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Roth vs Tax-Deferred: Should I Look At Marginal or Effective Tax Rate?

A reader writes in, asking:

“When choosing between a Roth 401k and regular 401k, people always talk about marginal tax rate. Does effective tax rate play into the decision as well? I expect to have a very low effective tax rate in retirement due to a lower income level and the tax advantaged nature of Social Security. Is that a point in favor of using a regular 401k rather than Roth?”

For those who are unfamiliar with the terms: Your “effective tax rate” is the average tax rate on all of your dollars of income within a given year (i.e., total tax, divided by total income). In contrast, your “marginal tax rate” refers to how much additional tax you would have to pay on an additional amount of income (i.e., additional tax, divided by additional income).

To answer the reader’s question, no, your effective tax rate doesn’t really play into the Roth-vs-tax-deferred decision. Your marginal tax rate (i.e., the tax rate on only the dollars of income in question) is what matters here.

This is, by the way, a general rule about economic decisions — they’re made at the margin. That is, we want to know, “if I make decision X, how will [something] change?”

  • If I sell more units, how does my revenue change (i.e., what is my marginal revenue)?
  • If I produce more units, how do my costs change (i.e., what is my marginal cost of production)?
  • If I buy more of this product, how does my happiness change (i.e., what is the marginal utility of this product)?

And when it comes to retirement accounts, we want to know: If I contribute to a tax-deferred account (as opposed to a Roth account), how does the amount of tax I have to pay this year change, and how does the amount of tax I have to pay in the future change when I take money out of the account? Marginal, not effective, tax rates are what answer these questions.

That said, there are a few important points that need clarification, as there’s more to the question of marginal tax rates than just, “what tax bracket am I in now, and what tax bracket will I be in later?”

First, it is important to account for the fact that there can be multiple applicable marginal tax rates within a given year, if the deduction/income in question would push you under/over a given threshold.

Second, it’s important to remember that your marginal tax rate is not necessarily the same as your tax bracket. For example, due to the way in which Social Security is taxed, it’s very common for retirees to have a marginal tax rate that is significantly greater than the tax bracket they’re in.

Finally, it’s important to note that it’s quite difficult to accurately predict your marginal tax rate decades into the future. This is, in itself, a good reason to hedge your bets by making sure that you have some money in Roth accounts and some money in tax-deferred accounts.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

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Investing Blog Roundup: The Downside of Short-Term Bonds

There’s no denying that interest rates are low right now. But that fact is not, in itself, a reason to think that rates are going up any time soon.

Using short-term bonds in your portfolio (rather than intermediate-term bonds) does indeed reduce the size of the loss you’ll incur whenever interest rates do rise. But, as Rick Ferri reminds us this week, using short-term bonds is not a clear “win,” given that you’ll be collecting less interest while you wait for rates to rise. And you could be waiting a very long time.

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More to Risk Tolerance Than Just Age

A reader writes in, asking:

“One thing I don’t understand about target date funds is the implicit assumption that the only thing that should determine your asset allocation is how old you are. Doesn’t this seem like an obvious mistake?”

I’m not sure I’d say it’s a mistake how target date funds are constructed. But I absolutely agree that there’s more to risk tolerance and asset allocation than just the year in which you plan to retire.

For example, how stable is your income? A person with a secure, steady-paying job can take on more risk than a person with a job that could be lost at any minute or a person with a job that pays entirely based on commission.

What other assets do you have? If you have a very large emergency fund that you’re not counting as part of your portfolio, you can take on more risk in the portfolio than somebody with a smaller emergency fund.

What other assets would you have access to, if the need arose? Consider two young investors. One comes from a poor family and knows with 100% certainty that she wouldn’t be able to get any sort of financial assistance from friends or family if she lost her job. The other comes from an upper middle class background and knows that the Bank of Mom and Dad would chip in (at least to some extent) if a financial emergency came up. All else being equal, these two investors have very different levels of risk tolerance.

How much investing experience do you have? Have you been through a bear market before? Until you’ve experienced one, you should assume that it will feel worse than you’d naturally expect. If your portfolio is small relative to the size of your total available assets and you can therefore afford to make a mistake (e.g., sell out at or near the bottom in the event that you can’t handle the stress), then go ahead and build a high-risk portfolio. But if selling out would be a problem and you’ve never been through a bear market, you should probably consider a less risky allocation.

Do you have any need for the higher expected returns that come from a risky portfolio? For example, author/advisor Larry Swedroe has often written that he has a “low marginal utility of wealth” (marginal utility being the additional happiness you would get from more of the item in question), meaning that he has little to gain from a high-risk portfolio. Or, as Bill Bernstein puts it, ”if you’ve won the game, why keep playing?”

Target Retirement Funds and Risk Tolerance

Due to all of the above factors, an investor might want an allocation that doesn’t vary solely with age. For example, for a young investor who has a relatively low risk tolerance and who doesn’t expect that risk tolerance to change any time soon, a fixed 60% stock, 40% bond allocation may be a good fit. But the Target Retirement funds don’t offer that option. For investors who want an allocation that doesn’t vary with age, and who still want the simplicity of an all-in-one fund, Vanguard’s LifeStrategy funds can be a good fit.

Investing Blog Roundup: Bernstein on International Bonds and More

This week, Olly Ludwig of ETF.com has an excellent interview with Bill Bernstein about his recent book If You Can. The interview covers a range of topics from why Bernstein doesn’t recommend owning international bonds, to how he’s trying to get the message of sensible investing out to millennials.

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3 Bad Reasons to Claim Social Security Early

Administrative note: My wife and I are moving this week, from St. Louis, Missouri to Manitou Springs, Colorado. As a result, there will be no articles this upcoming Friday (6/20) or Monday (6/23). Also, please be patient with me if I’m slower than usual in replying to emails.

There are many perfectly good reasons to claim Social Security early. For example:

  • You need the cash flow right now,
  • You are unmarried and have a shorter than average life expectancy,
  • You’re the higher earner in a married couple, and both you and your spouse have significantly shorter than average life expectancies,
  • You’re the lower earner in a married couple and either you or your spouse has a shorter than average life expectancy,
  • Inflation-adjusted interest rates are high, making the “take the money and invest it” strategy likely to work out well, or
  • You plan to take the money early and invest it in risky assets, you understand that there’s a significant possibility that you’ll end up worse-off as a result of that decision, and you can afford such an unfavorable outcome.

Unfortunately, people frequently claim Social Security early for reasons that don’t make a great deal of sense. Three especially common not-so-good reasons for taking Social Security early include:

  1. You want to spend more money in early retirement than in later retirement,
  2. You don’t want to work until age 70, and
  3. You want to leave behind money to your kids.

One way to assess the when-to-claim decision is to calculate the break-even point between two different strategies. For example, how long do you have to live for claiming at 70 to be a better strategy than claiming at age 62? As it turns out, if inflation-adjusted interest rates are below 2% or so, the break-even point occurs prior to age 83 (age 83 being the total life expectancy for an average 62-year-old).

Stated differently, unless investors can safely earn inflation-adjusted investment returns of 2% or more (not possible at the moment, given current TIPS yields), most people (specifically, most unmarried people and higher earners in married couples) can maximize the total number of dollars they’ll have available to them over their lifetimes by claiming Social Security at 70 rather than at 62.

The key insight here is that maximizing the total dollars you have available to you over your lifetime isn’t the same thing as maximizing your standard of living in late retirement only. If you prefer, you can use that increased amount of lifetime wealth to spend more in early retirement. Or, if you prefer, you can simply accumulate those dollars and leave them to your heirs.

In other words, even if you:

  1. Want to retire at age 62 or earlier,
  2. Want to spend more in the early stage of retirement than in later retirement, and
  3. Want to leave behind money for the kids…

…there’s still a good chance that delaying Social Security until 70 is the best strategy.

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Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

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Investing Blog Roundup: Taxpayer Bill of Rights

This week, after years of urging from the National Taxpayer Advocate (a position within the IRS, with the job of advocating on behalf of taxpayers to both the IRS and Congress), the IRS has officially adopted a Taxpayer Bill of Rights.

This is big news, not because these rights are new — they’re not — but because it’s the first time taxpayers have had a clear collection of their rights when interacting with the IRS. And, if you don’t know your rights, it’s hard to put them to use.

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