A Follow-up to the Rule-of-Thumb for Roth Contributions

Updated: Nov 16

I recently posted a simple rule-of-thumb for when to make Roth contributions (and converting tax-deferred assets to Roth). In case you missed it, here it is again.


If your federal tax bracket is 12% or lower, contribute to Roth accounts. Otherwise, contribute to tax-deferred accounts.


In my earlier post, I discussed how tax-deferred and Roth accounts work, why Roth contributions make sense in the 12% federal tax bracket, and some exceptions to the rule-of-thumb.


In this post, I elaborate on why tax-deferred contributions are generally superior to Roth contributions for those in higher tax brackets (i.e., 22% and above) and situations where that might not be true.


Value of Deferring Taxes


The Ledges, Cuyahoga Valley National Park

Remember that the key variables that determine whether tax-deferred or Roth contributions will result in more after-tax wealth are the investor's marginal tax

rate at the time of the contribution and later at the time of the withdrawal. If the tax rate is higher at the time of the contribution, then tax-deferred contributions 'win' and vice versa for Roth contributions.


Apart from Social Security benefits, investors need relatively large portfolios to reach high marginal tax rates in retirement. In 2022, a married filing jointly couple aged 65 withdrawing 4% from a tax-deferred portfolio will pay no income tax at all on the first $28,700 they withdraw (i.e., the standard deduction for a 65 year old couple); this corresponds to a tax-deferred balance of $717,500 ($28,700 / .04). That might seem like a monumental sum to many, but those who participate in workplace retirement plans like a 401(k) for decades can get there with greater ease than they might believe. Contributing $813 per month (don't forget that a big chunk of that may be an employer's match) for 30 years and achieving a 5% inflation-adjusted return on their funds would generate this amount.


The next $20,550 of income the same couple receives would only be taxed at 10%, and it would take an additional $513,750 of tax-deferred funds to 'fill up' this tax bracket. After that, the following $63,000 of income would be taxed at 12%, requiring an additional $1,575,000 of tax-deferred funds.


Putting all this together, a married filing jointly couple withdrawing 4% of their portfolio needs $2,806,250 of tax-deferred funds to 'fill up' the standard deduction, 10% tax bracket, and the 12% tax bracket. (For single individuals, the needed amount is half that, about $1.4 million.)


The bottom line: it takes a lot of tax-deferred funds before retirees reach the 22% marginal tax rate. As such, it makes good sense for most non-retired folks currently in the 22% or higher tax bracket.


But What if Tax Rates Go Up?


Some might be quick to say that if tax rates are increased in the future that tax-deferred contributions will be taxed horribly, thereby making Roth contributions now better for everyone. However, it's false to say that any increase in future tax rates will flip the above situation in favor of Roth contributions.


Workers currently in the 22% bracket can avoid paying that 22% tax rate in favor of 0%, 10%, or 12%, depending on how much they will have in tax-deferred accounts when they begin withdrawing from them. Let's say that tax rates increase by a whopping 50% in the future, meaning that the 10% bracket turns to 15%, and the 12% bracket turns to 18%. In even this very pessimistic scenario, it's still better to pay a 15% and/or 18% marginal tax rate than 22%.


Impact of Social Security Benefits


Social Security benefits complicate the above situation and not in retirees' favor.


Once Social Security benefits begin, it doesn't take significant non-Social Security income (e.g., withdrawals from tax-deferred accounts, pension, real estate income) to increase one's marginal tax rate. In 2022, a 65 year old married filing jointly couple receiving $30,000 of Social Security benefits and $24,000 of additional taxable income will just reach a 15% marginal tax rate. Additional income of $30,000 will result in an 18.5% marginal tax rate, and this increases to 22.2% for additional income of $36,000. However, between $52,000 and $84,000 of additional income, the marginal tax rate is only 12%. This means that if this couple had $84,000 of additional income, only a small portion of it would be taxed at a rate just barely higher than 22%. So, most of the tax-deferred contributions while this couple was in the 22% tax bracket or higher still resulted in greater after-tax wealth.

Dahlias on the Bridge of Flowers, Shelburne Falls, MA

Second, if you look at the table from the earlier post, you'll see that a couple with $58,000 or more in Social Security benefits and $30,000 of additional income would be in a 22.2% marginal tax rate, and as their additional income rose, their marginal tax rate would never fall below 22%; a small portion would be taxed at 40.7%. Those who are expecting to receive this level or more of Social Security benefits should consider making more Roth than tax-deferred contributions.


Since Social Security benefits can result in fairly high marginal tax rates, it often makes very good sense to convert a portion of one's tax-deferred funds to Roth funds before taking Social Security benefits. This requires that you pay regular income taxes on the converted funds. A very good strategy can be to convert tax-deferred funds between the time that one retires and one starts receiving Social Security benefits. If this period of time is long enough, it can provide retirees with the opportunity to convert enough tax-deferred funds to keep them out of the high marginal tax rates they would otherwise be in once their Social Security benefits begin. And by waiting until you're older before starting your Social Security benefits, the amount of those monthly benefits when they begin increases. I believe this to generally be a good strategy that I'll discuss in a future post.


Efficiently Using Tax-Deferred Funds


Those who give funds to charity, which I believe that Christians who are able to do so generally should, can do so very effectively with qualified charitable distributions (QCDs). If you are aged 70.5 or older, you (and your spouse) can give up to $100,000 annually from tax-deferred (aka 'traditional') IRAs and Simplified Employee Pension plans (SEP) to charities. These provide a significant tax benefit because the donated funds don't increase the giver's taxable income; the funds literally pass directly to the charity with no tax impact on the giver at all! This is especially helpful once retirees reach age 72, when they must withdraw a percentage of their tax-deferred funds every year (i.e., required minimum distributions or RMDs). QCDs can reduce or even eliminate the need to withdraw additional funds as part of RMDs.


Let's see an example of how QCDs can help reduce the giver's taxes. Suppose that a 72 year old, married filing jointly couple has $40,000 of Social Security benefits and $40,000 of additional income that they are required to take from their tax-deferred funds to meet the RMD requirement. They want to donate $8,000 to a charity. If they took all the $40,000 of RMDs themselves before making the $8,000 donation, the entire $40,000 would be taxable, and they would owe $3,300 in federal income taxes. But if they donated the $8,000 to the charity as a QCD instead, their additional income would only be $32,000, and they would owe $1,613 in federal income taxes.


More details regarding QCDs and their benefits can be found here.


Deducting significant medical expenses can be another way to efficiently use tax-deferred funds. In 2022, taxpayers can deduct qualified medical expenses that exceed 7.5% of their adjusted gross income (AGI). However, to reduce one's taxes, this means that all of your deductions must exceed your standard deduction, which is $28,700 in 2022 for a married filing jointly couple over age 65. This usually puts a very high threshold on one's ability to deduct medical expenses, but it's possible to incur such expenses with something like long-term care, which can be very pricey. Medically necessary long-term care expenses are deductible. So, if a spouse needs long-term care in a nursing home, which can easily cost $100,000 a year, it's very possible that the majority of the expense can be withdrawn from tax-deferred accounts without the withdrawal being taxed due to the expense being tax deductible. Consulting a tax professional is a very good idea if you find yourself in this position.


Final Words


In this post, I've explained the second part of the rule-of-thumb (i.e., why contributing to tax-deferred accounts makes sense in marginal tax brackets higher than 12%). If you'd like to understand the reasoning behind the first part of the rule-of-thumb, read my first post on this topic.


Managing one's taxes efficiently is something that, in my experience, few people seem to think about at all. While the topic can be dense and boring, it can save you significant money, enabling you to have a better retirement and more to share with others.

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