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A Simple Rule-of-Thumb for Roth Contributions

Updated: Nov 16, 2022

Contributing to tax-advantaged accounts is one of the most important actions consumers can take to help ensure a secure retirement. But those saving for retirement are very often faced with a seemingly difficult choice: should they contribute to tax-deferred accounts (e.g., traditional 401(k), traditional IRA) or Roth accounts (e.g., Roth 401(k), Roth IRA)?

Here's a very good rule-of-thumb to help make this decision easier:

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

Mendenhall Glacier near Juneau, AK

In the remainder of this post, I'll explain why this rule-of-thumb is mostly accurate along with exceptions to it.

How tax-deferred and Roth accounts work

Tax-deferred accounts, like 401(k) plans and traditional IRAs, allow you to make contributions to them and deduct those contributions from your income for federal income tax purposes. However, when you withdraw the funds, including any growth, the withdrawals are taxed as regular earned income.

When making contributions to Roth accounts, you cannot deduct those contributions for federal income tax purposes, but when you withdraw the funds, including any growth, the withdrawals are not taxed.

The fact that Roth funds not only grow tax-free but are also not taxed when they are withdrawn has led many giving financial advice, including some very well known folks, to say that, given the choice between the two, investors should always make Roth contributions rather than tax-deferred. But it can easily be shown that this is an error.

Let's assume that an investor in the 12% federal income tax bracket contributes $1,000 to a traditional IRA which goes on to double in value to $2,000. In retirement, this investor withdraws the $2,000 and pays 12% federal income tax on the funds, leaving $1,760 after the tax.

If the investor had contributed to a Roth IRA instead, 12% federal income tax would be paid before the contribution was made, leaving $880 to contribute to the Roth IRA. If those funds then double in value and are withdrawn tax-free in retirement, the investor will have $1,760, precisely the same amount as if the traditional IRA had been used instead. (The reason the investor above is left with identical after-tax funds in retirement is due to the commutative property of multiplication.)

The critical factor in the above examples is that the investor's federal tax rate, specifically, the marginal tax rate (i.e., the tax rate paid on additional dollars of income), was the same at the time of the contribution and withdrawal.

If the investor's marginal tax rate at the time of a contribution is higher than the investor's marginal tax rate at the time of the withdrawal, then tax-deferred contributions will result in greater after-tax funds. Conversely, if the marginal tax rate is higher at the time of the withdrawal, then Roth contributions will come out ahead.

Significance of the 12% bracket in the rule-of-thumb

Since marginal tax rates are the crucial factor in determining whether tax-deferred or Roth contributions will result in greater after-tax wealth, it might seem easy to determine which the investor should choose.

But while we know what an investor's marginal tax rate is right now (i.e., at the time of the contribution), we unfortunately don't know what the investor's marginal tax rate will be when the withdrawal is made.

The problem of not knowing with certainty what the marginal tax rate will be at the time of the withdrawal does not, however, mean that investors are clueless as to what to do. On the contrary, there is solid information to guide this decision.

Few in the U.S., including even those who are rather savvy about personal finance, fully understand how Social Security benefits are taxed (including me!). In-depth explanations are available elsewhere, but the relevant point here is that once you start receiving Social Security benefits, your marginal tax rate can be very high. See the table below from the Bogleheads Wiki for a visual illustration of this.

Federal Marginal Tax Rate of Married Filing Jointly Couples

vs. Social Security and Other Income in 2022

In 2022, a married filing jointly couple receiving $40,000 of Social Security benefits and with $24,000 of additional earned income, which might come from continued employment, withdrawals from tax-deferred accounts, or real estate, among other sources, would be in a 15% marginal tax rate. (Note that this means that additional income the couple earned would be taxed at 15% and not that the entire $64,000 of income would be taxed at 15%.) If the same couple had $34,000 of income besides their Social Security benefits, their marginal tax rate would be 22.2%. And those with $58,000 of Social Security benefits or more could have a portion of their income taxed at a whopping rate of 40.7%!

If that looks scary, it should be. A couple who was never in a higher federal tax bracket than 12% could be taxed at a much higher rate than that once they start receiving Social Security benefits. And it's only getting worse over time because the income levels needed to reach higher marginal tax rates are dropping over time because they are not adjusted for inflation. If the high inflation we've seen of late wasn't bad enough already, it's even worse for those receiving Social Security benefits because it can easily result in their marginal tax rate increasing! And the problem is even worse for single filers, including widows and widowers.

One of the best defenses against this significant tax issue, though there are others that I'll discuss in the future, is to reduce your 'additional income' after your Social Security benefits begin. This is where Roth accounts shine. Withdrawals from Roth accounts are not subject to federal income taxes and don't impact your marginal tax rate.

As the table above demonstrates, it doesn't take much income beyond Social Security benefits to result in a marginal tax rate above 12%. And remember that if your marginal tax rate when you withdraw funds is higher than when you contributed those funds, you're better off with Roth accounts.

And that is why it generally makes sense for those in the 12% federal tax bracket to contribute to Roth accounts over tax-deferred accounts.

A beach on the road to Hana on Maui, HI

It should be noted that in the above examples, a fair amount of income beyond Social Security benefits is needed before the couple would owe any federal income taxes (i.e., move out of the so-called '0% federal tax bracket'). This ranges from $12,000 to $26,000 for a married filing jointly couple. If we assume that the couple would achieve this by withdrawing from tax-deferred accounts and would withdraw 4% of those funds each year, that means that the couple could have between $300,000 (i.e., 4% / $12,000) and $650,000 in tax-deferred accounts and not paying any federal income taxes on the withdrawals in 2021. This is a valid and important point that is discussed more below.

Exceptions to the rule-of-thumb

No rule-of-thumb is universally true, and that's certainly the case here. There are several exceptions to the rule-of-thumb, some more common than others, and these are outlined below.

1. No retirement plan at work

According to the Bureau of Labor Statistics, 68% of workers in private industry had access to a retirement plan in 2021, and this was true of 92% of workers in state and local governments. And the most common types of retirement plans are broadly referred to as a defined contribution plan, which includes 401(k) plans, 403(b) plans, and others, and the income they provide to retirees is usually taxable. Many workers have access to Roth 'versions' of these accounts, but not all of the income from even these is tax-free. For instance, in a Roth 401(k) plan, the contributions made by the employer to the plan are tax-deferred and will be taxed when withdrawn. As such, it's not too difficult for most people with a retirement plan at work to generate enough 'additional income' in retirement to 'fill up' the $12,000 to $26,000 in 2021 that would not be taxed. And remember that these income levels are declining over time due to inflation. But for those without a retirement plan at work, it's more challenging to build enough assets to produce the above income. Some mix of both tax-deferred or perhaps even only tax-deferred contributions to an individual retirement account (IRA) may be appropriate for such people.

2. Unlikely to have much additional income in retirement

Similar to #1 above, those who are within a decade or so of retirement and aren't likely to have enough income beyond Social Security benefits to be taxed should prefer tax-deferred over Roth contributions, even if they're in the 12% bracket.

3. Early retirement

Those planning to retire well before claiming Social Security benefits should nearly always prefer making contributions to tax-deferred rather than Roth accounts. This is because a substantial chunk of their retirement income will not be taxed or will be taxed at a lower rate than 12%. In 2022, the standard deduction for a married filing jointly couple is $25,900, meaning that their first $25,900 of income will not subject to federal income taxes at all. And the next $20,550 of income for such people is only taxed at 10%. Assuming that they would withdraw 4% of their portfolio to generate this income, this means that they would need roughly $1.16 million ($46,450 / 4%) to 'fill up' the standard deduction and 10% tax bracket, a substantial hurdle for most workers. Those blessed to have more than this or are on track to do so may consider switching to Roth accounts for various reasons that will be discussed in a future post.

4. Moving from a high tax state to a low tax state

State tax rates have not been considered until now in this post, but they can be relevant to the topic and my rule-of-thumb. Those currently living in a state with very high income taxes but who are considering moving to a state with very low or zero income taxes in the future, especially in retirement, may well be better off making tax-deferred contributions now instead of Roth.

5. Ability to make substantial withdrawals with minimal taxes

Some retirees are able to make big withdrawals from tax-deferred accounts and yet pay little in taxes. A common means of achieving this is by having very large medical bills. Taxpayers can deduct medical expenses that are greater than 7.5% of their adjusted gross income. Note that a portion of long-term care expenses, which can be very substantial, are generally considered to be medical expenses.

6. No Social Security benefits

Those who are going to receive little or no Social Security benefits (e.g., legally opted out of Social Security, do not have enough credits to receive benefits) or will only receive minimal benefits should typically prefer tax-deferred contributions over Roth.

But Always Max a 401(k) Match First!!

There is a vital exception to the 'contribute to Roth if in the 12% bracket' rule-of-thumb: always max out any 401(k) match before contributing to anything else. The 'return' of 401(k) and similar plans' matches will exceed any other guaranteed benefit you could ever get. For instance, a it's very common for employers with 401(k) plans to match 50% of their employees' contributions up to 5% of their gross pay. A 50% return is unbeatable and should never be passed up!

Final Words

Note that the rule-of-thumb also applies to Roth conversions, where you convert existing tax-deferred funds to Roth accounts, and the funds converted are taxed as earned income.

In this post, I've explained the reasoning behind the first part of the rule-of-thumb (i.e., why contributing to Roth accounts makes sense in the 12% marginal tax bracket). In a future post, I'll explain why tax-deferred contributions should be preferred in higher tax brackets.

Taxes and efforts to legally reduce them can get complicated, but doing so can make a big difference in your ability to successfully fund your retirement and avoid being a burden to others. I hope that my rule-of-thumb and this post will help you secure a better retirement.

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