will only generate about $30-40,000 per year of investment income over the long run, so initial spending will need to be limited so the windfall can provide a lasting improvement in lifestyle. Specific goals, and allocation of money toward them, will be formalized later in a written financial plan.<br />
<br />
===Get educated===<br />
<br />
Like it or not, you now have a new job (in addition to any other jobs you may already have) - learning how to manage money. Whether or not you are inclined to "do-it-yourself", you will need at least the knowledge necessary to evaluate financial professionals. Educating yourself on personal finance and investing will likely be, by far, the most money you will ever "earn" per hour, if it makes the difference between lifelong prosperity and a fortune squandered within a few years. <br />
<br />
* Read some [[Books: Recommendations and Reviews|recommended books]] on personal finance and investing. Reading at least three, that cover the topics of personal finance and investing, would be a good start.<br />
* Browse the rest of the [https://www.bogleheads.org/wiki/Main_Page Bogleheads wiki]. Many pages are meant to be accessible to those with little or no investing experience.<br />
<br />
===Get help===<br />
<br />
Unless you are already an experienced investor, it may be beneficial to hire a professional, at least for some initial guidance. Should you decide to use an adviser, the authors of ''The Bogleheads' Guide to Investing'' (Chapter 16, p.193: Wiley. ISBN 978-0471730330) recommend choosing an adviser who has earned a CFA (Chartered Financial Analyst) or a CFP (Chartered Financial Planner) designation; uses a fee-only payment arrangement; and advocates an index fund investing approach. The fee-only compensation structure minimizes the advisor's conflicts of interest with respect to your financial success. A good financial advisor should be able to do the following:<br />
<br />
* Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package<br />
* Strategize about how to minimize taxes owed<br />
* Recommend an investment strategy<br />
* Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed<br />
* Determine whether you need to enlist an estate planning attorney<ref group="note"> The authors of ''The Bogleheads' Guide to Investing'' (Chapter 15, p.185: Wiley. ISBN 978-0471730330) recommend [http://www.martindale.com/ Martindale & Hubble] for checking out the credentials of an attorney. </ref> <br />
You can get free portfolio reviews and answers to personal finance questions on the [https://www.bogleheads.org/forum/index.php Bogleheads forums]. Most forum members are not finance professionals, but are nonetheless experienced investors, and as a whole have managed an enormous range of income and assets.<br />
<br />
Whether to retain a [https://www.bogleheads.org/wiki/Financial_planner financial planner] for a long time, or do your own investing using the [https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investment_philosophy Bogleheads® investment philosophy] or similar, is a personal choice. When you have time, consider the [https://www.bogleheads.org/wiki/Getting_started "getting started"] wiki article (and the rest of this one). The more you learn, the better you will be able to judge whether an advisor is worth the cost to you.<br />
<br />
==Creating a plan==<br />
<br />
{{Quotation|Once you begin to become comfortable in your new financial reality, you may be ready for the successive phases, which include reviewing your situation and deciding how the money will be used. This is the fun part, when you'll choose -- with the help of... a solid financial plan -- whether to retire, buy a vacation home, donate to charities or set up trust funds for your children. The ultimate goal of all these steps is to create a sensible plan for handling your windfall that also allows you to come out with your relationships and sanity intact.|Susan Bradley|[http://www.bankrate.com/finance/personal-finance/4-steps-to-profit-from-a-windfall-1.aspx#ixzz25oVhMsH4 4 steps to profit from a financial windfall]}}<br />
<br />
[[Financial planning|Financial planning]] is a ''long-term'' process<ref group="note">Sound financial planning incorporates these steps: <br />
#Establish a relationship with a CFP professional<br />
#Gather your data and develop your financial goals<br />
#Analyze and evaluate your financial status<br />
#Review your CFP professional’s recommendations<br />
#Set your course<br />
#Benchmark your progress against the financial goals you established<br />
Source: [https://www.letsmakeaplan.org/other-resources/financial-planning-process Financial Planning Process], by the [https://www.letsmakeaplan.org Certified Financial Planner Board of Standards, Inc.]</ref> of managing your finances so you can achieve your goals and dreams, while at the same time negotiating the financial barriers that inevitably arise in every stage of life. Fundamentally, the process for financial planning after receiving a windfall is the same as in any other situation. The only differences are:<br />
<br />
* Larger amounts of money increase the relative importance of certain aspects of financial planning, such as tax planning and [[Tax-efficient fund placement|tax-efficient investing]], [[Index fund|minimizing investment costs]], [[Asset protection|asset protection]], and [[Estate planning|estate planning]].<br />
* The windfall recipient is often thrust into a situation where they're required to manage a large amount of money without having the necessary skills, knowledge, and experience. <br />
* Serious emotional impacts often surround windfalls, which must be dealt with concurrently with financial planning.<br />
* The consequences of financial mistakes are higher, in terms of absolute dollars, with larger amounts of money.<br />
<br />
The core of the financial planning process is matching your goals, and the financial resources they will likely require, with your available resources, which can come from your present resources, but also future investment proceeds and any future earnings. This matching will require knowledge of the costs of your goals (both up-front and ongoing), how much of your available funds will need to go to taxes, and expected returns on various types of investments. Goals should be prioritized, and these priorities should be weighted by the amount of financial resources it will take to meet them. The end product of this process is a detailed financial plan that lists your goals, describes ''when'' and ''how'' you expect to meet them, and that is robust to factors beyond your control, such as job loss, unexpected expenses, and market swings. A complete financial plan should address all of the following areas:<br />
<br />
===Work, Income, and Education===<br />
<br />
If you are currently working, plan how long you will continue to work. If retirement is a high priority, and your windfall allows you to live off investment income with a [[Safe withdrawal rates|safe withdrawal rate]] (typically 3-4%), then you may be able to retire immediately. If you continue to work, include your expected future income in your financial plan.<br />
<br />
The windfall may provide you the opportunity to change jobs, start your own business, or get additional training that would enable a new career, so consider whether these options are desirable.<br />
<br />
===Location===<br />
<br />
Decide where you would like to live, and include in your plan costs with moving and residing there. Typically the largest financial factors connected to location are available jobs, cost of living (particularly housing), state and local taxes, and proximity to family (which can affect travel and childcare costs). <br />
<br />
Your plan should include a location while working (if appropriate), and while retired. Differences in income tax rates can affect [[Traditional versus Roth|traditional versus Roth]] decisions.<br />
<br />
===Spending===<br />
<br />
Create a [[Household budgeting|written budget]] that includes allocations for meaningful categories of expense (food, transportation, etc.), and has some cushion for unexpected changes. Everyone needs a budget, no matter how much money they have. <br />
<br />
Include any immediate or planned future purchases, such as replacing an aging car immediately, or when it will reach the end of its life, and include saving for future purchases in the plan.<br />
<br />
Consider both the up-front and ongoing costs of purchases. For example, windfall recipients often do not consider the ongoing costs associated with expensive properties (property tax, maintenance, utilities, cleaning) or vehicles (fuel, insurance, maintenance, storage for the winter, etc.), which can be substantial.<br />
<br />
Resist the temptation to spend a significant portion of a windfall on short-term consumption spending. The enjoyment you'll get from investing and spending the windfall over a long period of time, and the comfort from having financial security, will likely far outweigh that from any consumer purchases.<br />
<br />
===Accounts===<br />
<br />
Understand the different types of tax-advantaged accounts available to you ([[401(k)]], [[IRA]], [[HSA]], [[529 plan]], [[Defined benefit pension plan]], etc.) and plan on using those that give you the greatest advantage. <br />
<br />
[[Variable Annuity|Variable annuities (VAs)]] are usually high-fee products marketed by commissioned salespeople, which are inferior to tax-advantaged accounts and [[Taxable account|taxable accounts]] and are best avoided. However, ''low-cost'' VAs can make sense for some windfall recipients. If you receive a large lump sum windfall that cannot be [[IRA rollovers and transfers|rolled over]] into an [[IRA]], and you intend to invest in [[Tax-efficient fund placement|tax-inefficient investments]], a low-cost VA will allow you to defer taxes on interest, dividends, and capital gains. The tax deferral ''may'' offset the VA fees, which are around 0.25%/year for a good low-cost VA, such as from [https://www.fidelity.com/annuities/FPRA-variable-annuity/overview Fidelity]. If you think a low-cost VA may be appropriate, consult with a third party fee-only financial advisor, who can help make sure the VA you're considering is well-suited for you and not fee-laden. See also: [[Non-deductible_traditional_IRA#Comparison_between_non-deductible_tIRA_and_taxable_accounts|performance comparison between non-deductible IRAs and taxable accounts]] (non-deductible IRAs have the same tax structure as VAs). <br />
<br />
Make sure any withdrawal restrictions (eg. penalties for non-qualified withdrawals from a 401(k) or IRA before age 59½) fit into your overall financial plan.<br />
<br />
===Investments===<br />
{{Notice|For further guidance involving the selection of an investment portfolio refer to these pages:<br />
*[[Bogleheads® investment philosophy]]: This page explains the basic principles advocated by this site.<br />
*[[Asset allocation]]: this page explains the process of dividing an investment portfolio among different asset categories depending on the need, ability and willingness of the investor to take risk.<br />
*[[Three-fund portfolio]]: This page explains a simple portfolio popular with many of this site's members.<br />
*[[Lazy Portfolios]]: This page contains a number of widely diversified portfolios.}}<br />
<br />
Investing capital, and earning a good rate of return for an appropriate level of risk, is an essential component of almost all financial plans. Appropriate investments are strongly dependent on the time horizon of the goal being saved for. For example:<br />
* Short-term goals, within the next 3 years, should be saved for using low-risk and low-volatility investments, such as savings accounts, [[Money markets|money market]] accounts or funds, [[Certificate of deposit|certificates of deposit (CDs)]], or short-term bonds. <br />
* Medium-term goals, in the 3-10 year range, can be saved for with slightly more volatile investments, such as intermediate-term [[Bond basics|bonds]], and could include a small percentage of [[Stock basics|stocks]].<br />
* Long-term goals, 10 or more years away, can contain a large percentage of higher-volatility higher-return investments like [[Stock basics|stocks]] and real estate. <br />
<br />
Other key factors for choosing investments are need and willingness to take risk, and the consequences of falling short; see [[Asset allocation|asset allocation]] for a more detailed discussion.<br />
<br />
Stock and bond investments should generally be purchased through [[Index fund|low-cost passive mutual funds]] for [[Diversification|diversification]], [[Expense ratios|reduced costs]], and higher [[Tax-efficient fund placement|tax efficiency in a taxable account]]. Avoid purchasing individual stocks, due to the high volatility and risk of permanent loss.<br />
<br />
Windfall recipients should be especially cautious with high-risk investments (private equity, startup companies, etc.) that have a significant possibility of a total loss. Most windfall recipients don't have the necessary experience to properly evaluate high-risk investments, and also don't have the need for higher than market returns. Windfall recipients are also often the targets of bad investments or scams, so limiting investments to diversified funds from respectable institutions reduces this risk.<br />
<br />
Once you have made your investment decisions these should be formalized in an [[Investment policy statement]] (IPS) or [[Investment Policy Statement#Investing plan | Investment plan]].<br />
<br />
===Debts===<br />
{{Main|Prioritizing investments}}<br />
<br />
All financial plans should include a list of all current debts and a plan to pay them off. Medium- and high-interest debts, such as credit card debts, should be paid off quickly. See also: [[Paying down loans versus investing]].<br />
<br />
Most windfall recipients should prioritize eliminating all debts, even low-interest ones, because the balance versus investing favors paying down debts more strongly than for more normal investors, for these reasons:<br />
* Money put toward debt can't later be inappropriately spent, or lost to bad investments or [[Asset protection|civil judgments]]. Historically, these have been common ways windfall recipients have squandered their fortunes.<br />
* Once a debt is paid off, cash flow improves as a required monthly payment is eliminated. This is especially valuable when the windfall is a lump sum.<br />
* The most common reason to invest instead of paying down a debt is the possibility for a higher return than the debt's interest cost. However, most windfall recipients are investment novices who are less likely to reliably generate high returns from their investments. This makes the protection of principal plus guaranteed "return" of paying down a debt more attractive in comparison.<br />
* Windfall recipients have less ''need'' to earn a high return, so the guaranteed "return" of paying off debts is more likely to be adequate.<br />
<br />
Similarly, windfall recipients should avoid taking on new debts (for example, a large mortgage on an expensive new home), because servicing that debt will require good financial behavior over a much longer period of time, with many more opportunities for mistakes.<br />
<br />
===Taxes===<br />
{{Main|Tax basics}}<br />
<br />
Due to the [[Progressive tax|progressive]] nature of the US income tax code, taxes become a more important element of financial planning with larger income and assets. Most windfall recipients will be able to reduce lifetime taxes with some basic tax planning. Common legal methods of reducing taxes include:<br />
* Optimally timing the exercise of incentive stock options, sale of stock, etc. <br />
* If applicable, appropriate choice of a lump-sum or periodic payment<br />
* Maximizing use of tax-advantaged accounts<br />
* Appropriate choice of [[Traditional versus Roth|traditional versus Roth]] tax structures<br />
* Investing in [[Municipal bonds|municipal bonds]] and/or [[Tax-managed fund comparison|tax-managed funds]] if the expected after-tax return is higher than standard investments<br />
* Taking advantage of [[Step-up in basis|step-up in basis]] and [[Donating appreciated securities|donating appreciated shares to charity]]<br />
* [[Tax loss harvesting]] and, if appropriate [[Tax gain harvesting|tax gain harvesting]]<br />
* [[Tax-efficient fund placement]]<br />
* Appropriately-timed [[Roth IRA conversion|Roth conversions]]<br />
* Relocating to a low-tax or tax-free state, especially when withdrawing from tax-deferred accounts.<br />
<br />
Avoid tax evasion schemes, including IRS listed transactions and offshore tax shelters, because these have a high risk of legal problems and IRS levies. Many scams are marketed as tax shelters too. Windfall recipients shouldn't need to take on these high risks in order to meet their financial goals. <br />
<br />
===Insurance===<br />
{{Main|Insurance}}<br />
<br />
As one's assets increase, most financial experts recommend increasing liability insurance limits. Large assets, especially if others know or can find out, make you a more attractive target for lawsuits, so more protection is warranted. High limits on the liability portions of renter's, homeowner's, and auto policies are the best place to start. For more coverage, [[Umbrella insurance|umbrella insurance]] provides millions of dollars of additional liability coverage, which stacks on top of other policies. <br />
<br />
More assets mean that insurance deductibles can be raised. There's no need to pay higher premiums on a $250 or $500 deductible when a large reserve of assets can cover a $1,000 or $2,500 payment. <br />
<br />
Reconsider the need for life insurance and disability insurance. If your heirs would be able to sustain an acceptable standard of living on the assets you have, you don't need life insurance. Likewise, if you could maintain a decent standard of living for yourself and your family on your assets with no income, you don't need disability insurance. Canceling these policies will save premium costs.<br />
<br />
[[Long-term care insurance]] is not necessary if the windfall allows you to self-insure against the risk.<br />
<br />
Permanent life insurance (including whole life, cash value life, indexed universal life, and others) is a hybrid insurance/investing financial product that is often marketed to high net worth individuals. In reality, the products have high fees and low liquidity, and are not ideal for either life insurance or investing; they are only appropriate for very rare situations. It's probably best to simply avoid permanent life insurance, but if you think it would be appropriate, get a second opinion from a third party fee-only financial advisor (preferably a fiduciary CFP or CFA advisor), and shop around from several insurance companies to make sure you get the best deal.<br />
<br />
If you have put off buying any essential insurance (health and liability, and [[Homeowner's insurance|homeowner's]], [[Professional insurance|professional/malpractice]], life and/or disability if appropriate), take this opportunity to fix this part of your financial picture.<br />
<br />
===Emergency Funds===<br />
{{Main|Emergency fund}}<br />
<br />
Once you get out of debt, you should create an emergency fund that covers about 6 months of living expenses. <ref>{{cite web|author=Miriam Caldwell|date=February 01, 2019|url=https://www.thebalance.com/what-should-i-do-with-a-sudden-windfall-2385942|title=What to Do With a Sudden Windfall?|publisher=the balance|access-date = May 30, 2020}}</ref><br />
<br />
The [[Deposit insurance|Federal Deposit Insurance Corporation (FDIC)]] insures bank accounts up to $250,000. If you are going to keep more than this amount in a bank account, consider dividing it among several accounts to keep your balance under this limit.<br />
<br />
===Asset Protection===<br />
{{Main|Asset protection}}<br />
<br />
Asset protection is a branch of financial planning that seeks to protect assets from potential creditor claims. For the majority of high net worth individuals, simple and inexpensive asset protection techniques and good financial behaviors in general will provide more than adequate protection:<br />
* Keep comprehensive liability insurance with high limits<br />
* Maximize use of tax-advantaged accounts<br />
* Pay off debts, and especially your mortgage if home equity is protected from creditors in your state<br />
* Avoid activities likely to create liability (risky driving habits, keeping dangerous dog breeds, letting your teenager's friends borrow your boat, etc.)<br />
* Minimize spending on flashy, expensive items that advertise your wealth<br />
* [[Asset titling in the United States|Title joint assets]] as Tenants of the Entirety (in states where allowed)<br />
* Keep potentially liability-generating assets, such as rental properties, inside a Limited Liability Corporation (LLC)<br />
* Divorce is the most common cause of loss of assets, so choose a spouse that shares your values, and invest the time and energy into the relationship necessary to keep it healthy. Consider whether a pre-nuptial or post-nuptial agreement is appropriate for your situation; they often are when there is a significant disparity in assets, or when a spouse has children from a prior relationship.<br />
<br />
More complex and expensive asset protection techniques, such as offshore trusts, cost tens of thousands of dollars to set up, and thousands of dollars per year to maintain. They are also far from iron-clad, and even their proponents concede that they are intended to only dissuade potential lawsuits rather than provide reliable protection. The cost/benefit trade-off is not favorable for most individuals.<br />
<br />
===Giving===<br />
<br />
Charitable giving can be a meaningful part of a financial plan. Especially if your windfall is large enough to at least cover your basic needs for the rest of your life, strongly consider at least some charitable giving for these reasons:<br />
* It can enrich your life and be incredibly rewarding to help those less fortunate than you<br />
* Giving can change your perspective on your new wealth for the better, and even help teach good financial management behaviors that will make your windfall last much longer. For example, rather than viewing money as something to be hoarded or spent on fleeting pleasures, you can grow to view it as a powerful force that can be applied to create good in your and your family's life, and in your community. Adopting a ''stewardship'' perspective on your windfall will create a positive experience when you give to promote your values, and will also encourage you to preserve and manage your windfall to last a lifetime. <br />
* Charitable gifts are tax-deductible, so charitable giving can be significantly (although not completely) offset by tax savings.<br />
<br />
Consider giving money to family or friends (to whom you would leave assets in your will) during your lifetime, rather than after you die. With life expectancies what they are today, your children could easily be in their 60's or 70's by the time you pass away, many decades past when they would be able to put a gift to the best use. Giving during your lifetime also lets you enjoy seeing the positive effects of those gifts.<br />
<br />
While giving to family, friends, and charities can be immensely rewarding, take care of yourself first. While your windfall may seem like more money than you will ever need, progressive tax rates and the need for a low [[Safe withdrawal rates|safe withdrawal rate]] may mean you have far less money available on an ongoing basis than you first imagined. It's okay to give, but it should be prioritized against other goals and included in a comprehensive plan.<br />
<br />
Carefully consider the effect any gifts or loans to family or friends could have on your relationships. Experience indicates that loans to family and friends often strain relationships, creating stress and resentment on both sides, especially if the loan is not paid back exactly in accordance to the agreement. Giving, rather than lending, is usually a better way to help that minimizes the impact to the relationship, and will also limit your outlay to what you can afford to lose. <br />
<br />
Giving can also damage relationships, especially when the recipient is merely a friend or acquaintance as opposed to close family. After receiving a large gift, the recipient may feel pressure to behave a certain way (eg. spending time with you when it's inconvenient for them), and you may also wonder whether their friendship is predicated on the expectation of gifts. <br />
<br />
Be extremely cautious giving or lending money to anyone with severe financial trouble, including close family and friends. Most likely, behavioral finance problems were the dominant cause of the trouble. Unless and until those problems are fixed, they will quickly be back in similar trouble, and any money you gave would likely be wasted on high-interest debts and unnecessary spending. Look for other ways to help, such as hiring them a [[#Get_help|good fee-only financial planner]] or even providing some financial advice yourself using your newly acquired knowledge, if you feel comfortable. Not everyone would be receptive to this type of help, and some people's behavioral finance problems are irreparable, so be prepared to disengage with them on financial topics and provide support through other facets of your relationship.<br />
<br />
===Estate Planning===<br />
{{Main|Estate planning}}<br />
<br />
Estate planning is the branch of financial planning dealing with preparing for one's own death and the associated distribution of assets, and also planning for one's own incapacity. Major goals of estate planning usually include:<br />
* Ensuring that your financial affairs are managed the way you want them to, in the event you become temporarily or permanently incapacitated<br />
* Ensuring that medical decisions are made in accordance with your wishes, if you are not able to make them yourself<br />
* Ensuring that your assets are distributed the way you want after you die<br />
* Avoiding [[Probate|probate]], which is expensive, time-consuming, and creates a public record of your assets<br />
* Minimizing taxes (income tax, estate tax, gift tax, inheritance tax, capital gains tax, etc.). As of 2021, the estate tax exemption is $11.7M for individuals and $23.4M for married couples; assets above these levels will probably require additional planning.<br />
* Arranging for guardians for any dependents in the event of your death or incapacity<br />
<br />
'''Trusts''' are common in estate planning, especially when large amounts of money are involved. A trust is a legal entity where assets maintained within the trust are managed and disbursed by the trustee for the benefit of the trust's beneficiary, according to the terms of the trust. Trusts can have a very wide variety of purposes and structures. Appropriate uses of trusts include:<br />
* Requiring assets willed to a beneficiary to be spent in a particular way that aligns with your values, for example, allowing trust funds to be spent only on higher education and certain other expenses<br />
* Distributing assets over a long period of time, rather than all at once, for example, to reduce the chance of mismanagement for a younger child or an heir without the capacity to manage a large amount of money<br />
* Avoiding [[Estate and inheritance tax|estate tax]], for example, with an Irrevocable Life Insurance Trust (ILIT)<ref>[https://www.kitces.com/blog/unwinding-irrevocable-life-insurance-trust-rescue-modification-termination/ Unwinding An “Irrevocable” Life Insurance Trust (ILIT) That’s No Longer Needed], Michael Kitces, Nerd's Eye View, December 12, 2018</ref>. A-B trusts were also commonly used for this purpose before the estate tax exemption became portable between spouses.<ref>[https://www.investopedia.com/terms/a/a-b-trust.asp A-B Trust Definition], from Investopedia.</ref><br />
<br />
Estate laws are state-specific, so consult an attorney in your state who specializes in estate planning. A good estate planning attorney will work with you to determine your needs in all these different areas, and create the documents and trusts you need to execute your estate plan.<br />
<br />
==Monitor progress and make necessary adjustments==<br />
<br />
At least once per year, check your your progress toward your goals, and consider the following checks and adjustments:<br />
* Check your actual spending against your planned budget. The tendency to gradually increase one's spending is known as ''lifestyle creep''. If you find your actual spending significantly exceeds your plan, evaluate the reasons why, and either reduce spending on the items that provide the least value, or adjust your financial plan to include higher spending. Raising your spending could delay or prevent you from reaching certain financial goals.<br />
* Monitor the performance of your investments and [[Rebalancing|rebalance]] as necessary. Avoid any temptation to panic-sell either at market highs or lows. [[Bogleheads®_investment_philosophy#Stay_the_course|Stay the course]].<br />
* Stay up-to-date on changes in tax laws, and change tax strategy if necessary.<br />
* Reevaluate your insurance needs, and shop around with other insurance companies to make sure you are getting the lowest rates on policies, especially if your situation has changed significantly. <br />
* Reevaluate your estate plan. Beneficiaries may need to be changed, new trusts may need to be created, or old trusts may no longer be necessary. Estate tax laws also change frequently, so changes may be needed to avoid taxes.<br />
<br />
Avoid the temptation to tinker with your plan and investments unnecessarily. Hot new investments often get covered by the press and on social media, usually after their price has been run up on speculation. Buying into the top of a bubble usually means you'll lose a lot of money when the bubble bursts. If you think your investment plan needs a change, it's probably worth a consultation with a fee-only financial advisor.<br />
<br />
==Notes==<br />
<references group="note"/><br />
<br />
==See also==<br />
*[[Financial planning]]<br />
*[[Financial planner]]<br />
*[[Investment adviser]]<br />
*[[Inheriting an IRA]]<br />
*[[Inheriting a Roth IRA]]<br />
<br />
==References==<br />
{{Reflist|30em}}<br />
<br />
==External links==<br />
* Vanguard [https://personal.vanguard.com/us/insights/article/yil-managing-windfalls-042014?&Link=home_banner1&LinkLocation=HomepageOverviewContent Your Investing Life: Managing Financial Windfalls]<br />
* {{Forum post|t = 316411 | title = Proposed update to Managing a Windfall wiki page | author = fyre4ce | date = June 01, 2020}}<br />
{{Bogleheads investing start-up kit}}<br />
[[Category:Personal finance]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=Managing_a_windfall&diff=71583Managing a windfall2021-01-28T01:16:43Z<p>Fyre4ce: Updated estate exemption for 2021</p>
<hr />
<div>A '''windfall''', in personal finance, is defined as a significant amount of money that a person gets unexpectedly. Windfalls can range in magnitude from small additions to an individual's wealth to large fortunes. Since small and large windfalls, both of which are addressed below, can mean huge changes in a recipient's life, psychological and emotional factors<ref group="note"> A wide range of responses can accompany a financial windfall. Persons who have experienced financial windfalls have shared that they’ve experienced some or many of the following emotions as they adjusted to their new circumstances.<br />
<br />
{| <br />
|+ '''Emotional reactions to windfalls '''Source: [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events], NEFE <br />
| style="width: 30%" |<br />
*Elation <br />
*Fear of loss of money<br />
*Fear of a change in relationships with others<br />
*Anxiety<br />
*Paralysis<br />
*Inability to see the money as a gift or an advantage<br />
*Not knowing what to do with the money<br />
|style="width: 30%"|<br />
*Depression<br />
*Resistance<br />
*Anger<br />
*Grief<br />
*Distrust<br />
*Numbness<br />
*Isolation<br />
|style="width: 30%"|<br />
*Feelings of unworthiness<br />
*Resentment<br />
*Lack of confidence<br />
*Guilt<br />
*Desire to give it all away<br />
*Intimidated<br />
*Lack of identify<br />
*Sense of loss<br />
|}<br />
</ref> are often the most important factors determining outcomes. The National Endowment for Financial Education advises windfall recipients to take the following course of action.<ref name="NEFE">[http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events], NEFE </ref><br />
<br />
Do nothing rash. Set aside one year's living expenses and place the rest of the windfall into low risk investments (FDIC insured accounts, money market funds, treasury bills) for one year. As it may take as long as five years for the windfall recipient to adjust to a new life, this pause provides a chance for emotions to cool, helps avoid impulsive behavior, and, if warranted, allows the recipient time to put together a team of professional advisers. Then, create a detailed plan to meet your highest priority financial goals, and track your progress over the years. <br />
{{Notice|"Most financial practitioners agree that well over 50 percent [of windfalls] are lost in a relatively short period of time. NBC News reported that more than 70 percent of lottery winners exhaust their fortunes within three years." -''Larimore, Lindauer, and LeBoeuf (2006). The Bogleheads' Guide to Investing. Chapter 15, p.180: Wiley. ISBN 978-0471730330.''}}<br />
<br />
==Common sources of windfalls==<br />
Windfalls come in many forms. Here are some common types:<br />
<br />
* '''Legal settlements''' : Settlements include personal injury settlements, settlements involving workers compensation and settlements of employment discrimination. Settlements are taken as either a lump sum or, alternately, as a structured settlement of annuity payments.<br />
* '''Inheritances''': These can often involve retirement accounts and assets held in trust.<br />
* '''Gifts''': These can range from annual gift exclusions up to the lifetime estate taxation credit limit.<br />
* '''Lottery winnings''': Taken as a series of payments; or as the sales value of payments exchanged for a lump sum.<br />
* '''Insurance settlements''': These can be in the form of death benefits received as either a lump sum or annuity; as pre-death cash surrender values; or as life settlements, the sale of a life insurance policy by the owner to a third party in exchange for a lump sum.<br />
* '''Retirement lump sums''': Usually taken in lieu of a lifetime series of annuity payments<br />
* '''Sudden increases in income''': These can come in the form of bonus payments; stock options; or cashing shares in an IPO.<br />
<br />
While not being external sources of new wealth, other common sources of receiving large lump sums include the following:<ref name="Guide">Larimore, Lindauer, and LeBoeuf (2006). ''The Bogleheads' Guide to Investing''. Chapter 15: Wiley. ISBN 978-0471730330. </ref><br />
* A real estate sale<br />
* The sale of a business<br />
* Widowhood and divorce<br />
<br />
Sales of businesses and real estate involve the conversion of an illiquid asset into large sums of fungible cash. Death and divorce not only cause dislocation and trauma, but often result in suddenly thrusting an individual who has had little or no interest or no experience in investing, into the position of managing family wealth.<br />
<br />
==Size of a windfall==<br />
<br />
Windfall sizes vary dramatically. A small windfall might bring you a step closer to your financial goals, a bigger one may make you financially independent, and an enormous windfall might be more money than you ever imagined spending. Windfall size is somewhat relative to your income and assets; what would be a life-changing amount of money for one person might be only accelerate someone else's mortgage payoff by a few years. Some thresholds are more absolute, such as the federal estate tax exemption ($11.7M for singles and $23.4M for married couples as of 2021<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Estate tax], IRS</ref>); financial planners generally agree that additional planning is necessary with assets above this level.<br />
<br />
This wiki page will intends to provide guidance for windfalls that are ''relatively'' large compared to one's income and assets, enough to entail significant lifestyle changes and the need for additional planning. The guidance presented is intended to apply to a wide variety of windfall types, sources, and absolute sizes. Readers are encouraged to consider the guidance that applies to their individual situation.<br />
<br />
==Common pitfalls==<br />
<br />
Among windfall recipients, common errors of commission include:<ref> [http://www.stephenlnelson.com/WindfallFinancialPlanning.htm Financial Planning for a Windfall in Wealth: Lotteries, Stock Options, Inheritances and Other Surprises], Stephen L. Nelson, CPA, PLLC. </ref><br />
<br />
* quitting one's job prematurely<br />
* buying extravagantly priced automobiles or properties, or engaging in other expensive consumption spending<br />
* feeling overconfident about one's business or investing acumen, resulting in jumping into new high risk investments (such as hedge funds) or as an "angel" investor in start-up companies<br />
* falling prey to overcomplicated estate and investment management schemes. Be on the alert for people who may be trying to exploit you or take advantage of your new wealth. It’s important to recognize that you can be a target for all kinds of financial schemes. <br />
* by being too generous to family, friends, and charities<br />
<br />
Common errors of omission include failing to:<br />
<br />
* pay the legally required taxes<br />
* choose risk-appropriate investments and earn a reasonable return on invested capital<br />
* utilize appropriate accounts such as retirement plans<br />
* engage with the right professionals<br />
* set up the appropriate plans, including estate plans<br />
<br />
==Preparing==<br />
<br />
These initial steps will help put you in a position to manage a life-changing amount of money: <br />
<br />
===Take your time===<br />
<br />
Finance authorities are in agreement that avoiding immediate impulse decisions is key to prudent management of the windfall situation. Among the recommendations for this period are the following:<br />
* Tell as few people as possible. Unfortunately, even those close to you may become resentful or solicit you for gifts when they hear about your windfall. You can always tell people later on when you've had time to consider the effect that information may have on your relationships. <br />
* Set aside six months to one year's worth of expenses in a transaction account such as your checking account. Place the remaining windfall assets in separate accounts holding secure low-risk savings vehicles, such as FDIC guaranteed bank accounts and [[Certificate of Deposit|CD]]s, [[Money Markets|money market funds]], and [[Treasury bill|treasury bills]]. <br />
* Use this period of time to begin resolving emotional, family, and social issues. Different sources of windfall, such as the death of a loved one, may have powerful emotional consequences that you should focus on addressing, while spending minimal time worrying about finances. Coming to terms with your emotions will allow you to make better financial decisions.<ref group="note"> The emotional and social issues surrounding windfalls are explored in greater detail in the following links:<br />
* [http://www.amydomini.com/howview How You View Yourself], Amy Domini, Sharon Rich, and Dennis Pearne: Excerpted from ''The Challenges of Wealth'' (Homewood, Ill.: Dow Jones Irwin, 1988), a book on the psychology of wealth.<br />
* [http://www.bankrate.com/finance/personal-finance/4-steps-to-profit-from-a-windfall-1.aspx 4 steps to profit from a financial windfall] examines emotional issues involving individual behavior, family dynamics, and inheritance.<br />
* [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events] is a good general guide.<br />
* [http://www4.gsb.columbia.edu/filemgr?file_id=7217585 Entrepreneurs: Life after Exit] examines issues involved in selling businesses.</ref> <br />
* Hire a competent and unbiased tax professional, such as Certified Public Accountant (CPA), if you don't already have one. Estimated taxes may need to be filed. Complex tax issues may surround distributions from retirement plans, inheritances, and lottery winnings, as well as the exercise of stock options. If you're not sure if your windfall has tax consequences, many tax professionals will be willing to give you a free consultation, and prefer someone who doesn't sell investment products.<br />
* If you have more complex finance issues that should not wait at least 6-12 months, skip ahead to the ''[[#Get_help|Get help]]'' step and pay a fair hourly rate for consultation from a fiduciary financial advisor, preferably one with a CFP or CFA certification. Urgent financial issues include needing to decide whether to receive a lump sum or annuity stream; having a large amount of high-interest debt; or facing imminent eviction, foreclosure, or collection action due to delinquent debts. The focus of the consultation should just be resolving your urgent issues, not necessarily developing a complete financial plan or investing capital. The goal isn't to begin putting your money to work, but rather to reduce stress and distractions by stabilizing your financial situation. Only make the minimum payments that will allow you to focus on the future, and don't redirect payments from paid-off debts to more spending.<br />
<br />
====Lump sum vs. annuity====<br />
{{Main|Lump sum vs pension}}<br />
<br />
The choice of a lump sum or a stream of payments can be a complex one with many influencing factors, such as your financial goals, expected investment performance, taxes, inflation protection, life expectancy, estate planning goals, financial health of the annuity provider, and others. If you are at all unsure of the best course of action, a consultation with a fee-only fiduciary financial advisor would be extremely valuable. However, most windfall recipients should lean strongly toward choosing the annuity, for these reasons:<br />
<br />
* The windfall is much less likely to be squandered: a lump sum can be squandered by just one bad financial decision, whereas squandering an annuity would require a series of many bad choices, and not learning from prior mistakes.<br />
* The most common reason to choose a lump sum is the expectation of a higher rate of return than the effective rate of return of the annuity. However, most windfall recipients are investment novices who are less likely to reliably generate high returns from their investments. This makes the protection of principal plus guaranteed return of the annuity more attractive in comparison.<br />
* Windfall recipients have less ''need'' to earn a high return, so the guaranteed return of the annuity is more likely to be adequate to support a comfortable and prosperous lifestyle.<br />
<br />
Note that this reasoning is very similar to why windfall recipients should [[#Debts|pay off existing debts and avoid taking on new ones]]. These are in addition to any more general reasons that may apply, such as tax savings.<br />
<br />
===Think about goals===<br />
<br />
Begin to think about long term goals, with more focus on the life you would like to create and (for now) less focus about how to achieve it. Some ideas for goals that may be meaningful:<br />
<br />
* Retiring, either in the short or long term<br />
* Cutting back hours at work, and/or dropping less desirable shifts/jobs<br />
* Changing jobs<br />
* Starting a business<br />
* Going back to school, either to pursue a new career or just for enjoyment<br />
* Saving money for benefit of a loved one ([[529 plan]] for education, trust fund, helping pay for a wedding or house down payment, etc.)<br />
* Moving to another city, or country<br />
* Paying off debts<br />
* Certain consumer purchases<br />
* Purchasing real estate<br />
* Traveling<br />
* Taking up a new hobby<br />
* Growing your family<br />
* Donating to charity<br />
* Volunteering your time<br />
<br />
Even a very large windfall will likely not be enough to fully fund all or even most of these goals, so it's important to prioritize your goals, both in terms of overall priority, and the time it will take you to reach them. Many financial novices are surprised how ''little'' of a windfall they are actually able to spend immediately. For example, a $1M windfall will only generate about $30-40,000 per year of investment income over the long run, so initial spending will need to be limited so the windfall can provide a lasting improvement in lifestyle. Specific goals, and allocation of money toward them, will be formalized later in a written financial plan.<br />
<br />
===Get educated===<br />
<br />
Like it or not, you now have a new job (in addition to any other jobs you may already have) - learning how to manage money. Whether or not you are inclined to "do-it-yourself", you will need at least the knowledge necessary to evaluate financial professionals. Educating yourself on personal finance and investing will likely be, by far, the most money you will ever "earn" per hour, if it makes the difference between lifelong prosperity and a fortune squandered within a few years. <br />
<br />
* Read some [[Books: Recommendations and Reviews|recommended books]] on personal finance and investing. Reading at least three, that cover the topics of personal finance and investing, would be a good start.<br />
* Browse the rest of the [https://www.bogleheads.org/wiki/Main_Page Bogleheads wiki]. Many pages are meant to be accessible to those with little or no investing experience.<br />
<br />
===Get help===<br />
<br />
Unless you are already an experienced investor, it may be beneficial to hire a professional, at least for some initial guidance. Should you decide to use an adviser, the authors of ''The Bogleheads' Guide to Investing'' (Chapter 16, p.193: Wiley. ISBN 978-0471730330) recommend choosing an adviser who has earned a CFA (Chartered Financial Analyst) or a CFP (Chartered Financial Planner) designation; uses a fee-only payment arrangement; and advocates an index fund investing approach. The fee-only compensation structure minimizes the advisor's conflicts of interest with respect to your financial success. A good financial advisor should be able to do the following:<br />
<br />
* Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package<br />
* Strategize about how to minimize taxes owed<br />
* Recommend an investment strategy<br />
* Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed<br />
* Determine whether you need to enlist an estate planning attorney<ref group="note"> The authors of ''The Bogleheads' Guide to Investing'' (Chapter 15, p.185: Wiley. ISBN 978-0471730330) recommend [http://www.martindale.com/ Martindale & Hubble] for checking out the credentials of an attorney. </ref> <br />
You can get free portfolio reviews and answers to personal finance questions on the [https://www.bogleheads.org/forum/index.php Bogleheads forums]. Most forum members are not finance professionals, but are nonetheless experienced investors, and as a whole have managed an enormous range of income and assets.<br />
<br />
Whether to retain a [https://www.bogleheads.org/wiki/Financial_planner financial planner] for a long time, or do your own investing using the [https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investment_philosophy Bogleheads® investment philosophy] or similar, is a personal choice. When you have time, consider the [https://www.bogleheads.org/wiki/Getting_started "getting started"] wiki article (and the rest of this one). The more you learn, the better you will be able to judge whether an advisor is worth the cost to you.<br />
<br />
==Creating a plan==<br />
<br />
{{Quotation|Once you begin to become comfortable in your new financial reality, you may be ready for the successive phases, which include reviewing your situation and deciding how the money will be used. This is the fun part, when you'll choose -- with the help of... a solid financial plan -- whether to retire, buy a vacation home, donate to charities or set up trust funds for your children. The ultimate goal of all these steps is to create a sensible plan for handling your windfall that also allows you to come out with your relationships and sanity intact.|Susan Bradley|[http://www.bankrate.com/finance/personal-finance/4-steps-to-profit-from-a-windfall-1.aspx#ixzz25oVhMsH4 4 steps to profit from a financial windfall]}}<br />
<br />
[[Financial planning|Financial planning]] is a ''long-term'' process<ref group="note">Sound financial planning incorporates these steps: <br />
#Establish a relationship with a CFP professional<br />
#Gather your data and develop your financial goals<br />
#Analyze and evaluate your financial status<br />
#Review your CFP professional’s recommendations<br />
#Set your course<br />
#Benchmark your progress against the financial goals you established<br />
Source: [https://www.letsmakeaplan.org/other-resources/financial-planning-process Financial Planning Process], by the [https://www.letsmakeaplan.org Certified Financial Planner Board of Standards, Inc.]</ref> of managing your finances so you can achieve your goals and dreams, while at the same time negotiating the financial barriers that inevitably arise in every stage of life. Fundamentally, the process for financial planning after receiving a windfall is the same as in any other situation. The only differences are:<br />
<br />
* Larger amounts of money increase the relative importance of certain aspects of financial planning, such as tax planning and [[Tax-efficient fund placement|tax-efficient investing]], [[Index fund|minimizing investment costs]], [[Asset protection|asset protection]], and [[Estate planning|estate planning]].<br />
* The windfall recipient is often thrust into a situation where they're required to manage a large amount of money without having the necessary skills, knowledge, and experience. <br />
* Serious emotional impacts often surround windfalls, which must be dealt with concurrently with financial planning.<br />
* The consequences of financial mistakes are higher, in terms of absolute dollars, with larger amounts of money.<br />
<br />
The core of the financial planning process is matching your goals, and the financial resources they will likely require, with your available resources, which can come from your present resources, but also future investment proceeds and any future earnings. This matching will require knowledge of the costs of your goals (both up-front and ongoing), how much of your available funds will need to go to taxes, and expected returns on various types of investments. Goals should be prioritized, and these priorities should be weighted by the amount of financial resources it will take to meet them. The end product of this process is a detailed financial plan that lists your goals, describes ''when'' and ''how'' you expect to meet them, and that is robust to factors beyond your control, such as job loss, unexpected expenses, and market swings. A complete financial plan should address all of the following areas:<br />
<br />
===Work, Income, and Education===<br />
<br />
If you are currently working, plan how long you will continue to work. If retirement is a high priority, and your windfall allows you to live off investment income with a [[Safe withdrawal rates|safe withdrawal rate]] (typically 3-4%), then you may be able to retire immediately. If you continue to work, include your expected future income in your financial plan.<br />
<br />
The windfall may provide you the opportunity to change jobs, start your own business, or get additional training that would enable a new career, so consider whether these options are desirable.<br />
<br />
===Location===<br />
<br />
Decide where you would like to live, and include in your plan costs with moving and residing there. Typically the largest financial factors connected to location are available jobs, cost of living (particularly housing), state and local taxes, and proximity to family (which can affect travel and childcare costs). <br />
<br />
Your plan should include a location while working (if appropriate), and while retired. Differences in income tax rates can affect [[Traditional versus Roth|traditional versus Roth]] decisions.<br />
<br />
===Spending===<br />
<br />
Create a [[Household budgeting|written budget]] that includes allocations for meaningful categories of expense (food, transportation, etc.), and has some cushion for unexpected changes. Everyone needs a budget, no matter how much money they have. <br />
<br />
Include any immediate or planned future purchases, such as replacing an aging car immediately, or when it will reach the end of its life, and include saving for future purchases in the plan.<br />
<br />
Consider both the up-front and ongoing costs of purchases. For example, windfall recipients often do not consider the ongoing costs associated with expensive properties (property tax, maintenance, utilities, cleaning) or vehicles (fuel, insurance, maintenance, storage for the winter, etc.), which can be substantial.<br />
<br />
Resist the temptation to spend a significant portion of a windfall on short-term consumption spending. The enjoyment you'll get from investing and spending the windfall over a long period of time, and the comfort from having financial security, will likely far outweigh that from any consumer purchases.<br />
<br />
===Accounts===<br />
<br />
Understand the different types of tax-advantaged accounts available to you ([[401(k)]], [[IRA]], [[HSA]], [[529 plan]], [[Defined benefit pension plan]], etc.) and plan on using those that give you the greatest advantage. <br />
<br />
[[Variable Annuity|Variable annuities (VAs)]] are usually high-fee products marketed by commissioned salespeople, which are inferior to tax-advantaged accounts and [[Taxable account|taxable accounts]] and are best avoided. However, ''low-cost'' VAs can make sense for some windfall recipients. If you receive a large lump sum windfall that cannot be [[IRA rollovers and transfers|rolled over]] into an [[IRA]], and you intend to invest in [[Tax-efficient fund placement|tax-inefficient investments]], a low-cost VA will allow you to defer taxes on interest, dividends, and capital gains. The tax deferral ''may'' offset the VA fees, which are around 0.25%/year for a good low-cost VA, such as from [https://www.fidelity.com/annuities/FPRA-variable-annuity/overview Fidelity]. If you think a low-cost VA may be appropriate, consult with a third party fee-only financial advisor, who can help make sure the VA you're considering is well-suited for you and not fee-laden. See also: [[Non-deductible_traditional_IRA#Comparison_between_non-deductible_tIRA_and_taxable_accounts|performance comparison between non-deductible IRAs and taxable accounts]] (non-deductible IRAs have the same tax structure as VAs). <br />
<br />
Make sure any withdrawal restrictions (eg. penalties for non-qualified withdrawals from a 401(k) or IRA before age 59½) fit into your overall financial plan.<br />
<br />
===Investments===<br />
{{Notice|For further guidance involving the selection of an investment portfolio refer to these pages:<br />
*[[Bogleheads® investment philosophy]]: This page explains the basic principles advocated by this site.<br />
*[[Asset allocation]]: this page explains the process of dividing an investment portfolio among different asset categories depending on the need, ability and willingness of the investor to take risk.<br />
*[[Three-fund portfolio]]: This page explains a simple portfolio popular with many of this site's members.<br />
*[[Lazy Portfolios]]: This page contains a number of widely diversified portfolios.}}<br />
<br />
Investing capital, and earning a good rate of return for an appropriate level of risk, is an essential component of almost all financial plans. Appropriate investments are strongly dependent on the time horizon of the goal being saved for. For example:<br />
* Short-term goals, within the next 3 years, should be saved for using low-risk and low-volatility investments, such as savings accounts, [[Money markets|money market]] accounts or funds, [[Certificate of deposit|certificates of deposit (CDs)]], or short-term bonds. <br />
* Medium-term goals, in the 3-10 year range, can be saved for with slightly more volatile investments, such as intermediate-term [[Bond basics|bonds]], and could include a small percentage of [[Stock basics|stocks]].<br />
* Long-term goals, 10 or more years away, can contain a large percentage of higher-volatility higher-return investments like [[Stock basics|stocks]] and real estate. <br />
<br />
Other key factors for choosing investments are need and willingness to take risk, and the consequences of falling short; see [[Asset allocation|asset allocation]] for a more detailed discussion.<br />
<br />
Stock and bond investments should generally be purchased through [[Index fund|low-cost passive mutual funds]] for [[Diversification|diversification]], [[Expense ratios|reduced costs]], and higher [[Tax-efficient fund placement|tax efficiency in a taxable account]]. Avoid purchasing individual stocks, due to the high volatility and risk of permanent loss.<br />
<br />
Windfall recipients should be especially cautious with high-risk investments (private equity, startup companies, etc.) that have a significant possibility of a total loss. Most windfall recipients don't have the necessary experience to properly evaluate high-risk investments, and also don't have the need for higher than market returns. Windfall recipients are also often the targets of bad investments or scams, so limiting investments to diversified funds from respectable institutions reduces this risk.<br />
<br />
Once you have made your investment decisions these should be formalized in an [[Investment policy statement]] (IPS) or [[Investment Policy Statement#Investing plan | Investment plan]].<br />
<br />
===Debts===<br />
{{Main|Prioritizing investments}}<br />
<br />
All financial plans should include a list of all current debts and a plan to pay them off. Medium- and high-interest debts, such as credit card debts, should be paid off quickly. See also: [[Paying down loans versus investing]].<br />
<br />
Most windfall recipients should prioritize eliminating all debts, even low-interest ones, because the balance versus investing favors paying down debts more strongly than for more normal investors, for these reasons:<br />
* Money put toward debt can't later be inappropriately spent, or lost to bad investments or [[Asset protection|civil judgments]]. Historically, these have been common ways windfall recipients have squandered their fortunes.<br />
* Once a debt is paid off, cash flow improves as a required monthly payment is eliminated. This is especially valuable when the windfall is a lump sum.<br />
* The most common reason to invest instead of paying down a debt is the possibility for a higher return than the debt's interest cost. However, most windfall recipients are investment novices who are less likely to reliably generate high returns from their investments. This makes the protection of principal plus guaranteed "return" of paying down a debt more attractive in comparison.<br />
* Windfall recipients have less ''need'' to earn a high return, so the guaranteed "return" of paying off debts is more likely to be adequate.<br />
<br />
Similarly, windfall recipients should avoid taking on new debts (for example, a large mortgage on an expensive new home), because servicing that debt will require good financial behavior over a much longer period of time, with many more opportunities for mistakes.<br />
<br />
===Taxes===<br />
{{Main|Tax basics}}<br />
<br />
Due to the [[Progressive tax|progressive]] nature of the US income tax code, taxes become a more important element of financial planning with larger income and assets. Most windfall recipients will be able to reduce lifetime taxes with some basic tax planning. Common legal methods of reducing taxes include:<br />
* Optimally timing the exercise of incentive stock options, sale of stock, etc. <br />
* If applicable, appropriate choice of a lump-sum or periodic payment<br />
* Maximizing use of tax-advantaged accounts<br />
* Appropriate choice of [[Traditional versus Roth|traditional versus Roth]] tax structures<br />
* Investing in [[Municipal bonds|municipal bonds]] and/or [[Tax-managed fund comparison|tax-managed funds]] if the expected after-tax return is higher than standard investments<br />
* Taking advantage of [[Step-up in basis|step-up in basis]] and [[Donating appreciated securities|donating appreciated shares to charity]]<br />
* [[Tax loss harvesting]] and, if appropriate [[Tax gain harvesting|tax gain harvesting]]<br />
* [[Tax-efficient fund placement]]<br />
* Appropriately-timed [[Roth IRA conversion|Roth conversions]]<br />
* Relocating to a low-tax or tax-free state, especially when withdrawing from tax-deferred accounts.<br />
<br />
Avoid tax evasion schemes, including IRS listed transactions and offshore tax shelters, because these have a high risk of legal problems and IRS levies. Many scams are marketed as tax shelters too. Windfall recipients shouldn't need to take on these high risks in order to meet their financial goals. <br />
<br />
===Insurance===<br />
{{Main|Insurance}}<br />
<br />
As one's assets increase, most financial experts recommend increasing liability insurance limits. Large assets, especially if others know or can find out, make you a more attractive target for lawsuits, so more protection is warranted. High limits on the liability portions of renter's, homeowner's, and auto policies are the best place to start. For more coverage, [[Umbrella insurance|umbrella insurance]] provides millions of dollars of additional liability coverage, which stacks on top of other policies. <br />
<br />
More assets mean that insurance deductibles can be raised. There's no need to pay higher premiums on a $250 or $500 deductible when a large reserve of assets can cover a $1,000 or $2,500 payment. <br />
<br />
Reconsider the need for life insurance and disability insurance. If your heirs would be able to sustain an acceptable standard of living on the assets you have, you don't need life insurance. Likewise, if you could maintain a decent standard of living for yourself and your family on your assets with no income, you don't need disability insurance. Canceling these policies will save premium costs.<br />
<br />
[[Long-term care insurance]] is not necessary if the windfall allows you to self-insure against the risk.<br />
<br />
Permanent life insurance (including whole life, cash value life, indexed universal life, and others) is a hybrid insurance/investing financial product that is often marketed to high net worth individuals. In reality, the products have high fees and low liquidity, and are not ideal for either life insurance or investing; they are only appropriate for very rare situations. It's probably best to simply avoid permanent life insurance, but if you think it would be appropriate, get a second opinion from a third party fee-only financial advisor (preferably a fiduciary CFP or CFA advisor), and shop around from several insurance companies to make sure you get the best deal.<br />
<br />
If you have put off buying any essential insurance (health and liability, and [[Homeowner's insurance|homeowner's]], [[Professional insurance|professional/malpractice]], life and/or disability if appropriate), take this opportunity to fix this part of your financial picture.<br />
<br />
===Emergency Funds===<br />
{{Main|Emergency fund}}<br />
<br />
Once you get out of debt, you should create an emergency fund that covers about 6 months of living expenses. <ref>{{cite web|author=Miriam Caldwell|date=February 01, 2019|url=https://www.thebalance.com/what-should-i-do-with-a-sudden-windfall-2385942|title=What to Do With a Sudden Windfall?|publisher=the balance|access-date = May 30, 2020}}</ref><br />
<br />
The [[Deposit insurance|Federal Deposit Insurance Corporation (FDIC)]] insures bank accounts up to $250,000. If you are going to keep more than this amount in a bank account, consider dividing it among several accounts to keep your balance under this limit.<br />
<br />
===Asset Protection===<br />
{{Main|Asset protection}}<br />
<br />
Asset protection is a branch of financial planning that seeks to protect assets from potential creditor claims. For the majority of high net worth individuals, simple and inexpensive asset protection techniques and good financial behaviors in general will provide more than adequate protection:<br />
* Keep comprehensive liability insurance with high limits<br />
* Maximize use of tax-advantaged accounts<br />
* Pay off debts, and especially your mortgage if home equity is protected from creditors in your state<br />
* Avoid activities likely to create liability (risky driving habits, keeping dangerous dog breeds, letting your teenager's friends borrow your boat, etc.)<br />
* Minimize spending on flashy, expensive items that advertise your wealth<br />
* [[Asset titling in the United States|Title joint assets]] as Tenants of the Entirety (in states where allowed)<br />
* Keep potentially liability-generating assets, such as rental properties, inside a Limited Liability Corporation (LLC)<br />
* Divorce is the most common cause of loss of assets, so choose a spouse that shares your values, and invest the time and energy into the relationship necessary to keep it healthy. Consider whether a pre-nuptial or post-nuptial agreement is appropriate for your situation; they often are when there is a significant disparity in assets, or when a spouse has children from a prior relationship.<br />
<br />
More complex and expensive asset protection techniques, such as offshore trusts, cost tens of thousands of dollars to set up, and thousands of dollars per year to maintain. They are also far from iron-clad, and even their proponents concede that they are intended to only dissuade potential lawsuits rather than provide reliable protection. The cost/benefit trade-off is not favorable for most individuals.<br />
<br />
===Giving===<br />
<br />
Charitable giving can be a meaningful part of a financial plan. Especially if your windfall is large enough to at least cover your basic needs for the rest of your life, strongly consider at least some charitable giving for these reasons:<br />
* It can enrich your life and be incredibly rewarding to help those less fortunate than you<br />
* Giving can change your perspective on your new wealth for the better, and even help teach good financial management behaviors that will make your windfall last much longer. For example, rather than viewing money as something to be hoarded or spent on fleeting pleasures, you can grow to view it as a powerful force that can be applied to create good in your and your family's life, and in your community. Adopting a ''stewardship'' perspective on your windfall will create a positive experience when you give to promote your values, and will also encourage you to preserve and manage your windfall to last a lifetime. <br />
* Charitable gifts are tax-deductible, so charitable giving can be significantly (although not completely) offset by tax savings.<br />
<br />
Consider giving money to family or friends (to whom you would leave assets in your will) during your lifetime, rather than after you die. With life expectancies what they are today, your children could easily be in their 60's or 70's by the time you pass away, many decades past when they would be able to put a gift to the best use. Giving during your lifetime also lets you enjoy seeing the positive effects of those gifts.<br />
<br />
While giving to family, friends, and charities can be immensely rewarding, take care of yourself first. While your windfall may seem like more money than you will ever need, progressive tax rates and the need for a low [[Safe withdrawal rates|safe withdrawal rate]] may mean you have far less money available on an ongoing basis than you first imagined. It's okay to give, but it should be prioritized against other goals and included in a comprehensive plan.<br />
<br />
Carefully consider the effect any gifts or loans to family or friends could have on your relationships. Experience indicates that loans to family and friends often strain relationships, creating stress and resentment on both sides, especially if the loan is not paid back exactly in accordance to the agreement. Giving, rather than lending, is usually a better way to help that minimizes the impact to the relationship, and will also limit your outlay to what you can afford to lose. <br />
<br />
Giving can also damage relationships, especially when the recipient is merely a friend or acquaintance as opposed to close family. After receiving a large gift, the recipient may feel pressure to behave a certain way (eg. spending time with you when it's inconvenient for them), and you may also wonder whether their friendship is predicated on the expectation of gifts. <br />
<br />
Be extremely cautious giving or lending money to anyone with severe financial trouble, including close family and friends. Most likely, behavioral finance problems were the dominant cause of the trouble. Unless and until those problems are fixed, they will quickly be back in similar trouble, and any money you gave would likely be wasted on high-interest debts and unnecessary spending. Look for other ways to help, such as hiring them a [[#Get_help|good fee-only financial planner]] or even providing some financial advice yourself using your newly acquired knowledge, if you feel comfortable. Not everyone would be receptive to this type of help, and some people's behavioral finance problems are irreparable, so be prepared to disengage with them on financial topics and provide support through other facets of your relationship.<br />
<br />
===Estate Planning===<br />
{{Main|Estate planning}}<br />
<br />
Estate planning is the branch of financial planning dealing with preparing for one's own death and the associated distribution of assets, and also planning for one's own incapacity. Major goals of estate planning usually include:<br />
* Ensuring that your financial affairs are managed the way you want them to, in the event you become temporarily or permanently incapacitated<br />
* Ensuring that medical decisions are made in accordance with your wishes, if you are not able to make them yourself<br />
* Ensuring that your assets are distributed the way you want after you die<br />
* Avoiding [[Probate|probate]], which is expensive, time-consuming, and creates a public record of your assets<br />
* Minimizing taxes (income tax, estate tax, gift tax, inheritance tax, capital gains tax, etc.). As of 2021, the estate tax exemption is $11.7M for individuals and $23.4M for married couples; assets above these levels will probably require additional planning.<br />
* Arranging for guardians for any dependents in the event of your death or incapacity<br />
<br />
'''Trusts''' are common in estate planning, especially when large amounts of money are involved. A trust is a legal entity where assets maintained within the trust are managed and disbursed by the trustee for the benefit of the trust's beneficiary, according to the terms of the trust. Trusts can have a very wide variety of purposes and structures. Appropriate uses of trusts include:<br />
* Requiring assets willed to a beneficiary to be spent in a particular way that aligns with your values, for example, allowing trust funds to be spent only on higher education and certain other expenses<br />
* Distributing assets over a long period of time, rather than all at once, for example, to reduce the chance of mismanagement for a younger child or an heir without the capacity to manage a large amount of money<br />
* Avoiding [[Estate and inheritance tax|estate tax]], for example, with an Irrevocable Life Insurance Trust (ILIT)<ref>[https://www.kitces.com/blog/unwinding-irrevocable-life-insurance-trust-rescue-modification-termination/ Unwinding An “Irrevocable” Life Insurance Trust (ILIT) That’s No Longer Needed], Michael Kitces, Nerd's Eye View, December 12, 2018</ref>. A-B trusts were also commonly used for this purpose before the estate tax exemption became portable between spouses.<ref>[https://www.investopedia.com/terms/a/a-b-trust.asp A-B Trust Definition], from Investopedia.</ref><br />
<br />
Estate laws are state-specific, so consult an attorney in your state who specializes in estate planning. A good estate planning attorney will work with you to determine your needs in all these different areas, and create the documents and trusts you need to execute your estate plan.<br />
<br />
==Monitor progress and make necessary adjustments==<br />
<br />
At least once per year, check your your progress toward your goals, and consider the following checks and adjustments:<br />
* Check your actual spending against your planned budget. The tendency to gradually increase one's spending is known as ''lifestyle creep''. If you find your actual spending significantly exceeds your plan, evaluate the reasons why, and either reduce spending on the items that provide the least value, or adjust your financial plan to include higher spending. Raising your spending could delay or prevent you from reaching certain financial goals.<br />
* Monitor the performance of your investments and [[Rebalancing|rebalance]] as necessary. Avoid any temptation to panic-sell either at market highs or lows. [[Bogleheads®_investment_philosophy#Stay_the_course|Stay the course]].<br />
* Stay up-to-date on changes in tax laws, and change tax strategy if necessary.<br />
* Reevaluate your insurance needs, and shop around with other insurance companies to make sure you are getting the lowest rates on policies, especially if your situation has changed significantly. <br />
* Reevaluate your estate plan. Beneficiaries may need to be changed, new trusts may need to be created, or old trusts may no longer be necessary. Estate tax laws also change frequently, so changes may be needed to avoid taxes.<br />
<br />
Avoid the temptation to tinker with your plan and investments unnecessarily. Hot new investments often get covered by the press and on social media, usually after their price has been run up on speculation. Buying into the top of a bubble usually means you'll lose a lot of money when the bubble bursts. If you think your investment plan needs a change, it's probably worth a consultation with a fee-only financial advisor.<br />
<br />
==Notes==<br />
<references group="note"/><br />
<br />
==See also==<br />
*[[Financial planning]]<br />
*[[Financial planner]]<br />
*[[Investment adviser]]<br />
*[[Inheriting an IRA]]<br />
*[[Inheriting a Roth IRA]]<br />
<br />
==References==<br />
{{Reflist|30em}}<br />
<br />
==External links==<br />
* Vanguard [https://personal.vanguard.com/us/insights/article/yil-managing-windfalls-042014?&Link=home_banner1&LinkLocation=HomepageOverviewContent Your Investing Life: Managing Financial Windfalls]<br />
* {{Forum post|t = 316411 | title = Proposed update to Managing a Windfall wiki page | author = fyre4ce | date = June 01, 2020}}<br />
{{Bogleheads investing start-up kit}}<br />
[[Category:Personal finance]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71361User:Fyre4ce/Traditional versus Roth2021-01-19T20:46:30Z<p>Fyre4ce: Moved up Common Misconceptions one level of hierarchy</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you (or your heirs, if you are [[#Estate_planning|estate planning]]) more spendable income after all taxes are paid. Preference for one tax structure or another is under the broader umbrella of [https://www.investopedia.com/terms/t/tax-planning.asp tax planning].<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement.<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a [[#Calculating_marginal_tax_rate_now|known tax rate now]] vs. an [[#Estimating_future_marginal_tax_rate|estimated tax rate at withdrawal]]. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
For those who can't or won't make a reasonable estimate of future tax rates, traditional is likely the better choice, because it's best for most people most of the time. For those reluctant to save for retirement at all, either traditional or Roth or any mix is almost always a better choice than saving outside retirement accounts. In addition to providing more future income after taxes, traditional and Roth accounts also offer other benefits such as [[Asset protection|asset protection]] and [[Estate planning|estate planning]].<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Typical cases==<br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have sources of significant taxable income in retirement (pensions, royalties, real estate income not sheltered by depreciation, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.)<br />
* Investors who expect a [[#Social_Security_benefits|spike in Social Security taxation]] to give them a significantly higher marginal tax rate in retirement than they have now; this affects primarily investors in the 12% bracket<br />
* Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
==Common misconceptions==<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Establish a baseline plan for how long you will work, how much income you expect to earn, when you expect to retire, and when you expect to begin receiving Social Security and any other guaranteed income. Certain careers are characterized by long periods of low-income training followed by much higher earnings, and these changes should likely be included. If you're not sure, assuming that your current income continues to a typical retirement age is reasonable. If you think there's a chance your income could drop or disappear, assuming no future income could be reasonable.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#Typical_cases|Typical cases]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]]<br />
# Estimate any guaranteed retirement income (a pension, rental properties, royalties, etc.)<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your traditional IRA withdrawals, then the traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement,<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref> and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a traditional 401(k) but not a Roth 401(k), then you must use traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to traditional accounts. For example, contributing the full $19,500 to a traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a traditional or Roth account. The IRS contribution limits do not distinguish between traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [[Traditional versus Roth examples]].<br />
<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71334User:Fyre4ce/Traditional versus Roth2021-01-19T00:43:35Z<p>Fyre4ce: Made consistent capitalization of "traditional", put punctuation before references, added comment about tax planning</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you (or your heirs, if you are [[#Estate_planning|estate planning]]) more spendable income after all taxes are paid. Preference for one tax structure or another is under the broader umbrella of [https://www.investopedia.com/terms/t/tax-planning.asp tax planning].<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement.<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a [[#Calculating_marginal_tax_rate_now|known tax rate now]] vs. an [[#Estimating_future_marginal_tax_rate|estimated tax rate at withdrawal]]. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
For those who can't or won't make a reasonable estimate of future tax rates, traditional is likely the better choice, because it's best for most people most of the time. For those reluctant to save for retirement at all, either traditional or Roth or any mix is almost always a better choice than saving outside retirement accounts. In addition to providing more future income after taxes, traditional and Roth accounts also offer other benefits such as [[Asset protection|asset protection]] and [[Estate planning|estate planning]].<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Typical cases==<br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have sources of significant taxable income in retirement (pensions, royalties, real estate income not sheltered by depreciation, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.)<br />
* Investors who expect a [[#Social_Security_benefits|spike in Social Security taxation]] to give them a significantly higher marginal tax rate in retirement than they have now; this affects primarily investors in the 12% bracket<br />
* Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Establish a baseline plan for how long you will work, how much income you expect to earn, when you expect to retire, and when you expect to begin receiving Social Security and any other guaranteed income. Certain careers are characterized by long periods of low-income training followed by much higher earnings, and these changes should likely be included. If you're not sure, assuming that your current income continues to a typical retirement age is reasonable. If you think there's a chance your income could drop or disappear, assuming no future income could be reasonable.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#Typical_cases|Typical cases]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]]<br />
# Estimate any guaranteed retirement income (a pension, rental properties, royalties, etc.)<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your traditional IRA withdrawals, then the traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement,<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref> and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a traditional 401(k) but not a Roth 401(k), then you must use traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to traditional accounts. For example, contributing the full $19,500 to a traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a traditional or Roth account. The IRS contribution limits do not distinguish between traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [[Traditional versus Roth examples]].<br />
<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71275User:Fyre4ce/Traditional versus Roth2021-01-13T04:50:01Z<p>Fyre4ce: Various edits based on forum feedback</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a [[#Calculating_marginal_tax_rate_now|known tax rate now]] vs. an [[#Estimating_future_marginal_tax_rate|estimated tax rate at withdrawal]]. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
For those who can't or won't make a reasonable estimate of future tax rates, traditional is likely the better choice, because it's best for most people most of the time. For those reluctant to save for retirement at all, either traditional or Roth or any mix is almost always a better choice than saving outside retirement accounts. In addition to providing more future income after taxes, traditional and Roth accounts also offer other benefits such as [[Asset protection|asset protection]] and [[Estate planning|estate planning]].<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Typical cases==<br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have sources of significant taxable income in retirement (Social Security, pensions, royalties, real estate income not sheltered by depreciation, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.)<br />
* Investors who expect a [[#Social_Security_benefits|spike in Social Security taxation]] to give them a significantly higher marginal tax rate in retirement than they have now; this affects primarily investors in the 12% bracket<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement, should usually prefer partial or total Roth contributions.<br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Establish a baseline plan for how long you will work, how much income you expect to earn, when you expect to retire, and when you expect to begin receiving Social Security and any other guaranteed income. Certain careers are characterized by long periods of low-income training followed by much higher earnings, and these changes should likely be included. If you're not sure, assuming that your current income continues to a typical retirement age is reasonable. If you think there's a chance your income could drop or disappear, assuming no future income could be reasonable.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#Typical_cases|Typical cases]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]]<br />
# Estimate any guaranteed retirement income (a pension, rental properties, royalties, etc.)<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [[Traditional versus Roth examples]].<br />
<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71228User:Fyre4ce/Traditional versus Roth2021-01-08T16:43:38Z<p>Fyre4ce: Clarified SS spike wording per discussion in forums</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
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This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect a [[#Social_Security_benefits|spike in Social Security taxation]] to give them a significantly higher marginal tax rate in retirement than they have now; this affects primarily investors in the 12% bracket<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
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===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
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If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
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Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement, should usually prefer partial or total Roth contributions.<br />
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===Business tax considerations===<br />
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The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
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As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
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In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
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A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
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This analysis should be repeated each year, until retirement.<br />
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There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
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The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
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There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
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If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
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As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
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===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71220User:Fyre4ce/Traditional versus Roth2021-01-08T06:13:04Z<p>Fyre4ce: Added sentence clarifying above or below</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement, should usually prefer partial or total Roth contributions.<br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. If your withdrawal rate is predicted to be above the result in the table, Roth is preferred.<br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71219User:Fyre4ce/Traditional versus Roth2021-01-08T05:21:30Z<p>Fyre4ce: Clarified above vs. below</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement, should usually prefer partial or total Roth contributions.<br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate above just ~27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71217User:Fyre4ce/Traditional versus Roth2021-01-07T21:32:33Z<p>Fyre4ce: Added future low-income condition for traditional, edited comment about ND-tIRA, added comment on military, header for business tax issues</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with expected future low-income years (due to volatile incomes, planned leaves of absence, early retirement, etc.) which would provide opportunities for [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA do not receive the primary benefit of tax deferral, and should be evaluated separately. <br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate. <br />
<br />
Members of the military, who often are legal residents of tax-free states, receive part of their compensation tax-free, and expect significant pensions in retirement, should usually prefer partial or total Roth contributions.<br />
<br />
===Business tax considerations===<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers as of 2021<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate below 27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Retirement_plan_analysis&diff=71169User:Fyre4ce/Retirement plan analysis2021-01-01T06:18:25Z<p>Fyre4ce: Added analysis with match and Saver's Credit</p>
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<div>This page contains a database of analysis and formula derivations for retirement plan-related articles, including [[Traditional versus Roth]] and [[Roth IRA conversion|Roth conversion]].<br />
<br />
==Relative value of contributions and conversions==<br />
<br />
Define variables:<br />
<br />
<math><br />
\begin{align}<br />
R & = \text{Roth balance} \\<br />
T & = \text{Traditional balance} \\<br />
C & = \text{Roth-converted amount} \\<br />
V & = \text{Total value of tax-advantaged space} \\<br />
A & = \text{After-tax amount} \\<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
\end{align}<br />
</math><br />
<br />
The overall value of a change to tax-advantaged space is equal to:<br />
<br />
<math>\Delta V = \Delta T (1 - MTR_w) + \Delta R</math><br />
<br />
Consider a given after-tax investment <math>A</math> that can be contributed to a traditional account, a Roth account, or used to pay the taxes on a Roth conversion. When making a traditional contribution, the change in traditional balance is:<br />
<br />
<math>\Delta T = \frac{A}{(1 - MTR_n)}</math><br />
<br />
Therefore, the change in value when making a traditional contribution is:<br />
<br />
<math>\Delta V_T = A \frac{(1 - MTR_w)}{(1 - MTR_n)}</math><br />
<br />
When making a Roth ''contribution'', the change in Roth balance is simply:<br />
<br />
<math>\Delta R = A</math><br />
<br />
Therefore, the change in value when making a Roth contribution is:<br />
<br />
<math>\Delta V_R = A</math><br />
<br />
When making a Roth ''conversion'', the converted amount is:<br />
<br />
<math>C = \frac{A}{MTR_n}</math><br />
<br />
Therefore, the change in value when making a Roth conversion is:<br />
<br />
<math>\Delta V_C = C - C(1 - MTR_w) = \frac{A}{MTR_n} - \frac{A}{MTR_n} \cdot (1 - MTR_w) = \frac{A}{MTR_n}(1 - (1 - MTR_w)) = A \frac{MTR_w}{MTR_n}</math><br />
<br />
When <math>MTR_n < MTR_w</math> (current marginal tax rate is ''less than'' predicted future marginal tax rate),<br />
<br />
<math> \Delta V_C > \Delta V_R > \Delta V_T </math><br />
<br />
When <math>MTR_n = MTR_w</math> (current marginal tax rate ''equals'' predicted future marginal tax rate),<br />
<br />
<math> \Delta V_C = \Delta V_R = \Delta V_T </math><br />
<br />
When <math>MTR_n > MTR_w</math> (current marginal tax rate is ''greater than'' predicted future marginal tax rate),<br />
<br />
<math> \Delta V_C < \Delta V_R < \Delta V_T </math><br />
<br />
--[[User:Fyre4ce|Fyre4ce]] 23:10, 10 March 2020 (UTC)<br />
<br />
==Conversions on estates subject to estate tax==<br />
<br />
Define variables:<br />
<br />
<math><br />
\begin{align}<br />
R & = \text{Roth balance} \\<br />
T & = \text{Traditional balance} \\<br />
A & = \text{After-tax balance} \\<br />
C & = \text{Roth-converted amount} \\<br />
V_h & = \text{Total value of estate to heirs after-tax} \\<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_e & = \text{marginal tax rate on estate} \\<br />
MTR_h & = \text{marginal tax rate on heirs} \\<br />
\end{align}<br />
</math><br />
<br />
When a Roth conversion is performed on assets, during the owner's life on assets expected to be subject to estate tax, and the taxes can be paid from after-tax assets, the net effect on types of assets are as follows:<br />
<br />
<math>\Delta T = -C</math><br />
<br />
<math>\Delta R = +C</math><br />
<br />
<math>\Delta A = -C \cdot MTR_n \cdot (1 - MTR_e)</math><br />
<br />
The change in after-tax value of the estate to heirs will be as follows:<br />
<br />
<math>\Delta V_h = \Delta T \cdot (1 - MTR_h) + \Delta R + \Delta A = -C \cdot (1 - MTR_h) + C - C \cdot MTR_n \cdot (1 - MTR_e)</math><br />
<br />
<math>\Delta V_h = C \cdot ((MTR_h - 1) + 1 + MTR_n \cdot (MTR_e - 1)) = C \cdot (MTR_h + MTR_n \cdot (MTR_e - 1))</math><br />
<br />
It follows that Roth conversions increase the value of the after-tax value of the estate if:<br />
<br />
<math>MTR_h + MTR_n \cdot (MTR_e - 1) > 0</math><br />
<br />
or<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math><br />
<br />
--[[User:Fyre4ce|Fyre4ce]] 04:44, 10 December 2020 (UTC)<br />
<br />
==Saver's Credit==<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
T &= \text{traditional contribution} \\<br />
R &= \text{Roth contribution} \\<br />
A &= \text{after-tax cost of making retirement contributions (traditional or Roth)} \\<br />
G &= \text{growth factor of investments between now and withdrawal} \\<br />
V &= \text{after-tax value of retirement accounts} \\<br />
\end{align}<br />
</math><br />
<br />
For a fair comparison, the two take home pays must be equal:<br><br />
<math>A = T \cdot (1 - MTR_{n,T}) = R \cdot (1 - MTR_{n,R})</math><br />
<br />
Solving for T and R in terms of A:<br />
<br />
<math>T = \frac{A}{1 - MTR_{n,T}}</math><br><br />
<math>R = \frac{A}{1 - MTR_{n,R}}</math><br />
<br />
The changes in after-tax value of retirement accounts for the two contribution options are:<br />
<br />
<math>\Delta V_T = \frac{A}{1 - MTR_{n,T}} \cdot G \cdot (1 - MTR_w)</math><br><br />
<math>\Delta V_R = \frac{A}{1 - MTR_{n,R}} \cdot G</math><br />
<br />
Traditional contributions are preferred when the <math>\Delta V_T > \Delta V_R</math><br />
<br />
<math>\frac{A}{1 - MTR_{n,T}} \cdot G \cdot (1 - MTR_w) > \frac{A}{1 - MTR_{n,R}} \cdot G</math><br />
<br />
Canceling <math>A</math> and <math>G</math> (assumed to be the same in both cases), and solving for <math>MTR_w</math>:<br />
<br />
<math>\frac{1 - MTR_w}{1 - MTR_{n,T}} > \frac{1}{1 - MTR_{n,R}}</math><br />
<br />
<math>MTR_w < 1 - \frac{1 - MTR_{n,T}}{1 - MTR_{n,R}}</math><br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math><br />
<br />
==Maxing out retirement accounts==<br />
<br />
Define variables as follows:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
C &= \text {contribution (fixed dollar amount for traditional or Roth)} \\<br />
G_T &= \text {growth factor on traditional balance, before taxes} \\<br />
G_R &= \text {growth factor on Roth balance (tax-free)} \\<br />
G_{Tx} &= \text {growth factor on taxable balance, after taxes} \\<br />
r_T &= \text{total rate of return on the traditional balance} \\<br />
r_R &= \text{total rate of return on the Roth balance} \\<br />
r_{Tx} &= \text{total rate of return on the taxable balance} \\<br />
y &= \text{yield on the taxable balance} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
When contributing a fixed dollar amount <math>C</math> to either traditional or Roth accounts, and investing the tax savings <math>C \cdot MTR_n</math> in a taxable account, traditional contributions are preferred when:<br />
<br />
<math>C \cdot G_T \cdot (1 - MTR_w) + MTR_n \cdot C \cdot G_{Tx} > C \cdot G_R</math><br />
<br />
Canceling <math>C</math> and solving for <math>MTR_w</math> gives:<br />
<br />
<math>MTR_w < \frac{G_T - G_R + MTR_n \cdot G_{Tx}}{G_T}</math> <br />
<br />
Rather than plug in the formulas for these factors to create one large equation, it is easier to calculate each factor separately. Assuming annual compounding, the three growth factors can be calculated as follows:<br />
<br />
<math>G_T = (1 + r_T)^t</math><br><br />
<math>G_R = (1 + r_R)^t</math><br><br />
<math>G_{Tx} = (v - (v - b) \cdot MTR_{cg})</math><br />
<br />
Recall from [[Taxable_account#Performance|taxable account performance]] that:<br />
<br />
<math>v = \frac{V(t)}{V(0)} = (1 + r_{Tx} - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = \frac{B(t)}{V(0)} = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r_{Tx} - y \cdot MTR_{div}} \right ) \left ( (1 + r_{Tx} - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Separate rates of return for traditional, Roth, and taxable accounts allow the comparison between different accounts (eg. IRA or 401(k)) with different investments and fees. Assuming the same investments and fees <math>(r_T = r_R = r_{Tx} = r)</math> and <math>G_T = G_R</math>, the equations simplifies somewhat to:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{G_{Tx}}{(1 + r)^t}</math> <br />
<br />
with <math>G_{Tx}</math>, <math>v</math>, and <math>b</math> the same as above.<br />
<br />
==Employer match==<br />
<br />
Define variables as follows:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
m &= \text {employer match rate} \\<br />
T &= \text{traditional balance} \\<br />
R &= \text{Roth balance} \\<br />
A &= \text{after-tax cost of making retirement contributions (traditional or Roth)} \\<br />
G &= \text{growth factor of investments between now and withdrawal} \\<br />
V &= \text{after-tax value of retirement accounts} \\<br />
\end{align}<br />
</math><br />
<br />
When making a traditional contribution, the changes in the two types of balances will be:<br />
<br />
<math>\Delta T_T = \frac{A}{1 - MTR_n} \cdot (1 + m)</math><br><br />
<math>\Delta R_T = 0</math><br />
<br />
When making a Roth contribution, the changes in the two types of balances will be:<br />
<br />
<math>\Delta T_R = A \cdot m</math><br><br />
<math>\Delta R_R = A</math><br />
<br />
The after-tax values at withdrawal of the two contribution choices are:<br />
<br />
<math>\Delta V_T = \frac{A}{1 - MTR_n} \cdot (1 + m) \cdot G \cdot (1 - MTR_w)</math><br><br />
<math>\Delta V_R = A \cdot m \cdot G \cdot (1 - MTR_w) + A \cdot G</math><br />
<br />
Traditional contributions are preferred when <math>\Delta V_T > \Delta V_R</math>:<br />
<br />
<math>\frac{A}{1 - MTR_n} \cdot (1 + m) \cdot G \cdot (1 - MTR_w) > A \cdot m \cdot G \cdot (1 - MTR_w) + A \cdot G</math><br />
<br />
Canceling <math>A</math> and <math>G</math> (assumed to be the same in both cases):<br />
<br />
<math>\frac{1 - MTR_w}{1 - MTR_n} \cdot (1 + m) > m \cdot (1 - MTR_w) + 1 </math><br />
<br />
Solving for <math>MTR_w</math> using a Computer Algebra System (CAS):<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math><br />
<br />
===Employer match combined with Saver's Credit===<br />
<br />
The above equations can be modified to also include a Saver's Credit. When making a traditional contribution, the changes in the two types of balances will be:<br />
<br />
<math>\Delta T_T = \frac{A}{1 - MTR_{n,T}} \cdot (1 + m)</math><br><br />
<math>\Delta R_T = 0</math><br />
<br />
When making a Roth contribution, the changes in the two types of balances will be:<br />
<br />
<math>\Delta T_R = \frac{A}{1 - MTR_{n,R}} \cdot m</math><br><br />
<math>\Delta R_R = \frac{A}{1 - MTR_{n,R}}</math><br />
<br />
The after-tax values at withdrawal of the two contribution choices are:<br />
<br />
<math>\Delta V_T = \frac{A}{1 - MTR_n} \cdot (1 + m) \cdot G \cdot (1 - MTR_w)</math><br><br />
<math>\Delta V_R = A \cdot m \cdot G \cdot (1 - MTR_w) + A \cdot G</math><br />
<br />
Traditional contributions are preferred when <math>\Delta V_T > \Delta V_R</math>:<br />
<br />
<math>\frac{A}{1 - MTR_{n,T}} \cdot (1 + m) \cdot G \cdot (1 - MTR_w) > \frac{A}{1 - MTR_{n,R}} \cdot m \cdot G \cdot (1 - MTR_w) + \frac{A}{1 - MTR_{n,R}} \cdot G</math><br />
<br />
Canceling <math>A</math> and <math>G</math> (assumed to be the same in both cases):<br />
<br />
<math>\frac{1 - MTR_w}{1 - MTR_{n,T}} \cdot (1 + m) > \frac{m \cdot (1 - MTR_w) + 1}{1 - MTR_{n,R}} </math><br />
<br />
Solving for <math>MTR_w</math> using a Computer Algebra System (CAS):<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot (MTR_{n,T} - MTR_{n,R})}{m \cdot (MTR_{n,T} - MTR_{n,R}) +1 - MTR_{n,R}}</math></div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71132User:Fyre4ce/Traditional versus Roth2020-12-31T09:15:55Z<p>Fyre4ce: Reworded sentence per feedback</p>
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<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA are more similar to a [[Taxable account|taxable account]] than either traditional or Roth tax structures, and should be evaluated separately.<br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate.<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, great precision is usually not needed to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate below 27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71131User:Fyre4ce/Traditional versus Roth2020-12-31T08:52:42Z<p>Fyre4ce: Slightly updated values (they were calculated with continuous compounding; switched to annual compounding to be consistent with example)</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA are more similar to a [[Taxable account|taxable account]] than either traditional or Roth tax structures, and should be evaluated separately.<br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate.<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, most people should still be able to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.95%<br />
| 11.92%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.87%<br />
| 20.58%<br />
| 19.67%<br />
| 18.96%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.45%<br />
| 26.31%<br />
| 24.83%<br />
| 23.69%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.85%<br />
| 28.80%<br />
| 26.74%<br />
| 25.18%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.59%<br />
| 33.51%<br />
| 29.64%<br />
| 26.88%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate below 27%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71128User:Fyre4ce/Traditional versus Roth2020-12-31T06:09:04Z<p>Fyre4ce: Reduced number of cases in General guidelines, moved business-related discussion to Current marginal rate section</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate, and/or leave large traditional accounts to their heirs; see [[Stretch IRA]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement, and/or expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA are more similar to a [[Taxable account|taxable account]] than either traditional or Roth tax structures, and should be evaluated separately.<br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate.<br />
<br />
The loss of a [[Marginal_tax_rate#Section_199A_deductions|Section 199A Deduction]] lowers the federal marginal tax rate on business contributions by 20% (eg. 32% to 25.6%). Business owners may be able to get a larger Section 199A deduction by contributing through a [[After-tax_401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions. This requires a customized [[Solo_401(k)_plan|Solo 401(k)]] through a Third Party Administrator, with setup and operating fees. Fee-free Solo 401(k) plans offered by major brokerages do not allow Mega Backdoor Roth contributions, although some offer a Roth option for elective deferrals. Owners of Specified Service Trades or Businesses (SSTBs) in the income phase-out range for Section 199A deductions ($164,900-$214,900 for single filers, and $329,800-$429,800 for married joint filers<ref>https://www.nerdwallet.com/blog/taxes/pass-through-income-tax-deduction/</ref>) can see [[User:Fyre4ce/Tax_analysis#Variable_Marginal_Rates_with_Section_199A_Deduction|very high marginal tax rates]] and should probably choose traditional contributions. <br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, most people should still be able to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.94%<br />
| 11.91%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.79%<br />
| 20.45%<br />
| 19.52%<br />
| 18.77%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.31%<br />
| 26.10%<br />
| 24.58%<br />
| 23.39%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.65%<br />
| 28.51%<br />
| 26.40%<br />
| 24.79%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.20%<br />
| 32.98%<br />
| 29.05%<br />
| 26.23%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate as low as ~26.3%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://thefinancebuff.com/the-forgotten-deductible-ira.html The Forgotten Deductible IRA] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br />
* [http://www.thedigeratilife.com/blog/invest-pre-tax-or-after-tax-dollars-retirement-401k-vs-roth-ira/ Should You Invest Pre-Tax or After Tax Dollars? 401K vs Roth IRA] on [http://www.thedigeratilife.com The Digerati Life], 15 February 2012, retrieved 9 September 2012<br />
* [http://badmoneyadvice.com/2009/02/iras-roth-and-other-kind.html IRAs: Roth and the Other Kind] on [http://badmoneyadvice.com Bad Money Advice], 21 February 2009, retrieved 9 September 2012<br />
* {{Forum post | t = 281352 | title = Seeking comment on proposed revisions to Marginal Tax Rate and Traditional v. Roth wiki articles | author = fyre4ce | date = May 17, 2019}}<br />
<br />
{{Managing your IRA}}<br />
[[Category:IRAs]]<br />
[[Category:Pages requiring annual tax updates]]</div>Fyre4cehttps://www.bogleheads.org/w/index.php?title=User:Fyre4ce/Traditional_versus_Roth&diff=71127User:Fyre4ce/Traditional versus Roth2020-12-30T23:23:03Z<p>Fyre4ce: Clarified SS spike should be avoided only if it's a higher marginal rate than today</p>
<hr />
<div>{{US}}<br />
<br />
'''{{PAGENAME}}''' refers to the common investment decision whether to use a '''traditional''' (pre-tax) or '''Roth''' tax structures. You must make this decision if your employer offers both a traditional and [[401(k)#Roth 401(k)| Roth 401(k)]], or when you can deduct a [[traditional IRA]] contribution or use a [[Roth IRA]], or when you consider leaving money in a traditional account or [[Roth IRA conversion|converting some to Roth]]. The better option is the one that gives you more spendable income after all taxes are paid.<br />
<br />
In a traditional retirement account such as a deductible [[traditional IRA]] or traditional [[401(k)]], your contributions are deductible, no tax is paid on account growth while the money remains in the account, and withdrawals are taxed as ordinary income. In a Roth retirement account such as a [[Roth IRA]] or [[401(k)#Roth 401(k)| Roth 401(k)]], your contributions are not deductible, but all future growth and withdrawals are tax-free in retirement<ref>[https://www.irs.gov/pub/irs-pdf/p590b.pdf IRS Publication 590-B: Distributions from IRAs]</ref><ref>[http://www.irs.gov/Retirement-Plans/Roth-Comparison-Chart IRS Roth Comparison Chart]</ref> The approach that incurs a lower [[marginal tax rate]] will, in most cases, provide you more spendable income. Neither is inherently better, as either one may be a better tax structure choice in different situations. Here are some of the considerations.<br />
<br />
==General guidelines==<br />
<br />
See [[Prioritizing investments]] for general investment considerations.<br />
<br />
The decision between deductible traditional vs. Roth contributions hinges primarily on a comparison between a known tax rate now vs. an estimated tax rate at withdrawal. Assuming you have an estimate for your future marginal tax rate, prefer traditional when your current marginal rate is higher than that estimate, and prefer Roth when your current marginal rate is lower. <br />
<br />
This article explores, in depth, the factors that can affect this analysis, plus other complicating factors. However, in the absence of a rigorous analysis, traditional contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in their peak earnings years, who expect to work a normal-length career and save a normal percentage of their income<br />
* Low-income investors who can realize a substantial tax savings through lowering Adjusted Gross Income, due to [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit], [[#Saver's credit|Saver's Credit]], [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act ACA subsides], lowering interest payments on an income-driven repayment plan for loans expected to be forgiven under [http://www.irs.gov/Credits-&-Deductions/Individuals/Premium-Tax-Credit-Affordable-Care-Act Public Service Loan Forgiveness], and other benefits<br />
* Investors with unusually volatile incomes and/or expected future low income years, which would present opportunities for future [[Roth IRA conversion|Roth conversions]] at low tax rates<br />
* Investors who are not able to realize their full [[#Employer_match|employer plan match]]<br />
* Investors planning to retire to a [[State income taxes|lower-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a lower expected tax rate, or to a tax-exempt charity<br />
* Investors with little-to-no traditional savings already, and little-to-no expected taxable income in retirement<br />
<br />
Partial or total Roth contributions are usually preferred in these situations:<br />
<br />
* Middle-income and higher earners in unusually low-income years (due to unemployment, leave of absence, training, sabbatical, part-time work, early in a career before peak earnings, etc.)<br />
* [[Importance of saving rate|Heavy savers]], who have (or expect to have) large traditional and/or [[Taxable account|taxable]] balances that will create high taxable income in retirement, due to [[SEC Yield|yield]], planned withdrawals, and [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]]<br />
* Investors who expect to have other sources of taxable income in retirement (Social Security, pensions, royalties, real estate income, [[Variable annuity|annuity]] income, [[Stretch IRA|Inherited IRAs]], etc.) which, when combined with traditional withdrawals, will put them in a higher bracket than today<br />
* Investors who expect to be affected by the [[#Social_Security_benefits|spike in Social Security taxation]] in retirement<br />
* Members of the military, who may be legal residents of a tax-free state, receive a substantial percentage of their income tax-free, and expect significant pensions in retirement<br />
* Investors planning to retire to a [[State income taxes|higher-tax state]] (asymmetric state taxation rules can change this analysis)<br />
* Investors planning to leave their savings to heirs with a higher expected tax rate<br />
* Investors planning to leave large traditional accounts to their heirs (more than ~$500,000 per person; see [[Stretch IRA]])<br />
* Investors who expect to leave estates larger than the estate tax exemption; see [[#Estate_planning|Estate planning]]<br />
* Investors with [[#Very_high_income_and_wealth|very high income and wealth]], who are in the top tax bracket now and expect to remain there throughout retirement<br />
* Business owners who can get a larger [[Marginal_tax_rate#Section_199A_deductions|Section 199A deduction]] by contributing through a [[After-tax 401(k)|Mega Backdoor Roth]] rather than deducting traditional business contributions<br />
* Investors whose current and future tax rates look to be about equal, and would like some [[#Tax_diversification|tax diversification]]<br />
* Investors with a current marginal tax rate of 12% or less <br />
<br />
These guidelines apply to Roth vs. fully deductible traditional accounts (eg. [[Traditional IRA]], [[401(k)]], [[403(b)]], etc.). [[Non-deductible traditional IRA|Non-deductible contributions]] to a Traditional IRA are more similar to a [[Taxable account|taxable account]] than either traditional or Roth tax structures, and should be evaluated separately.<br />
<br />
===Eligibility===<br />
<br />
Not all investors will be able to choose between traditional and Roth options in all their accounts.<br />
<br />
[[Employer retirement plans overview|Employer-sponsored accounts]] ([[401(k)]], [[403(b)]], [[457(b)]]) always offer a traditional option, but may or may not offer a Roth option. However, there are no income limitations on contributions, as there are for IRAs. <br />
<br />
For the self-employed, there are several [[Solo 401(k) plan|Solo 401(k) plans]] available at no cost from major brokerages that offer traditional and Roth options. Note that only employee contributions (elective deferrals) may have a Roth option; business contributions must be traditional. There are customized Solo 401(k)'s available through Third Party Administrators with more features, including [[After-tax 401(k)|after-tax]] and Mega Backdoor Roth contributions, although these plans have additional fees. [[SEP|SEP-IRAs]] only allow traditional contributions.<br />
<br />
With [[IRA|IRAs]], the eligibility of traditional vs. Roth is affected by income. There is an [[Traditional_IRA#Contribution_Eligibility_and_Limits|income limit]] for ''deducting contributions'' to a traditional IRA. Above that limit, and below the [[Roth_IRA#Contribution_Eligibility_and_Limits|Roth IRA contribution income limit]], a Roth IRA is best. Above the Roth IRA income contribution limit, one may choose either the [[Backdoor Roth|backdoor Roth IRA contribution process]], a [[Non-deductible traditional IRA]], or a [[Taxable account|taxable account]]- see those pages for more details.<br />
<br />
Traditional contributions and [[Roth IRA conversion|Roth conversions]] have the same net effect as a Roth contribution. So, Roth contributions can be simulated by, for example, making traditional contributions to a 401(k) and doing Roth conversions from a traditional IRA.<br />
<br />
See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer plans]].<br />
<br />
==Calculations==<br />
The main reason to prefer one type of account over the other is the comparison of [[marginal tax rate]]s. <br />
<br />
===Simplest situation===<br />
For the same contribution amount and growth, the after-tax value is entirely determined by the marginal tax rate on contributions and withdrawals. You can calculate the amount you get after taxes as:<br /><br />
<math><br />
\begin{align}<br />
traditional = Original\ amount * Growth\ factor * (1 - withdrawal\ tax\ rate)<br />
\\<br />
Roth = Original\ amount * (1 - contribution\ tax\ rate) * Growth\ factor<br />
\end{align}<br />
</math><br />
<br />
The "Growth factor" can be calculated as (1 + r)^t, where ''r'' is the annual rate of return and ''t'' is the time in years. Because one may choose identical investments regardless of whether held in a traditional or Roth account, the "Growth factor" is the same in each case.<br />
<br />
If your marginal tax rate now (the "contribution tax rate") is higher than your marginal tax rate in retirement (the "withdrawal tax rate"), then the traditional account is better; if it is lower, then the Roth account is better. <br />
<br />
When the withdrawal tax rate is the same as the contribution tax rate (a.k.a. the marginal tax rate that would be saved by a traditional contribution), thanks to the commutative property of multiplication (i.e., A * B * C = A * C * B) the traditional and Roth results are equal.<br />
<br />
The simple analysis above is valid for many situations, but it does make assumptions that aren't always applicable. For any of the following complicating factors, see the relevant sections see [[#More complicated situations|below]]:<br />
* Investors who are contributing the [[#Maxing_out_your_retirement_accounts|maximum to their retirement accounts]]<br />
* Investors who are not able to get the [[#Employer_match|maximum employer match]]<br />
* Investors who may be in the [[#Social_Security_benefits|phase-in range for Social Security benefits]] in retirement<br />
* Investors eligible for the [[#Saver's_Credit|Saver's Credit]] on both traditional and Roth contributions<br />
<br />
===Common misconceptions===<br />
<br />
There are two common misconceptions, one that incorrectly favors traditional, and one that incorrectly favors Roth.<br />
<br />
The first misconception is sometimes described as "contributions are taken from the top tax rate and are withdrawn later at the average rate". In other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. Following is an example of why that is not true.<br />
<br />
Consider a 50 year old who has already accumulated a $500K traditional balance. Even without any further contributions, that could reasonably double to $1 million by age 65. Taking a 4%/yr withdrawal then gives $40K/yr. Any traditional contributions at age 51 (or later) will increase the traditional balance at age 65, thus allowing more than $40K/yr withdrawal. The taxation on the amount above $40K/yr will occur at the marginal rate on that amount, not the effective rate on the total income.<br />
<br />
The second misconception is that "it's better to pay tax on the seed than the harvest." In other words, that it is better to pay a lesser tax amount now to make a Roth contribution, instead of a larger amount of tax later on a traditional withdrawal. This is not true because taking a percentage of the "seed" is the same as letting the full seed grow and then taking the same percentage of the "harvest." The result will be the same in either case. The goal should not be to pay as little tax as possible. The goal should be to have as much money leftover after taxes as possible. Comparing marginal rates between contribution (or conversion now) and withdrawal in the future is the most direct way to achieve this goal. <br />
<br />
==Calculating marginal tax rate now==<br />
<br />
Your marginal tax rate now is relatively easy to determine. It is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits (e.g., various credits and [[Taxation of Social Security benefits]]) and tax-like costs (e.g., [[Expected Family Contribution]] and Medicare premiums); see [[Marginal tax rate]] for a more detailed explanation, and [[Traditional versus Roth examples]] for examples. <br />
<br />
One can use any commercial tax software to calculate the tax change for the maximum contribution or conversion amount considered. If the (change in tax) divided by (change in income) does match one of the nominal tax brackets (e.g., 12%, 22%, 24%, etc.), that is all one need know. If one gets a different answer, more work is needed: using small ($100 or so) changes in income to determine at what point(s) (change in tax) divided by (change in income) gets a new result. This can be done by hand, or using a tool such as the [[Tools_and_calculators#Personal_finance_toolbox|Personal finance toolbox]] that will provide answers in chart form.<br />
<br />
If you can contribute to Roth accounts today at a marginal tax rate of 12% or less, it is usually a good idea. This is a low tax rate historically, and especially if you are far from retirement, many things can change that could cause you to pay a higher rate at withdrawal, such as [[#Tax risk|changes in tax law]], moving to a [[State income taxes|higher-tax state]], unexpected increases in income, [[Stretch IRA|inheriting an IRA]], and others. Only defer taxes at 12% or less if you're close to withdrawal and are very confident you will be able to withdraw at a lower rate.<br />
<br />
==Estimating future marginal tax rate==<br />
<br />
Estimating your marginal tax rate in retirement is considerably harder than for today. For one, tax laws may change, and the further you are from retirement, the more likely this becomes.<br />
<br />
As a starting point, it makes sense to assume the current tax code will still be in place in retirement. But if you have strong feelings that taxes will go up or down in the future, you could make adjustments to these numbers.<br />
<br />
In any case, you should account for inflation by adjusting the investments' [[Historical and expected returns#Expected future returns|expected rates of return]] for the predicted inflation rate. You will also need to estimate your taxable retirement income, which will depend both on your current situation, and on your financial future between today and retirement. While all of these factors have high uncertainty, most people should still be able to make a reasonable estimate.<br />
<br />
===Method===<br />
<br />
Consider any expected changes in income over the course of your career. Some careers have very stable income that can be safely relied upon. Certain careers are characterized by long periods of low-income training followed by much higher earnings; other careers have early periods of high income followed by more uncertainty. Make reasonable assumptions that are consistent with your overall financial plan; don't include unlikely swings in income, up or down.<br />
<br />
A challenge in this analysis is that you first must assume a pattern of future traditional, Roth, and [[Taxable account|taxable]] contributions in order to estimate your taxable income in retirement. But how can this be done without first knowing which type of contribution is best? The answer is that you need to make a "guess", then use the analysis to check that the guess is the correct choice. If you are doing this analysis for the first time, your guess can be choosing the case from [[#General guidelines|General guidelines]] that best matches your situation. If you've done this analysis in previous years, use the answer that it generated as a starting point. <br />
<br />
One approach (based on [https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153 Investment Order]):<br />
# Estimate an expected pattern of future income, and also expected future contributions to traditional, Roth, and [[Taxable account|taxable]] accounts.<br />
# Estimate any guaranteed retirement income. E.g., pension you can't defer in return for higher payments when you do start, rentals, royalties, etc.<br />
# Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 4% of that value as an annual withdrawal.<br />
# Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a real rate of return to adjust for inflation. Take 2% of that value as qualified dividends.<br />
# Decide whether Social Security (SS) income should be considered, or whether you will be able to do enough [[Roth IRA conversion|traditional -> Roth conversions]] before starting SS. Include SS income projections if needed.<br />
# Add the taxable income from Steps 2-5 and calculate what marginal tax rate you would have under current tax law. If your current marginal tax rate is greater than this value, traditional contributions should be preferred. If your current marginal tax rate is less than this value, Roth contributions should be preferred. <br />
# If you are expecting to receive Social Security income, check whether you are near a tax rate spike due to [[#Social_Security_benefits|phase-in range for Social Security taxation]]. If you are, and the spiked tax rate is higher than you are paying now, the best solution is to go under the spike by making more Roth contributions and/or [[Roth IRA conversion|conversions]]; go back to Step 1 with different assumptions if needed.<br />
# Check your answer against the assumption you made for this year in Step 1. If the answer matches, then you can be confident it was the correct choice. If not, go back to Step 1, assume the opposite type of contribution, and rerun the analysis. If assuming traditional contributions predicts Roth is the correct choice, and assuming Roth predicts traditional is the best choice, then you should split your contributions between some traditional and some Roth; see [[#Stradding brackets|Straddling brackets]].<br />
<br />
This analysis should be repeated each year, until retirement.<br />
<br />
There is some [https://www.bogleheads.org/forum/viewtopic.php?t=281352 debate] over whether assumed rates of return should be as realistic as possible, or conservative. Conservative rates of return will bias the answer toward traditional, which will partly offset a shortfall if your account balances at retirement are less than you expect for some reason. <br />
<br />
The steps above may look complicated at first, but you don't need great precision. The answer will either be "obvious" or "difficult to choose". If the latter, it likely won't make much difference which you pick, so you might choose to mix traditional and Roth contributions, to take advantage of [[#Tax diversification|tax diversification]].<br />
<br />
===Results===<br />
<br />
Most investors will find that traditional contributions are better during their normal working career, for two reasons:<br />
* Retirees usually need lower income than while working to maintain the same standard of living, because they are no longer saving for retirement, expenses for children have ended, the mortgage is probably paid off, many retirees relocate to lower cost-of-living areas, work-related expenses have ended, life and disability insurance are no longer needed, etc.<br />
* Retirees pay a lower tax rate on the income they do draw, because [[Progressive tax|lower income usually means lower tax rates]], many retirees live in [[State income taxes|low-tax or tax-free states]], Roth withdrawals and return of basis from [[Taxable account|taxable]] investments are tax-free, [[Capital gains distribution|capital gains]] are taxed at a reduced rate, [[Payroll tax|payroll taxes]] have ended, [[Taxation of Social Security benefits|Social Security]] is 15-100% federally tax-free and not taxed by many states, [[HSA]] withdrawals for medical expenses are tax-free, etc.<br />
<br />
There are plenty of exceptions to this rule, however, including those with very high or very low incomes, planning to move from low-tax to high-tax states, heavy savers who expect more taxable income in retirement than while working, planning to leave money to higher-tax heirs, working around unusual tax laws, and others. A non-exhaustive list of cases where Roth contributions are preferred is [[#General_guidelines|above]]. <br />
<br />
If you currently have very little tax-deferred retirement savings, your calculated retirement tax rate will be very low, so you’ll get a big value by contributing more. In fact, due to the federal standard deduction, the first $14,250 or $27,800 you withdraw in retirement each year (assuming you're over age 65 at the time) should be tax-free. (These values decrease slightly, but not much, with significant [[Taxation of Social Security benefits|Social Security income]]). Assuming a 4% withdrawal rate, that corresponds to an account balance of $356,250 (= $14,250 / 4%) or $695,000 (= $27,800 / 4%) that can be accessed federally tax-free, and these figures should grow with inflation. <br />
<br />
As your tax-deferred balance rises, so will your expected tax rate, but as long as it’s less than your marginal tax rate now it still makes sense to contribute to tax-deferred accounts. If your expected retirement marginal tax rate ever reaches or exceeds your current marginal tax rate, and you still want to save more, then additional savings should be done in a Roth account.<br />
<br />
===Example===<br />
<br />
A single investor earns $200,000 gross income and has a marginal tax rate of 32%. He plans to retire in 25 years at age 65. He currently has $450,000 in traditional (tax-deferred) savings, contributes $19,500 per year to this account, and expects it to grow at 8% after fees, and assumes 3% inflation. He also has a $50,000 taxable account, to which he contributes $10,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. He also expects to take $3,000 per month inflation-adjusted Social Security benefit immediately after retiring, of which he expects 85% to be taxable. He does not expect any additional income in retirement. His 401(k) allows either traditional or Roth contributions; which should he be making? Given his relatively high income compared to his savings, it's reasonable to guess that continuing to make 100% traditional contributions will be best. Assuming he continues to make $19,500 traditional contributions, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(8%-3%,25,-19500,-450000) * 4% || $98,182<br />
|-<br />
| Taxable Account Dividends || =FV(8%-3%-(2%*15%),25,-10000,-50000) * 2% || $12,313<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*85% || $30,600<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$126,844'''<br />
|}<br />
<br />
Under the current tax bracket structure, his future marginal rate with that income is predicted to be only 24%, which is less than his current marginal rate is 32%. The assumptions in this analysis (maximum ongoing traditional contributions, and maximum Social Security taxation) represent a "worst case" for taxable income in retirement, and because his marginal rate is still predicted to be less than today, the guess was correct, and he should prefer traditional contributions to Roth for the current year. He should repeat this analysis each year, accounting for actual investment growth and tax law changes.<br />
<br />
==Other tax considerations==<br />
<br />
===State taxes===<br />
{{Main|State income taxes}}<br />
<br />
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.<br />
<br />
Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.<br />
<br />
===Estate planning===<br />
<br />
For those planning on leaving a significant estate to their heirs, multi-generational effects should be considered. For example, if you are a high earner in the 32% tax bracket, and expect to be throughout retirement, but your heirs are lower earners in the 12% tax bracket, you should prefer traditional contributions - your heirs will receive a larger inheritance after tax. Likewise, if you are in a lower tax bracket than your heirs, you should prefer to contribute to Roth accounts. If you plan to bequeath assets to a tax-exempt charity, that bequest should be from a traditional account as opposed to a Roth, because neither you nor the charity will pay taxes on the funds, and the charity will receive a larger donation.<br />
<br />
The federal estate tax exemption, $11.7M for individuals and $23.4M<ref>[https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax Small Businesses and Self-Employed: Estate Taxes], IRS.</ref> for married couples as of 2021, applies regardless of whether the accounts being bequeathed are traditional or Roth. Because Roth dollars are worth more than traditional dollars, investors who are at-risk of being above the estate tax exemption limit should prefer Roth investments, and/or perform Roth conversions. Even if there is a marginal tax rate disadvantage, your heirs could possibly receive more after taxes by avoiding or reducing double taxation. You will increase the after-tax value of your estate to your heirs when you make Roth contributions and do [[Roth IRA conversions|Roth conversions]] when:<br />
<br />
<math>MTR_h > MTR_n \cdot (1 - MTR_e)</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Conversions_on_estates_subject_to_estate_tax|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_h & = \text{predicted marginal income tax rate for your heir} \\<br />
MTR_n & = \text{marginal income tax rate for you now} \\<br />
MTR_e & = \text{predicted marginal estate tax rate on your eventual estate} \\<br />
\end{align}<br />
</math><br />
<br />
There are other ways to lower the value of one's estate (eg. gifting money during your lifetime) or otherwise avoid estate tax, so this method should be weighed against other options.<br />
<br />
The [https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SECURE%20Act%20section%20by%20section.pdf SECURE Act of 2019] now requires [[Inheriting_an_IRA|inherited IRAs]] to be completely distributed by the end of the tenth calendar year following the year of the owner's death. If you expect to leave large [[IRA|IRAs]] as part of your estate, such that withdrawals will likely push your heirs into a tax bracket higher than yours is now, favor Roth contributions and [[Roth IRA conversions|conversions]] during your lifetime. See the [[Stretch IRA]] page for strategies for large inherited IRAs. For small IRAs that will not affect your heirs' tax status, simply comparing your marginal tax rate to your heirs' current rate will be sufficient.<br />
<br />
===Opportunity to convert later===<br />
<br />
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. Your income (and therefore marginal tax rate) might be lower in a year when you separate from an employer. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution. There is no analogous "traditional conversion" whereby you can move money from a Roth account to traditional and reduce your taxable income, so this is an advantage for traditional accounts.<br />
<br />
This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 12% tax bracket before taking Social Security, and don't need the whole 12% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 12%, reducing the amount you will have in the IRA when you start taking Social Security.<br />
<br />
But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 22% tax bracket and retire in a 22% tax bracket but happen to have some years in a 12% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 12% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.<br />
<br />
===Required Minimum Distributions===<br />
<br />
Traditional accounts have the disadvantage of having [[Required Minimum Distribution|Required Minimum Distributions (RMDs)]] begin at age 72. (Roth 401(k)'s have RMD's as well<ref>[https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds IRS list of accounts subject to RMDs]</ref>, but can easily be rolled over into a Roth IRA upon retirement<ref>[https://www.irs.gov/pub/irs-tege/rollover_chart.pdf IRS rollover chart]</ref>, and Roth IRA's do not have RMD's). RMD's are a reasonable percentage of the account balance, but if you expect to want to leave large IRAs as part of your estate and RMD's would hinder this goal, then prefer Roth contributions.<br />
<br />
===Tax risk===<br />
<br />
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.<br />
<br />
Traditional accounts have a slight advantage when future income is uncertain. Choosing traditional today and being wrong usually means you have [[Progressive tax|more money]] than you expected in retirement, which is not the worst problem to have. But choosing Roth today and being wrong means you had a significant shortfall in savings for some reason. The size of this asymmetry and whether it should impact decisions today is [https://www.bogleheads.org/forum/viewtopic.php?f=10&t=318512 debated].<br />
<br />
Another risk for MFJ filers is the death of one spouse, leaving the survivor with single filing status and its higher marginal rates. This risk would be partly mitigated if the spouse's death substantially reduced household expenses. If one or both spouses has health issues, it may make sense to bias toward Roth accounts to insure against this possibility. <br />
<br />
===Tax diversification===<br />
<br />
Tax Diversification is the principle that having assets spread across different kinds of accounts (Traditional, Roth, [[Taxable account|taxable]], etc). The further you are from retirement, the harder it is to predict what tax law will be. By diversifying between current and future tax rates, you effectively provide yourself insurance against large tax rate changes (up or down). Also, it may be the case that there will be certain steep phase-outs, or "bumps" in marginal rates in the future (eg. the current Social Security taxation bumps), and having the flexibility to control your taxable income to some degree might allow you to better optimize around future tax laws. Conversely, if you only have Traditional investments, you will be required to withdraw RMD's or whatever you need to live on, and pay whatever tax results. Even if the Traditional vs. Roth analysis described above favors one type or the other, there is a potential advantage to having a mix.<br />
<br />
==Investment options==<br />
<br />
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use Traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.<br />
<br />
===Employer match===<br />
<br />
If your employer matches 401(k) contributions, this is by far the [[Prioritizing investments|best investment]] you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.<br />
<br />
If your employer offers both traditional and Roth accounts, any match goes to a traditional account, and the match is calculated without regard to whether your contribution is traditional or Roth. Therefore, if you cannot contribute enough to a Roth account to get the maximum match, you can get a larger match for the same out-of-pocket cost by choosing traditional contributions. You should choose traditional contributions when:<br />
<br />
<math>MTR_w < \frac{(1+m) \cdot MTR_n}{m \cdot MTR_n + 1}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Employer_match|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n & = \text{marginal tax rate now} \\<br />
MTR_w & = \text{marginal tax rate at withdrawal} \\<br />
m & = \text{employer match rate} \\<br />
\end{align}<br />
</math><br />
<br />
Note that if <math>m=0</math>, then the equation simplifies to a simple comparison of current and future marginal rates.<br />
<br />
====Example====<br />
<br />
You can afford to contribute $3,000 out-of-pocket (after taxes) to an employer 401k, with both traditional and Roth options, that matches 100% of the first $4,000 of contributions. Your current marginal tax rate is 12%, and your expected marginal tax rate at withdrawal is 18.5% due to [[#Social Security benefits|taxation of Social Security benefits]]. You can contribute $3,000 to the Roth account and receive a $3,000 traditional match, or $3,409 (=$3,000 / (1 - 12%)) to the traditional account, and receive a $3,409 traditional match. The break-even marginal tax rate at withdrawal is calculated as:<br />
<br />
<math>\frac{(1+100%) \cdot 12%}{100% \cdot 12% + 1} \approx 21.4%</math><br />
<br />
Because the predicted marginal tax rate at withdrawal (18.5%) is less than this value, traditional contributions are preferred. If the match rate were only 50%, or if the marginal tax rate at withdrawal were 22%, then Roth would be preferred instead.<br />
<br />
===Investment quality and fees===<br />
<br />
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k). Conversely, some retirement plans, such as the [[Thrift Savings Plan]], have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost. Investment quality and tax considerations can be combined into the same calculation, by using the Growth_factor in addition to the marginal tax rates. See also: [[IRA#Comparison_to_employer_accounts|Comparison between IRAs and employer accounts]].<br />
<br />
====Example====<br />
<br />
You can either contribute $5,000 pre-tax earnings to a Traditional 401(k) or a Roth IRA. Your marginal tax rate is 22% now, predicted to be 12% in retirement. The investment is expected to grow at 8% before fees in either case, but the Traditional 401(k) charges a 1.00% expense ratio, and the Roth IRA charges a 0.04% expense ratio. Either investment would be withdrawn in 20 years. The future after-tax values of the two investments will be as follows:<br />
:Traditional 401(k): $5,000 * (1 + 8% - 1%)^20 * (1 - 12%) = '''$17,026.61'''<br />
:Roth IRA: $5,000 * (1 + 8% - 0.04%)^20 * (1 - 22%) = '''$18,043.56'''. <br />
<br />
Assuming the investments are held for the full 20 year term, the fees in the 401(k) outweigh the tax savings, and the Roth IRA is a superior investment. However, the tax savings from the Traditional contribution is immediate, whereas the fees reduce performance gradually over time. In this circumstance, if you expected to separate from your employer well before the 20 year term, you could roll the 401(k) into either a low-expense Traditional IRA, or the 401(k) at your new employer. Depending on how long the money remained in the high-expense 401(k), you might come out ahead contributing to the 401(k) now.<br />
<br />
==Complex cases==<br />
<br />
===Social Security benefits===<br />
{{Main|Taxation of Social Security benefits}}<br />
<br />
One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may experience a marginal rate in retirement of 22.2% or 40.7% despite being in the 12% or 22% brackets. The 22.2% "bump" affects Social Security recipients with annual Social Security benefits less than '''$19,310''' (Single) or '''$53,266''' (Married Filing Jointly), and the 40.7% bump affects those receiving more than these values. See the [[Taxation of Social Security benefits|main article]] for more details on where these formulas come from, and for useful visualizations of the phase-in effects. As a function of annual Social Security benefit (SS), the 22.2% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 22.2% Bump Begins !! 22.2% Bump Ends<br />
|-<br />
| Single || $34,000 - 0.5 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $42,757 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
As a function of annual Social Security benefit (SS), the 40.7% bump begins and ends at the following levels of income from other sources:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Filing Status !! 40.7% Bump Begins !! 40.7% Bump Ends<br />
|-<br />
| Single || $42,797 - 0.2297 * SS || $28,706 + 0.5 * SS<br />
|-<br />
| Married Joint || $75,810 - 0.2297 * SS || $36,941 + 0.5 * SS<br />
|}<br />
<br />
The 40.7% bump is more abrupt, because it's bracketed by 22.2% below and 22% above. The 22.2% bump is bracketed by 18% below and 12% above. If you are reasonably close (10-15 years or less) to retirement and are in the benefits and income range where you may be affected by either bump, you should try to either come in under the bump, or go far above it, depending on which option is easier. For those making Traditional contributions, switching to Roth to lower taxable income in retirement might be the easiest option.<br />
<br />
====Example====<br />
<br />
A single investor, age 55, earns $80,000 gross income and has a marginal tax rate of 22%. He plans to retire in 10 years. He currently has $650,000 in Traditional (tax-deferred) savings, expected to grow at 6% after fees, and has been making $12,000 annual contributions. He has no significant taxable investments. He expects to receive a $2,500 per month inflation-adjusted Social Security benefit starting upon retirement at age 65. He does not expect any additional income in retirement, from part-time work, investments income, rental properties, pensions, etc. His 401(k) allows either Traditional or Roth contributions; which should he be making? Making the overly-simplistic assumption that 50% of his Social Security benefit is taxable, his ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(6%-3%,10,-12000,-650000) * 4% || $40,444.49<br />
|-<br />
| Taxable Social Security Benefits || =2500*12*50% || $15,000.00<br />
|-<br />
| Single Standard Deduction (age 65+) || N/A || -$14,250.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$41,194.49'''<br />
|}<br />
<br />
By inspection of the tax bracket structure, his future marginal rate would be 22%, the same as today, so it would seem that Traditional and Roth contributions would be equally valuable. His future income would be only slightly above the start of the 22% bracket ($40,525), so he might choose to favor Traditional in case his predictions were off. However, the picture changes when considering Social Security taxation. Because he receives more than $19,310 annual benefit, he is susceptible to the 40.7% bump. Using the above formulas, the bump begins and ends at the following levels of other income:<br />
<br />
{| class="wikitable"<br />
|-<br />
! 40.7% Bump !! Calculation !! Value<br />
|-<br />
| Begins || $42,797 - 0.2297 * $30,000 || $35,905<br />
|-<br />
| Ends || $28,706 + 0.5 * $30,000 || $43,706<br />
|}<br />
<br />
Unfortunately, his $40,444 Traditional withdrawals put him right in the middle of the 40.7% bump. If he instead contributes $10,000 per year to his 401(k) as '''Roth''' for the next 10 years, his future income from Traditional accounts will be reduced to '''$34,942''' (=FV(6%-3%,10,'''0''',-650000)*4%), keeping him below the 40.7% bump. He will still be in the 85% phase-in range for Social Security, but will be in the 12% bracket, so his marginal tax rate in retirement will be 22.2% (12% * (1 + 85%)). Roth contributions are by far the better choice.<br />
<br />
===Straddling brackets===<br />
<br />
Note that the marginal tax rates now and in the future can be affected by the amount contributed to Traditional accounts. For example, contributing the full $19,500 to a Traditional 401(k) might bring an investor down from the 32% bracket into the 24% bracket. Likewise, contributing more to Traditional accounts might raise the predicted future marginal tax rate such that it might cross into a higher bracket. In these cases, the Traditional vs. Roth analysis should be done for ''each dollar'' invested; contributions can be divided in any proportion. The higher the investment performance, longer the time horizon, and higher the contribution limit to Traditional accounts, the more likely straddling becomes. <br />
<br />
====Example====<br />
<br />
A married couple earns $410,000 gross income and plans to retire in 30 years. They currently have $350,000 in traditional (tax-deferred) savings, expected to grow at 9% after fees. They plan to contribute the maximum $77,500 total to their 401(k) accounts, $38,500 of which can be traditional only, and the remaining $39,000 can be either traditional or Roth. They also have a $50,000 taxable account, to which they expect to contribute $5,000 per year, with an expected growth of 8%, a yield of 2%, and a dividend tax rate of 15%. They expect to each receive a $3,000 per month inflation-adjusted Social Security benefit, of which 85% will be taxable. They do not expect any additional income in retirement, from part-time work, investments income other than tax drag from the taxable account, rental properties, pensions, etc. Should they make traditional or Roth 401(k) contributions with their $39,000 per year? For fully traditional contributions, their ''predicted'' retirement marginal tax rate could be calculated as follows:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-77500,-350000) * 4% || $325,489.25<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*12*2*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$369,167.26'''<br />
|}<br />
<br />
Assuming the current tax system remains in effect, their future marginal rate is predicted to be 32%. Their ''current'' marginal tax rate with full Traditional contributions would be 24% (taxable income = $410,000 - $77,500 - $25,100 = $307,400). On these assumptions, it appears as though they should prefer Roth contributions.<br />
<br />
However, if the calculation is run assuming maximum Roth contributions, the result is different:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Taxable Income Source !! Excel Calculation !! Value<br />
|-<br />
| Traditional Savings Withdrawals || =FV(9%-3%,30,-39000,-350000) * 4% || $203,739.65<br />
|-<br />
| Taxable Account Tax Drag || =FV(8%-3%-(2%*15%),30,-5000,-50000) * 2% || $10,278.00<br />
|-<br />
| Taxable Social Security Benefits || =3000*2*12*85% || $61,200.00<br />
|-<br />
| Married Standard Deduction (age 65+) || N/A || -$27,800.00<br />
|-<br />
| '''Predicted Taxable Income''' || '''=SUM(''above values'')''' || '''$247,417.65'''<br />
|}<br />
<br />
Their future marginal rate would therefore be only 24%, and their current marginal rate with full Roth contributions would be 32% (taxable income = $410,000 - $38,500 - $25,100 = $346,400), the opposite of before. The optimal solution is to split contributions between Traditional and Roth contributions. For simplicity, we can check six possible proportions, although in practice, spreadsheet or optimization software could automate this calculation to be more precise:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Traditional Contribution !! Roth Contribution !! Taxable Income Now !! Taxable Income Future !! Marginal Rate Now !! Marginal Rate Future !! Result<br />
|-<br />
| $38,500 (minimum possible) || $39,000 || $346,600 || $245,836.49 || 32% || 24% || Too much Roth<br />
|-<br />
| $46,300 || $31,200 || $338,600 || $270,502.64 || 32% || 24% || Too much Roth<br />
|-<br />
| $54,100 || $23,400 || $330,800 || $295,168.79 || 32% || 24% || Too much Roth<br />
|-<br />
| '''$61,900''' || '''$15,600''' || '''$323,000''' || '''$319,834.95''' || '''24%''' || '''24%''' || '''Close to optimal'''<br />
|-<br />
| $69,700 || $7,800 || $315,200 || $344,501.10 || 24% || 32% || Too much traditional<br />
|-<br />
| $77,500 || $0 || $307,400 || $369,167.26 || 24% || 32% || Too much traditional<br />
|}<br />
<br />
By splitting the contribution, this couple can lower their total taxes by staying within the 24% bracket both now ''and'' in retirement. Note that this analysis is extremely imprecise; it depends on future contributions being made, investments performing as expected, and the tax code remaining the same, most of which are very unlikely to occur. However, current tax rates are well-known, so if the optimum traditional contribution is close to a step down in marginal rate, it's usually a good idea to contribute just up to that step, then contribute the rest to Roth. In this case, a traditional contribution of '''$55,050''' is probably best, as it puts the couple's taxable income exactly at the 24%/32% bracket boundary at $329,850. They would therefore also contribute '''$22,450''' (=$77,500 - $55,050) to Roth. <br />
<br />
===Maxing out your retirement accounts===<br />
<br />
The IRS sets a maximum contribution to retirement accounts. If you have reached this maximum, anything else you contribute must be in a taxable account that will (if you pay more than 0% on annual earnings or capital gains) lose money to taxes not incurred in either a Traditional or Roth account. The IRS contribution limits do not distinguish between Traditional (pre-tax) and Roth (after-tax) accounts. Because after-tax money is worth more than pre-tax money, Roth accounts effectively allow you to contribute more than Traditional accounts. For example, if your marginal tax rate is 32%, a $19,500 Roth 401(k) contribution will tax-shelter '''$28,676.47''' (=$19,500 / (1 - 32%)) of pre-tax earnings, whereas a Traditional 401(k) contribution can only tax-shelter $19,500. A fair comparison between Roth and Traditional contributions when at a fixed-dollar limit must therefore also take into account the performance of the remaining money in a taxable account. The after-tax amount invested in the taxable account is simply the tax savings from the traditional contribution, in this case '''$6,240''' (=$19,500 * 32%). The future after-tax values of the Traditional account plus the taxable account can then be compared to the Roth account. The equivalent conversion decision would be to convert a $19,500 traditional IRA to a Roth IRA, paying the $6,240 tax with money that would otherwise have been invested in a taxable account.<br />
<br />
When contributing the maximum, traditional contributions have a higher after-tax value when:<br />
<br />
<math>MTR_w < MTR_n \cdot \frac{v - (v - b) \cdot MTR_{cg}}{(1 + r)^t}</math> <br />
<br />
with <br />
<br />
<math>v = (1 + r - y \cdot MTR_{div})^t</math><br />
<br />
and<br />
<br />
<math>b = 1 + \left ( \frac{ y \cdot (1-MTR_{div})}{r - y \cdot MTR_{div}} \right ) \left ( (1 + r - y \cdot MTR_{div})^t-1 \right )</math><br />
<br />
Variables are defined as:<br />
<br />
<math><br />
\begin{align}<br />
MTR_n &= \text{marginal tax rate now, for traditional contributions} \\<br />
MTR_w &= \text{marginal tax rate for traditional accounts at withdrawal} \\<br />
MTR_{div} &= \text{marginal tax rate on dividends} \\<br />
MTR_{cg} &= \text{marginal tax rate on capital gains} \\<br />
v &= \text{growth factor on the taxable balance} \\<br />
b &= \text{growth factor on the taxable basis} \\<br />
r &= \text{total rate of return} \\<br />
y &= \text{yield on the taxable balance} \\<br />
t &= \text{time} \\<br />
\end{align}<br />
</math><br />
<br />
The formula is derived [[User:Fyre4ce/Retirement_plan_analysis#Maxing_out_retirement_accounts|here]]. That page also contains a more complex formula that includes different rates of return for different accounts.<br />
<br />
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=150516#p2773840 This spreadsheet] can be used to perform the calculation using a very similar formula.<br />
<br />
Other factors affect this decision besides simply after-tax value. The combination of traditional and taxable money retains more flexibility than the Roth; traditional money can be converted to Roth in future years, and taxable money can be withdrawn at any time penalty-free. On the other hand, effectively sheltering more money inside retirement plans by choosing Roth can have [[Asset protection|asset protection]] benefits, and Roth accounts do not require [[Required Minimum Distribution|RMDs]].<br />
<br />
====Typical values====<br />
<br />
The following table calculates the break-even withdrawal tax rates for various sets of tax rates at different time horizons. All cases assume an investment with a total return of 8% and yield of 2%, of which 90% is taxed at long-term capital gains rates and 10% as ordinary income. <br />
<br />
{| class=wikitable style="text-align:center"<br />
! style="background:#f0f0f0;" colspan="2"|'''Tax Rates'''<br />
! style="background:#f0f0f0;" colspan="4"|'''Time (Years)'''<br />
|-<br />
! style="background:#f0f0f0;"|'''Ordinary Income'''<br />
! style="background:#f0f0f0;"|'''Long-Term Capital Gains'''<br />
! style="background:#f0f0f0;"|'''10'''<br />
! style="background:#f0f0f0;"|'''20'''<br />
! style="background:#f0f0f0;"|'''30'''<br />
! style="background:#f0f0f0;"|'''40'''<br />
|-<br />
| 12.0%<br />
| 0.0%<br />
| 11.97%<br />
| 11.94%<br />
| 11.91%<br />
| 11.89%<br />
|-<br />
| 24.0%<br />
| 15.0%<br />
| 21.79%<br />
| 20.45%<br />
| 19.52%<br />
| 18.77%<br />
|- <br />
| 32.0%<br />
| 18.8%<br />
| 28.31%<br />
| 26.10%<br />
| 24.58%<br />
| 23.39%<br />
|- <br />
| 37.0%<br />
| 23.8%<br />
| 31.65%<br />
| 28.51%<br />
| 26.40%<br />
| 24.79%<br />
|- <br />
| 50.3%<br />
| 37.1%<br />
| 39.20%<br />
| 32.98%<br />
| 29.05%<br />
| 26.23%<br />
|}<br />
<br />
Note how dramatic the effect is for investors with high tax rates; even with a marginal tax rate today of 50.3%, after 40 years Roth contributions give more money after taxes with a withdrawal rate as low as ~26.3%.<br />
<br />
====Very high income and wealth====<br />
<br />
Investors with high income and wealth, who expect to be in the top tax bracket now ''and in retirement'', should usually prefer Roth contributions, for these reasons:<br />
<br />
*Being in the same (top) tax bracket now and in retirement eliminates any tax rate arbitrage between contribution and withdrawal, which is a typical advantage of traditional accounts<br />
*High tax rates on dividends and capital gains heavily degrade the performance of taxable investments, and shift the advantage more toward Roth accounts<br />
*The asset protection benefits of sheltering more money in Roth accounts are probably more significant for those with high income and wealth, and the higher liquidity of taxable accounts is probably less significant<br />
<br />
====Example====<br />
<br />
You are deciding between traditional and Roth contributions in your 401(k), with a contribution limit of $19,500. Your marginal rate now is 24%, your marginal rate in retirement is predicted to be 22%, your tax rate on qualified dividends and long-term capital gains are both 15%. Your investments in any account are expected to have annual capital growth of 6% and a yield of 2%, for 8% total return, compounding annually. The yield is comprised of 90% [[Qualified dividend|qualified dividends]] and long-term [[Capital gains distribution|capital gains distributions]]; the remaining 10% yield is taxed as ordinary income. You plan to withdraw the money in 25 years. Are traditional or Roth contributions preferred?<br />
<br />
The dividend tax rate on the taxable investment is:<br />
<br />
<math>MTR_{div} = 90% \cdot 15% + 10% \cdot 24% = 15.9%</math><br />
<br />
The growth factors for the balance and basis of the taxable investment are:<br />
<br />
<math>v = (1 + 8% - 2% \cdot 15.9%)^{25} \approx 6.362</math><br><br />
<br />
<math>b = 1 + \left ( \frac{ 2% \cdot (1-15.9%)}{8% - 2 \cdot 15.9%} \right ) \left ( (1 + 8% - 2 \cdot 15.9%)^{25}-1 \right ) \approx 2.174</math><br />
<br />
The withdrawal rate below which traditional contributions are preferred is:<br />
<br />
<math>24% \cdot \frac{6.362 - (6.362 - 2.174) \cdot 15%}{(1 + 8%)^{25}} \approx 20.09%</math> <br />
<br />
Despite the predicted withdrawal tax rate (22%) being less than the current tax rate, Roth contributions have a higher after-tax value. The spreadsheet linked above gives a similar value:<br />
<br />
[[File:Maxing contribution comparison.PNG]]<br />
<br />
You should decide whether the tax savings (about 2% of the contribution) is worth the partial loss of liquidity. <br />
<br />
===Saver's credit===<br />
<br />
[[Saver's credit|Saver's Credit]]<ref>[http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions Get Credit for Your Retirement Savings Contributions], and [http://www.irs.gov/pub/irs-pdf/f8880.pdf IRS Form 8880: Credit for Qualified Retirement Savings Contributions]</ref> is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2,000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit. While qualifying for the Saver's credit, Traditional or Roth can be decided upon using the following analysis. Traditional contributions are preferred when:<br />
<br />
<math>MTR_w < \frac{MTR_{n,T} - MTR_{n,R}}{1 - MTR_{n,R}}</math> (derived [[User:Fyre4ce/Retirement_plan_analysis#Saver's_Credit|here]])<br />
<br />
where:<br />
<br />
<math><br />
\begin{align}<br />
MTR_{n, T} &= \text{marginal tax rate now, for the traditional contribution, including Saver's Credit} \\<br />
MTR_{n, R} &= \text{marginal rate now of Saver's Credit for the Roth contribution} \\<br />
MTR_w &= \text{marginal tax rate for traditional contributions at withdrawal} \\<br />
\end{align}<br />
</math> <br />
<br />
====Example====<br />
<br />
Consider a single filer with $30,000 gross income. For that person, up to a $2,000 contribution, <math>MTR_{n,T} = 22%</math> and <math>MTR_{n,R} = 10%</math>.<br />
<br />
For a $2,000 traditional contribution, the equivalent Roth contribution is <math>R = $2,000 \cdot (1 - 22%) / (1 - 10%) = $1,733</math>.<br />
<br />
The withdrawal marginal tax rate for equivalent results is:<br />
<br />
<math>\frac{22% - 10%}{1 - 10%} \approx 13.33%</math>.<br />
<br />
If this investor expects the actual withdrawal marginal tax rate will be less than 13.3%, traditional is better. If more than 13.3%, Roth is better.<br />
<br />
===Real-world example===<br />
<br />
The methods described earlier in this article assume that one's marginal tax rate vs. contribution curve is either [https://en.wikipedia.org/wiki/Monotonic_function flat or decreasing], and one's marginal tax rate vs. withdrawal curve is flat or increasing. This behavior would be typical of a simple [[Progressive tax|progressive tax]] system. The US tax code, however, is not simple. Some credits, e.g., the [https://en.wikipedia.org/wiki/Earned_income_tax_credit Earned Income Tax Credit (EITC)] and the [[Saver's credit]], may apply only after a certain amount of low benefit contributions. Similarly, the [[Taxation of Social Security benefits]] may cause high rates on some portion of withdrawals, but past that portion the rates decrease.<br />
<br />
Consider a couple with two children earning $54,000 per year gross income. Their marginal tax rate curve looks as follows. The plot has negative values because the tax goes down as the 401(k) contribution goes up. The rest of this example follows the convention of ignoring the negative sign and refers to the rate at which tax was avoided when using "tax rate."<br />
<br />
[[File:NonMonotonicMarginalRate2.png|frame|none|Tax Rate vs. 401k Contribution (negative values because tax decreases as contributions go up)]]<br />
<br />
Their marginal tax rate goes through regions of 22%, 43%, 33%, 31%, and 21%, and there is a $200 spike due to a change in the saver's credit tier from 10% to 20%.<br />
* 22%: 12% bracket plus 10% saver's credit<br />
* 43%: 12% bracket plus 10% saver's credit plus 21% Earned Income Tax Credit phase-in<br />
* 33%: 12% bracket plus 21% Earned Income Tax Credit phase-in (saver's credit maximum contribution reached for this example)<br />
* 31%: 10% bracket plus 21% Earned Income Tax Credit phase-in<br />
* 21%: 0% bracket plus 21% Earned Income Tax Credit phase-in<br />
<br />
====Method====<br />
<br />
In order to capture the effect of the various peaks, valleys, and spikes, remember the operative definition of marginal tax rate: '''[total additional tax] / [total additional contribution]'''. In the chart above, the "Cumulative" curve shows that calculation for the given starting point. For example, even though the marginal tax rate is 43% for contributions between $1,500 and $2,000, this couple would have to contribute $1,500 at only 22% in order to achieve that benefit. A $2,000 401(k) contribution would result in a tax decrease of $543.83, for a marginal tax rate of about 27% ($543.83 / $2,000). If the marginal tax rate on withdrawals is fixed, a simple method to optimize contributions is as follows:<br />
<br />
# Starting at a traditional contribution of $0, calculate the marginal tax rates ([total additional tax saved] / [total additional contribution]) for all contributions between the starting point and the maximum contribution (limited by either IRS rules, or how much you can afford to save).<br />
# Find the maximum marginal rate and the corresponding contribution<br />
# If the maximum marginal rate is greater than your predicted marginal tax rate at withdrawals, make that traditional contribution. Then return to Step #1 with the starting $0 reset to the traditional contributions so far. If the contribution marginal tax rate becomes lower than the expected withdrawal tax rate, contribute remaining retirement savings to Roth accounts.<br />
<br />
It may be helpful to use charts such as the example given here to understand these situations. One can download the [https://www.bogleheads.org/wiki/Tools_and_calculators#Personal_finance_toolbox Personal finance toolbox] Excel spreadsheet and use it for a wide variety of tax situations. Simply eyeballing the chart, it appears that somewhere between $13K and $14K would be the best traditional contribution. See below for more exact numbers.<br />
<br />
====Analysis====<br />
<br />
The married one-earner couple described above predict a 22% marginal tax rate in retirement. They can afford to save $10,000 after taxes to retirement accounts. How much should they contribute to traditional and Roth accounts?<br />
<br />
* Starting from $0 contribution, their maximum marginal savings rate is at a 401k contribution of '''$12,500''', just enough to reach the 20% Saver's credit tier. This contribution results in a total tax savings of '''$4,169''', for an incremental savings rate of '''~33.35%'''. This rate is higher than the expected marginal tax rate on withdrawals of 22%, and the after-tax cost of $8,331 ($12,500 - $4,169) is less than the maximum, so contribute $12,500 to traditional accounts and try another iteration.<br />
* Starting from $12,500 contribution, their maximum incremental savings rate is at an incremental contribution of '''$1,100''', resulting in an incremental tax savings of '''$342''', for an incremental savings rate of '''~31.1%''' ($342 / $1,100). This rate is still higher than the withdrawal tax rate, and the total after-tax cost is '''$9,089''' ($1,100 - $342 + $8,331), so contribute an additional $1,100 to traditional accounts and try another iteration.<br />
* The marginal rate for all traditional contributions beyond $13,600, up to the $19,000 IRS limit, is '''~21.06%'''. This is less than the marginal tax rate on withdrawals, so contribute no additional traditional money. Contribute the remaining '''$911''' ($10,000 - $9,089) to Roth accounts. To maximize the saver's credit, the $911 should be contributed by the non-earning spouse. If both spouses are eligible for a 401k, having each contribute at least $2,000 will maximize the saver's credit, and then who contributes to the Roth doesn't matter. <br />
<br />
These steps can be summarized in the following table:<br />
<br />
{| class="wikitable"<br />
|-<br />
! Cumulative Traditional Contribution !! Incremental Traditional Contribution !! Incremental Tax Savings !! Incremental Savings Rate !! Cumulative After-Tax Cost !! Invest?<br />
|-<br />
| $12,500 || $12,500 || $4,169.15 || 33.3532% || $8,330.85 || Yes<br />
|-<br />
| $13,600 || $1,100 || $341.66 || 31.0602% || $9,089.19 || Yes<br />
|-<br />
| Up to $19,000 || Up to $5,400 || Up to $1,137.25 || 21.0602% || Up to $13,351.93 || No<br />
|}<br />
<br />
The optimal retirement contributions for this couple are '''$13,600''' to traditional accounts and '''$911''' to Roth.<br />
<br />
Additional examples may be found in [https://www.bogleheads.org/wiki/Traditional_versus_Roth_examples Traditional versus Roth examples]<br />
===Direct calculation method===<br />
<br />
For situations where ''both'' the marginal savings rate and marginal tax rate at withdrawal are irregularly shaped (perhaps due to [[Taxation of Social Security benefits|taxation of Social Security benefits]]), direct calculation of future after-tax value in retirement is best. One possible method could be as follows:<br />
<br />
# For every possible Traditional contribution, calculate the maximum amount of Roth and [[Taxable account|taxable]] contributions that can be made while still having enough spending money to cover expenses.<br />
# For each case, calculate the future value (using "=FV" in Excel, or similar) of the Traditional, Roth, and taxable accounts at retirement.<br />
# Calculate the total taxes due in retirement, and the after-tax value of investment withdrawals. The set of contributions with the highest after-tax value is best.<br />
# The analysis should be repeated every year.<br />
<br />
==See also==<br />
*[[Traditional versus Roth examples]] contains additional examples<br />
<br />
==References== <br />
{{Reflist|30em}}<br />
<br />
==Further reading==<br />
* [[Bogleheads' Guide to Retirement Planning]], Chapter 10<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=14166 Roth vs Traditional 401K] on Bogleheads.org forum, 5 March 2008.<br />
* [http://www.bogleheads.org/forum/viewtopic.php?t=61529 Why the Roth IRA bias?] on Bogleheads.org forum, 14 October 2010.<br />
<br />
==External links==<br />
* [http://thefinancebuff.com/case-against-roth-401k.html The Case Against Roth 401(k)] on [http://thefinancebuff.com TheFinanceBuff.com], retrieved 9 September 2012<br /&g