I see this question being asked all the time, is there a resource here that talks about how to assess which is better? I didn't see anything in the stickies. One piece of information I see people missing is considering the difference between marginal tax rate vs effective tax rate for Roth and Traditional contributions.
Here are some major factors at play from my understanding, please feel free to correct me if I'm wrong on any of this:
- Taxes paid now on Roth contributions are paid at your highest marginal rate, and taxes paid in retirement on Traditional withdrawals are paid at your effective tax rate (overall average income taxes). You can use this calculator (scroll to bottom of page for your specific state) to determine your current marginal and effective tax rates to compare.
- Roth contributions are generally good at low tax brackets (12% and below currently), and traditional contributions are usually superior when you're up to higher brackets (22% and higher)
- State residence also plays a major factor. You could potentially save ~10% in state income tax if you live in a state like Oregon (high income tax) then move to Washington or Texas (no income tax) in retirement, and make traditional contributions now. This also works in reverse to favor Roth contributions.
- There is benefit in having money in both Roth & traditional, since it provides flexibility in retirement based on differing tax situations
- Roth IRA can function as pseudo-emergency fund, since contributions (not earnings) can be pulled out penalty-free. (Note: this is not advised to replace a proper emergency fund in an HYSA)
- Nobody knows what will happen with income taxes in the future. It's not likely they'll drop lower than we have today, and even if taxes rise in the future it could be in forms other than income tax, such as a VAT (Value Added Tax common in Europe, basically a federal sales tax).
- Side note: An HSA (if applicable) can function effectively as a 401k in retirement, plus has added benefits such as entirely tax-free medical expenses. Payroll HSA contributions also reduce FICA taxes (as much as 7.65%). Many HSAs have very high fees though, so you'll want to rollover HSA investments to a low-fee provider (such as a Fidelity HSA). Also, some states tax contributions to HSAs, such as California.
My rules of thumb:
- Contribute to a Roth IRA at tax brackets 12% and below if you expect to significantly increase your income in retirement and/or or move to a state that has a much higher income tax
- Contribute to Traditional 401k or IRA at brackets 22% and above
- If you live in a state with high income taxes, this could dramatically shift the equation in favor of traditional contributions (or vice versa)
- Use a mixture of both if possible for flexibility in retirement and to hedge against future tax uncertainty.
- Roth IRA is superior to a Roth 401k due to extra versatility
- Max out a HSA if possible, especially if available through your employer via payroll. Be sure to rollover HSA investments to a low-fee HSA provider such as Fidelity.
Did I miss anything?
Submitted May 23, 2019 at 08:05PM by Joeliolioli http://bit.ly/2HyEAa6
