August 25, 2013
What is a person’s marginal tax rate? How can it be used to decide between a traditional 401K or a Roth 401K?
What is a person’s marginal tax rate? How can it be used to decide between a traditional 401K or a Roth 401K?
A person’s marginal tax rate is the taxes they pay on the last dollar they earned for the year. That is the highest federal and state income tax they are paying on their earned income. If you think you will be taxed at a higher rate later in life, choose the Roth 401K. If you think you will pay higher taxes now, select the traditional 401K.
You are spot on, Katherine. Great job! Let’s look at an example. Let’s say you you are going to earn $50,000 as a single person this year. First let’s take that number down to $40,000 based on the $3,900 personal exemption and $6,100 standard deduction for 2013. This means you start paying income tax AFTER you have earned $10,000.
Next, what tax bracket does $40,000 put you in. The 25% federal tax bracket for singles starts at $36,250 in 2013 and let’s use Iowa income tax for this example. You will end up in the 6.8% bracket with that $40,000. This means your marginal tax bracket is 31.8% with those last dollars. Now you are ready to decide whether you want the traditional or Roth 401k.
The traditional will get you 31.8% knocked off in taxes until you fall to the next brackets which will take a few thousands of dollars. The Roth would get you no tax deduction now, but all of the earnings and future payouts will be tax free when you are ready to pull the money out later (follow the rules to avoid penalties).
So what is the number that helps you decide this issue? There is no exact answer for this question, but here is my recommendation. If your total marginal tax rate is under 30%, I would probably go with the Roth. If it was over 40%, I would probably go with the traditional. That space in between is kind of a gray area. If I was torn, I would probably go with the Roth because that type of retirement account has one very big benefit. The earnings on the account will never be taxed. The earnings on your traditional will be taxed one day.
BOTTOM LINE: Focus on identifying what your total marginal tax rate is (federal and state) and then you make the call based on what works best for your particular situation. Do this every year because your situation can change and that means you may have both accounts up and running as the years play out. Take control!