Most financial articles are written for people with higher incomes, because people with more discretionary income naturally want to know what to do with their discretionary money. However, people with modest incomes actually have more need for advice. People with higher incomes will do fine either way, while even a slight improvement will make a big difference to people with modest incomes. Unfortunately, the right moves for people with higher incomes are often exactly the wrong moves for people with modest incomes. When you read an article, you really have to know whom it’s for.
For instance, when it comes to saving for retirement, a typical rule of thumb is that when you are in a low tax bracket, you should use Roth accounts. The thinking is when you don’t pay much tax anyway, you might as well pay the tax now and make your retirement withdrawals tax free. Except it doesn’t apply to people with modest incomes, especially those with kids.
Why? Because being in a low tax bracket doesn’t mean you have a low marginal tax rate when you receive tax credits linked to your income. When you lose tax credits as your income goes up, you face a much higher marginal tax rate than just the tax bracket indicates.
I will give three examples. All calculations are done with H&R Block 2018 tax software.
Single, No Child
Tim is single, with no child. He makes $21,000 from his job. He decides to save 10% of his income for retirement. His employer matches contributions to the 401k plan. If he saves $2,000 in the company’s 401k, should he go with Traditional 401k or Roth 401k?
Assuming Tim has no other income or deductions, if he goes with Roth 401k, after the standard deduction of $12,000, Tim’s taxable income is only $9,000. He’s in the 10% tax bracket. His federal income tax will be $903 (not exactly 10% of $9,000 due to tax table lookup). He also qualifies for $200 Saver’s Credit. The net total will be $703.
If Tim contributes $2,000 to Traditional 401k, his W-2 income becomes $19,000. After the same standard deduction of $12,000, his taxable income is $7,000. His federal income tax will be $703. But, because his AGI is now $19,000 as opposed to $21,000, it goes into the 50% tier for the Saver’s Credit. He will qualify for $1,000 in Saver’s Credit but because the credit is non-refundable, it’s reduced to $703, which makes him pay net $0.
| $2,000 to Roth 401k | $2,000 to Traditional 401k | |
|---|---|---|
| Gross | $21,000 | $21,000 |
| W-2 | $21,000 | $19,000 |
| Taxable income | $9,000 | $7,000 |
| Tax before credits | $903 | $703 |
| Saver’s Credit | $200 | $703 |
| Net after credits | $703 | $0 |
| Traditional Advantage | $703 |
Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Tim $703 in tax savings. That’s 35%, far higher than the 10% tax bracket. The extra 25% comes from qualifying for additional Saver’s Credit.
Single Parent, One Child
Jen is a single parent with one child. She files taxes as Head of Household. Jen makes $32,000 from her job. Her employer matches 401k contributions up to 6% of pay. Jen knows she should contribute to get the full match. When she contributes $2,000, should she go with Traditional 401k or Roth 401k?
The standard deduction for Head of Household is higher than that for Single. If Jen contributes to Roth 401k, assuming she has no other income or deductions, her taxable income is $14,000, which is barely in the 12% tax bracket. She receives $200 in Saver’s Credit. With one child, she gets $2,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). She also qualifies for $1,325 in Earned Income Tax Credit (EITC). All told, she will receive $2,114 in net tax refund.
However, if she contributes $2,000 to Traditional 401k, her W-2 income becomes $30,000. Her taxable income is $12,000 after the $18,000 standard deduction, which puts her in the 10% tax bracket. Her Saver’s Credit goes up to $400. She still receives $2,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). Her Earned Income Tax Credit (EITC) goes up to $1,645. Altogether, she will receive $2,842 in net tax refund.
| $2,000 to Roth 401k | $2,000 to Traditional 401k | |
|---|---|---|
| Gross | $32,000 | $32,000 |
| W-2 | $32,000 | $30,000 |
| Taxable income | $14,000 | $12,000 |
| Tax before credits | $1,411 | $1,203 |
| Saver’s Credit | $200 | $400 |
| Child Tax Credit and Additional Child Tax Credit | $2,000 | $2,000 |
| Earned Income Tax Credit | $1,325 | $1,645 |
| Net after credits | -$2,114 | -$2,842 |
| Traditional Advantage | $728 |
Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Jen extra $728. That’s a gain of 36%, also far higher than the 10% or 12% tax bracket. That 36% is broken down into 10% in regular tax, 10% in Saver’s Credit, and 16% in Earned Income Tax Credit.
Married Filing Jointly, Two Kids
Mike and Lori are a a married couple with two kids, ages 5 and 2. Mike makes $42,000 from his job. Lori stays at home and takes care of the kids. Mike’s employer matches 401k contributions. When Mike contributes $2,000 to the 401k, should he go with Traditional 401k or Roth 401k?
If Mike contributes to Roth 401k, assuming they have no other income or deductions, after the $24,000 standard deduction, their taxable income is $18,000. That’s in the 10% tax bracket. With their $42,000 AGI, they will receive $200 in Saver’s Credit. With two kids, they get $4,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). They also qualify for $1,994 in Earned Income Tax Credit (EITC). Altogether, Mike and Lori will receive $4,391 in net tax refund.
However, if Mike contributes $2,000 to Traditional 401k, his W-2 income becomes $40,000. Their taxable income is $16,000 after the standard deduction. Their Saver’s Credit goes up to $400. They still receive $4,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). Their Earned Income Tax Credit (EITC) goes up to $2,415. Altogether, they will receive $5,212 in net tax refund.
| $2,000 to Roth 401k | $2,000 to Traditional 401k | |
|---|---|---|
| Gross | $42,000 | $42,000 |
| W-2 | $42,000 | $40,000 |
| Taxable income | $18,000 | $16,000 |
| Tax before credits | $1,803 | $1,603 |
| Saver’s Credit | $200 | $400 |
| Child Tax Credit and Additional Child Tax Credit | $4,000 | $4,000 |
| Earned Income Tax Credit | $1,994 | $2,415 |
| Net after credits | -$4,391 | -$5,212 |
| Traditional Advantage | $821 |
Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Mike and Lori extra $821. That’s a gain of 41%, also far higher than their 10% tax bracket. The 41% is broken down into 10% in regular tax, 10% in Saver’s Credit, and 21% in Earned Income Tax Credit.
Conclusion
The three examples here showed that the tax bracket is far from the full story when someone also receives tax credits. I only included the effect of the Saver’s Credit and the Earned Income Tax Credit (EITC). If they also get health insurance from the Affordable Care Act marketplace, their Premium Tax Credit (aka the Obamacare subsidy) also changes with their income. If they contribute to a Traditional 401k, they will increase their Premium Tax Credit by another 15% or so of the contribution. The total increase in tax credits can be well over 50% of the contribution.
Gaining extra tax credits from lowering income that’s already modest gives a big advantage to saving in a Traditional 401k. With one child, EITC alone increases at 16% for each dollar removed from the W-2. With two or more kids, EITC increases at 21%. If you receive EITC or the ACA subsidy, you should contribute to Traditional 401k, not to Roth 401k.
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Frugal Professor says
Amen brother! I’ve been trying to teach people this very point for years. One’s effective marginal marginal tax rate is infuriatingly difficult to determine.
https://www.frugalprofessor.com/etic-guest-post-on-gocurrycracker/
Kent says
Yes, you gain tax deductions on your 401k contributions at your marginal tax rate but you pay taxes on future retirement income at your effective tax rate.
Another way to look at this issue. Contributing to a traditional 401k is, in part, a form of insurance against the chance that you will be poorer in retirement. Contributing to a Roth 401k is, in part, a form of insurance against the chance that you might be richer in retirement. Which is eventuality is more important to insure against?
For example, if your financial life melts down in retirement, would you rather have $100k in a traditional 401k or $70k in a Roth? Most people at the end of the rope would much rather have the 100k in the traditional 401k because if they are indeed in dire financial straits they aren’t likely to owe much if any in taxes anyway. On the other hand, if your financial status in retirement is golden then yes, perhaps the $70k in the Roth might be more valuable. Maybe. But then it isn’t likely to be as important to you anyway. Personally I think it is more important to insure against the downside risk rather than the upside risk.
Kate Horrell says
I agree 100%. While all this math works out logically for today, it doesn’t take into account the net effect in 20-30-40 years.
Tim may love having an extra $703 today, but will he love having to pay taxes on his 401k withdrawals into the future? He’s not terribly likely to be in such a low tax bracket when he’s taking distributions.
There’s no single right answer to the Roth vs. traditional question, and it is important to consider the second- and third-order tax implications of that choice each year. But to only look at the outcomes today, without considering the outcomes into the future, is the definition of short-sighted.
Ritch says
Harry,
This is an excellent post, and it’s exactly what I’ve found to be true over the years in my Tax Practice – some of the most interesting and highest payoff tax planning opportunities arise when the taxpayer(s) has/have rather modest income(s). For folks attempting to live on relatively limited incomes, every little bit helps. My experience has been that adding another $700 – $800 to their refund is often very beneficial, and is generally greatly appreciated. From time to time we can do even better, depending on other factors that can come into play, a couple of which I’ve mentioned below because they dovetail with what you wrote about.
If you’re an older taxpayer, it’s important to note that the strategy you discussed can also impact how much of an individual or couple’s Social Security Benefits are taxable as well. Some of my age 60+ clients who are drawing SSB’s but who are still working to pump up their retirement savings nest egg use tax deferred 401k or 403b elective deferrals (or tax deductible Traditional IRA contributions) to reduce their taxable SSB’s, Adjusted Gross Income, and Taxable Income, while also qualifying them for (or boosting the percentage allowed on) the Retirement Savers Credit.
Another related benefit that sometimes comes into play on returns like these in the state where I live (Virginia) is that, if you can get the Virginia Adjusted Gross Income below a certain threshold (which varies based on Filing Status), your Virginia Income Tax is $0.00, and the taxpayer(s) is/are entitled to a refund of any (all) income tax withholding or estimated tax payments. These State Income Tax Savings can be substantial in some cases, and they’re like “icing on the cake.”
Thanks for sharing this article, and for giving such clear examples of the potential tax savings opportunities available in situations like the scenarios you gave. As you said in your piece, this is very much a case by case analysis and decision, which needs to be customized for the facts and circumstances that apply to each individual or couple.
RIck Pyper says
Thank you for your thoughtful post. It demonstrates how detrimental the common “rule of thumb” financial advice can be. Specific examples like yours illuminate while general blunt pronouncements obscure the realities of many people’s financial situations. Another potential advantage of a lower AGI is increased college assistance for yourself and/or your children (such as federal Pell grants and Gilman scholarships, and college-specific need-based awards).
Heath says
First of all great post and thank you. A few things I’ve been thinking about.
Isn’t the Child Tax Credit only refundable up to $1,400? Savers credit is also non refundable. Therefore you could be forfeiting part of these credits by reducing your taxable income with traditional.
Harry Sit says
It could if you contribute a lot more than $2,000 at these income levels, but look at the “Tax before credits” row for each of the examples. It’s still above the amount of available non-refundable credits. If you’re contributing so much more that pushes your income down and the “tax before credits” will fall below the available non-refundable credits, do the first $2,000 or whatever as traditional and the rest as Roth.