The title statement is incorrect because it ignores a huge factor in this decision. It doesn't make sense to compare your top marginal rate right now to your top marginal rate in retirement. You should be comparing your top marginal rate right now to the effective rate you'll be paying in retirement. Let's break it down.
Gimme the juicy numbers.
Let’s get right into an example. Say you’re a married, upper-middle income couple making $190,000 yearly, and you’ve been following my advice to invest in a traditional account at the 22% marginal rate and above and Roth at the 12% marginal rate and below. Then you’ve avoided your highest marginal rate this year of 22%.
Next, you then tell me that you’ll be in a higher tax bracket in retirement. You have some passive income streams and you’ll also be living the high life making huge withdrawals from your retirement accounts, even before RMDs kick in. Your retirement income will now be $400,000 per year! Woo-wee! That’s more than double what you’re earning right now, and you’re now up in the 32% bracket! Definitely should have paid that 22% when you had the chance, right? Let’s check the numbers:
The 2020 tax liability for joint filers with an income of $400,000 and taking the standard deduction will shake out like this:
Hey, check it out! You’re actually only paying 20.43% on that money. That’s less than your original marginal rate (22%) and a saved difference of $5,200 in taxes, even though you’re in a much higher bracket (32%)! And that’s if your expenses more than double in retirement (who does that?).
Let’s do a more reasonable example and assume your income goes up by $60,000 — from $190,000 to $250,000. This puts you well in the 24% bracket (higher than the original 22%).
This one is even better! You’re still in a higher bracket, but paying 5.5% less! A savings of $13,575! In fact, you would need an income of $468,000 as a married couple before your effective rate reaches 22%!
You can see that simply “being in a higher bracket” does not mean you’ll pay a higher rate overall. To summarize the two examples:
What the heck? Why have I been lied to?
Just like our last myth, you haven’t been lied to; it’s just incomplete advice, making it unclear. Allow me to correct the advice:
“If you’ll be paying a higher effective tax rate in retirement than your top marginal rate right now, Roth is best for you.”
The fact that we’re comparing effective rates with marginal rates makes a huge difference in this discussion. Allow me to explain why.
Marginal Tax Rates tax each dollar at a specific rate depending on where it falls in your income. The first dollars you make are taxed at lower rates than the last dollars you make. Your top marginal bracket is the bracket your last earned dollar falls in (it will be the highest rate you pay). If you need a more thorough explanation of marginal rates, you can find that here.
Effective Tax Rates are the average tax rate you pay on all your money; it’s also referred to as a “total tax rate”. You can find it by taking your total taxes paid and dividing it by your gross income. Find a more thorough explanation here.
To reuse a graphic from the Roth vs Traditional post, you can see that the money that was on top of your marginal brackets gets moved to the bottom. In this example, you would have paid the top marginal rate (22%) on all $40,000 during earning, but when withdrawing it in retirement, it gets new life by starting on the bottom. So that same money is now taxed at 0%, 10%, and 12% along the way as it works up the brackets. So your effective tax rate ends up being much lower on the same amount of money.
There are other things to consider
The most common question to this is, "What if tax rates go up in the future?" I wrote a post with some considerations there. Find it with this link.
Beyond just this rate, there are other things to consider — particularly Required Minimum Distributions for traditional accounts. For a more thorough dive into Roth versus traditional and how to optimize your taxes, you can read my other post with this link — Roth or Traditional: The Simple Guide to Optimizing Your Taxes.
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