# Will Moving to a Higher Income Tax Bracket Cost You Money?

Written by Nickel - 61 Comments

I recently received a question from a reader that we’ll call Frank. Frank is up for a possible promotion, but was told by his boss that the pay increase would push him into a higher tax bracket, and would therefore “not be worth it.” Here are the details:

I work 33 hours/week at \$11.40/hour. My boss wants to give me a lead position and a raise of \$0.20/hour. However, he then told me he was doing some figuring, and found that the raise would put in in a new tax bracket, and would thus not be worth it. I am single, no dependents. What do you think?

The short answer is that I don’t think Frank’s boss understands how income tax brackets work. Either that, or he’s trying to pull the wool over Frank’s eyes.

Here’s the deal: Income tax brackets reflect your so-called marginal income tax rate. It might help to picture your income falling into separate buckets.

At the low end, you have a 10% bucket. In 2010, the first \$8375 of a single individual’s income would fall in that bucket. Next, we have the 15% bucket. The next \$25,625 would fall in that bucket (for a total of \$34,000). After that, we have 25% bucket, the 28% bucket, the 33% bucket, and the 35% bucket.

(Click through for a full rundown of the 2010 Federal income tax brackets.)

This is, of course, a bit of an oversimplification, as you also need to adjust the numbers for whatever income tax deductions, tax credits, etc. for which you might qualify.

Setting aside that fact that Frank doesn’t actually appear to be near the boundary of any of the current tax brackets, let’s work through a quick example…

## Income tax bracket example

Consider a single individual earning \$50,000. This puts him in the 25% tax bracket. That does not, however, mean that he pays 25% taxes on his full taxable income. Rather, he pays 10% on the first \$8375 (bucket #1), 15% on the next \$25,625 (bucket #2) and 25% on the remainder of his income (a partially filled bucket #3). In total, this works out to \$8681.25 in taxes, or a “real” rate of roughly 17.4% (ignoring deductions, credits, and other adjustments).

If this individual got a big raise that pushed him into the 28% tax bracket, he wouldn’t lose anything. He’d pay 25% on the balance of bucket #3 (up to \$82,400) and then 28% thereafter (until he hit the 33% bracket). As you can see, you have nothing to fear from moving up a tax bracket, and anyone who tells you different is either uninformed or trying to take advantage of you.

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Published on January 29th, 2010
Modified on January 10th, 2012 - 61 Comments
Filed under: Taxes

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### 61 Responses to “Will Moving to a Higher Income Tax Bracket Cost You Money?”

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1. 1
Storch Money Says:

This is a good post. During the 2008 election campaign (and the many conversations it spawned about taxes) I was surprised at how frequently I encountered people who did not understand the way income tax brackets work.

2. 2
Kurt Says:

I believe some states charge a rate based on your income and you pay that rate for all your income (it is not a ladder system, or marginal rate). I think most states do not do it like this, so although his boss could be correct – I think he is trying to pull one over on ‘Frank’. Not to mention any retirement matches he would get to add to his income.

3. 3
rzrshrp Says:

This is the most misunderstood tax issue ever. It’s always good when someone decides to shed light on it again.

Also, Kurt, I think that would be a flat tax. That would mean you pay a set percentage of your income no matter how much you make. It’s not possible to get in a situation where more = less there either.

4. 4
BG Says:

Wow, Franks boss has no clue. Frank should tell the boss to pay him what he is worth, that he’ll worry about his own taxes.

Or, perhaps, Frank’s boss is trying to save some money by seeing how bright Frank is…sneaky.

Quick calculation: divide the taxes you paid last year, by your gross income last year. We’ll call this the ‘average effective tax rate’. If that number is 10%, then every dollar you earn (extra) will be taxed 10 cents. At no point, EVER, will getting paid more result in a loss for you — ever, ever, ever. If anything, the more you make the lower your taxes will be (effectively): I’m looking at you people making over \$200k a year (I’ve done the calculations).

I’m in the 25% marginal bracket, yet my average effective tax rate is something like 12% — so every dollar I make extra, I’ll need to pay about 12 cents in taxes.

Simple answer, look at your tax forms, and get the real numbers that take into account your deductions / exemptions, credits, etc. Just divide TaxesPaid by GrossIncome — simple as that.

5. 5
Evan Says:

FCN,

GREAT POST! I think the points can easily be seen when you check out the IRS rates:

10% on income between \$0 and \$8,350
15% on the income between \$8,350 and \$33,950; plus \$835 (This amount is the total owed from the first category)
25% on the income between \$33,950 and \$82,250; plus \$4,675 (Amount owed from the top 2 categories)
28% on the income between \$82,250 and \$171,550; plus \$16,750 (etc.)
33% on the income between \$171,550 and \$372,950; plus \$41,754 (etc.)
35% on the income over \$372,950; plus \$108,216 (etc.)

These are 2009 #s

6. 6
Ryan Says:

Reminds me of my social studies teacher, good guy but uninformed, who told our class that people might not want to take a raise that puts you over 250000 because of Obama’s new tax breaks.

I tried to explain but I don’t think he understood…

7. 7
BG Says:

#5 Evan) Not really true either. You are ignoring the ’standard deduction’ that is untaxed completely. This amount is \$5,700 (single), \$8,400 (head of household), and \$11,400 (married). That is a good sized 0% tax bracket.

But, you really need to look at your own tax forms, because it takes into account social security taxes — there are no taxes for social security on income over \$106,800. You tax form also takes into account child tax credits, state sales/income taxes paid, and all the other deductions you can itemize over the standard deduction: home ins, medical costs, gambling/stock losses. Plus many people are using Health Savings Accounts (HSA), which is untaxed, etc.

Just look at your 1040 or 1040ez from last year, and divide TaxesPaid by GrossIncome. Forget about looking at the marginal tax bracket tables, because you will never get a correct number using only that information.

If Frank is single, then he is somewhere below a 15% effective tax (15 cents tax on every dollar earned) — if he has kids, he isn’t paying any taxes (might even be receiving a check from us — negative taxes!)

8. 8
Evan Says:

BG,

I didn’t post that table to allow the emailer to figure out his actual tax bill. I meant it as an illustration of the marginal tax system in place.

My Bad if there was any confusion

9. 9
Keith Morris Says:

I learned about this recently myself, when I started to take more of an interest in taxes. This makes perfect sense to me. How awful would it be if taking a raise were to cause you to make less money?

Now the question is, what do you say to your boss when you find out he’s trying to pull a fast one on you?

10. 10
BG Says:

Like to mention the ‘personal exemption’ as well. This year, it is an additional \$3,650 per person deduction that is not taxed at all.

Ironically when the personal exemption was reformed in 1913, the amount was the equivalent of \$54,000 in modern-day dollars.

Man, I sure would love to have a \$54,000 income exemption…

11. 11
Ryan Says:

Reminds me of my government teacher last year. He mentioned how people might not want to take a raise if it would increase their income over \$250,000 because of Obama’s planned tax brackets.

He’s a cool guy, but not the most informed.

12. 12
BG Says:

#8 Evan) Yeah, you got it. The marginal brackets are useful only after you have figured out what your ‘taxable income’ is, which is vastly lower than your ‘gross income’ (before deductions, etc). Practically nobody knows what they taxable income is.

But even after figuring out the tax bill using that table on your ‘taxable income’, you then subtract right off the tax bill your credits (child tax credit is \$1000 per qualifying child, for example). Credits come off the _tax_bill_, not off the taxable income, which is a massive tax break. For married w/ 2 kids, that is \$2,000 off the tax bill, equivalent to something like an additional \$17,000 of income that is not taxed at all.

Rough calculations for a family of four in the low/low-middle class: about \$43,000 of income is not taxed at all: \$11,400 std deduction, \$3,650*4 personal exemptions, plus \$17,000 income equivalent for the two child-tax-credits.

And people want to go to a flat-tax…you must be insane! Low/middle class people need to fight any arguments for a flat-tax like your wallet depends on it (cause it will).

13. 13
mlathe Says:

I think there are corner cases when you hit AMT or loose an adjustment where a minor pay increase can actually lower your final Net Income.

14. 14
Floridian Says:

“Iâ€™m in the 25% marginal bracket, yet my average effective tax rate is something like 12% â€” so every dollar I make extra, Iâ€™ll need to pay about 12 cents in taxes.”

While you seem very knowledgable in taxes, this one particular statement is not true. While your effective tax rate may be 12%, if you are in the 25% marginal tax bracket, every EXTRA dollar you make is taxed at 25%. Your effective tax rate may not go up by much, but if your income increases without any increases in your deductions or credits, you can be sure that you will pay 25 cents on every dollar that your income increased over last year.

But that’s where it pays to know your tax code (or have a CPA do your taxes)!!

and as a CPA who knows how to take advantage of all the tax deductions and credits, I am sooooo against a flat tax!! I’ve got my effective tax rate down around 5% to 6%

15. 15
Floridian Says:

I was wrong, our effective tax rate for 2009 was just over 3% But oh with all the energy efficient credits we are taking advantage of, our effective tax rate will be less than 3% for 2010 I could get it closer to zero if we contributed to Traditional IRAs, but I’m a ROTH IRA girl!

16. 16
Dan Says:

Well, I had to chuckle… a raise of \$0.20/hr, based on a standard 2080 work year, yields a gross raise of \$416.

17. 17
Kathy F Says:

BG, you are wrong. In general, every extra dollar you make is taxed at 25% rate, as long as your total taxable income is still within the 25% bracket. For you it may not be. Also, every dollar you have in deductions to income (mortgage interest, for example) can reduce your taxes by 25% of the amount of the deduction. Between my tax bracket of 25% and 5.75% tax bracket for VA state taxes, I can save almost 31% of the mortgage interest I pay. This is a fact that most of the real estate agents will use as a selling point for potential property buyers.

18. 18
John Says:

If I did my taxes right, I missed the 25% tax bracket by \$14 in taxable income. So If I had made \$14 more in 2009, it would have cost me 14 x .15 = \$2.10 more tax. If I had made an additional \$14 last year, it would have cost me 14 x .25 = \$3.50 more tax.

19. 19
Rob Atkins Says:

Franks boss’s information shows that you should always be in charge of your own destiny when its comes to tax withholding. Keep informed. Thanks for the great example!

20. 20
BG Says:

#14 Floridian) Wow, 3% effective! Very impressed. As for the rates, you are right.

I’m at the very bottom of the 25% marginal bracket — which means the vast majority of my dollars are either not taxed at all, or at a much lower rate. But you are right, any ‘new’ dollars will be taxed at the 25% rate — even though it barely even budges my ‘effective average’ (12% or so) that is pretty much locked in by the other 95% of my earnings.

But who looks at money that way? For me to stay sane, the only way to look at things is by using the effective average rates, which takes into account all the deductions, exemptions, credits, etc.

Instead of saying you will need to pay \$25 on the next \$100 earned — say instead, your overall effective average tax rate will go up 0.01% on the next \$100 earned, from 12.00 to 12.01 — because it is not like that child-tax credit is discriminating on which tax dollars it is eliminating (same goes for all the other deductions).

Maybe this is one of those left-brain / right-brain things where two people see the same thing in two different ways…

21. 21
Jim Says:

Good article. This is a topic that probably needs repeating. Way too many people think that increased pay will hurt them.

Its surprising how little many of us understand about the tax rates, but then not that surprising considering how complicated our tax laws really are. Way back I used to have the same misunderstanding myself about how the tax rates work, and I thought that being in the 25% bracket meant you paid 25% of everything. But nobody had explained it to me properly and as soon as I investigated it was clear how the marginal rate applies to only the income at the top.

There are a couple exceptions to the rule where more income can raise your tax bill enough to hurt your bottom line overall. AMT was already mentioned which impacts a small % of us at the high income levels. Another more common issue is if you make just enough income to put you at a threshold to qualify for a tax deduction or credit. For example if your modified gross is \$70k or less taxable income then you can deduct your student loan interest. Say you are on the borderline with modified gross of \$69,999 and then you get a raise. THis would not allow you to deduct that student loan interest and you’d end up paying a larger tax bill. These situations are very rare though and most people are not sitting on such borderline then getting a raise large enough to push them over the border but too small to add to their total income.

22. 22
Kathy F Says:

Yes, more income can cause disadvantages. For example, you can make too much money to qualify to contribute to a Roth IRA. The income limit is based on adjusted gross income, I believe. Also, maybe this limit is eliminated for 2010? Anyway, putting some of your salary into tax-deferred 401(K), lowers the reportable earnings and thus adjustable gross income reported to IRS. Thereby allowing me to qualify to contribute to a Roth IRA. So I can get the benefits of both types of contributions.

Another way to consider your top tax bracket is thinking about the saying “A penny saved is a penny earned.” Really, a penny saved is better than a penny earned. Better to save (not spend) the penny you have earned and already paid taxes on to stay within budget rather than to earn another penny to cover increased spending. You will only end up with 75% of that additional penny if you are in the 25% federal tax bracket. Of course, if you can save a penny and earn a penny, that is even better.

23. 23
Kathy F Says:

I think people need to understand the tax brackets so they can know the impact on any increased earnings and plan accordingly. I often hear people complain about getting a pay raise, but not seeing any much as they thought they would get in their take home pay after deductions. If you already have plans for spending an anticipated raise, then you need to know how much of that extra money you are really going to take home. Especially if that extra money moves you up to a higher tax bracket (say from 15% to 25%)

Also, someone who makes, say \$50K per year (25% bracket), may think that life would be perfect if they only made \$100K a year. They may not realize that doubling their salary will not be doubling their take home pay. Not only will part of the 50K increase be taxed at 25%, but some of it will be taxed at 28%.

24. 24
VT Says:

I think Frank’s boss was out of line for saying that to him.
I’ve heard of companies trying to weasle out of raises, but that’s a new tactic.

25. 25
M Says:

I use tax software every year and one thing that I enjoy doing is using it for “what if” calculations.

What if I made \$1000 more….I just type it in and see what happens to my tax payment.

What if I paid off the mortgage, and didn’t have that deduction….just delete the interest line.

What if my wife didn’t work……just delete the entire W2!

Hours of fun and enjoyment–and something you could never have done with the old paper and pencil on the 1040, especially considering some of the vagaries of deduction phase outs, AMT, etc.

As it relates to this post, I would have brought up my taxes last year and modeled it.

26. 26
BG Says:

#17 Kathy F) If you think the mortgage deduction is such a good deal, then mail me \$100, and I’ll return to you \$31 (equivalent to what you are doing).

Floridian) I’m really curious how you can lower your effective rate to only 3%? For it to be that low, you must be bleeding the money out somewhere else: a bunch of kids, massive mortgage, stock losses, or something else?

I’ve done my own taxes since my first return, started on paper, then using TaxAct. I’m no Tax professional, but if I could go from 12% to 3% by paying a professional it would be well worth it — but I seriously doubt I’m missing anything in my filings. And I refuse to pay interest to save some pennies in taxes (that is just dumb).

27. 27
GaryL Says:

-

…a worker’s actual employment “tax rate” involves much more than merely the ‘Federal Individual Income Tax’ and its current IRS tax brackets.

Most states (and some cities) also heavily tax incomes.

The Federal payroll tax (FICA) is an additional 15.3% of a workers income. State & local payroll taxes usually apply too.

Look at the Big-Picture when calculating how much the government really charges you… for the privilege of working for a living.

28. 28
Lazo Says:

The only time I talk about “moving up a tax bracket” is when people are looking to take a chunk of money out of some investment vehicle, making the amount of money taxable.

People may be looking to estimate the amount of taxes they will pay on the withdrawal, and if they don’t take into consideration it moving them up a tax bracket…they could be on the hook for more than they anticipated.

29. 29
floridian Says:

BG – I agree with you on paying interest to save some pennies – it is dumb! We aren’t “bleeding out money” anywhere, but we are working on one income (mine), which, if I were by myself would put me well into the 25% tax bracket. But for the both us (MFJ), keeps us in the 15% tax bracket (even if just barely). We get personal exemptions and credits for the 3 kids, but that’s about it for the large items. We don’t have enough stuff to itemize (darn that small mortgage )

If you’re in the 25% bracket and effectively only paying 12%, you’re doing good! I guess you could lower your effective rate by getting yourself a househusband/wife(?), like I did ha!

30. 30
A1M0S Says:

When you get to the higher tax brackets you really look for ways to reduce your AGI. Back in the 70’s tax rates on the last dollar were awful!

31. 31
BG Says:

#27 GaryL said) “…Look at the Big-Picture when calculating how much the government really charges youâ€¦ for the privilege of working for a living….”

well, you are not paying for the privileged to work. You are paying for the privilege to have SocialSecurity, Medicare, Military, Federal Prisons, FAA, TSA, FDA, ATF, FBI, CIA, Homeland Security, NASA, Interstate highway system, public education, research grants, and the list just goes on and on.

#29 floidian) It is having being married w/ two kids that get me down to 12% — another child would drop us down a few more percentages I expect, but she doesn’t want anymore (can’t blame her since she works pretty hard w/ the family side of things and also working a part-time job).

I guess I could make traditional 401k (or IRA) contributions instead of the Roth versions that I’m doing — that would lower my effective rate too.

But I think 12% is pretty low as it is, so I’m investing in Roth vehicles (pay taxes now), so I won’t have to pay taxes on those earnings in retirement, where I expect my effective rate to be higher than 12%. I won’t have those oh-so-sweet child-tax-credits in retirement. I’m sure you did the same calculations and that is why you are going with Roth accounts as well (it’s a no-brainer if you are at 3% effective today).

32. 32
Floridian Says:

Exactly BG (RE the ROTH)! And if things keep going the way they are going, heaven knows what the lowest tax rate will be by the time I retire!! They are going to have to pay back all that debt the Prez and his cohorts are racking up somehow! With the ROTH, I pay taxes on the contributions now, and then it all grows tax free for the next 22 – 30 years! I keep tring to convince a friend of mine – who is also an accountant and my age (lots of time till retirement) – that a ROTH is the way to go, but he gets a kick out of having a ZERO tax liability each year (partly using traditional IRA contributions to get it down to zero). I just don’t get him! Some people are living so much for the moment that they just can’t see how the alternative will provide a much bigger benefit down the road.

33. 33
Dan Says:

BG,

You have a pretty solid understanding of tax issues, so the fact that you’re investing in the Roth instead of the 401k/traditional IRA surprises me.

I think you’re missing something critical — your Roth contributions are taxed at your marginal rate, NOT your effective rate. However, I believe it is short sighted to have NO taxable income in retirement. You speak of “effective rates” quite frequently (and I understand what you mean) so I’m sure you realize that you want SOME taxable income in retirement. In 2009 dollars (and tax rules!) your first \$18

34. 34
Dan Says:

BG,

You have a pretty solid understanding of tax issues, so the fact that you’re investing in the Roth instead of the 401k/traditional IRA surprises me.

I think you’re missing something critical — your Roth contributions are taxed at your marginal rate, NOT your effective rate. However, I believe it is short sighted to have NO taxable income in retirement. You speak of “effective rates” quite frequently (and I understand what you mean) so I’m sure you realize that you want SOME taxable income in retirement. In 2009 dollars (and tax rules!) your first \$18,700 is tax free! In fact, if you made \$67,900 in gross earnings (top of the 15% bracket for MFJ) your effective tax rate is 9.6%!

I tend to agree with those that think tax rates are going up in the future. But I don’t forsee a scenario where effective rates exceed marginal rates for this income range. They’d have to screw around too much with the rates, brackets, exemptions, and deductions for that to happen, and I don’t see the politicians screwing around with the poor/lower middle class like that. It’s more likely that they screw around with the marginal rates at the higher brackets — where us upper middle class fall today.

35. 35
Floridian Says:

I agree with Dan on having some taxable income in retirement (which is why I don’t plan on converting certain retirement accounts to a ROTH). I can’t speak for BG, but I’ve got other investments that will provide taxable income in retirement. Since my husband and I will still be paying taxes each year in retirement, any withdrawals from a traditional IRA would be taxed at our marginal tax rate in retirement (which will no doubt be higher than it is now). Hence, my IRA of choice is a ROTH. But a ROTH may not be a good choice for others. Everyone’s situation is different.

36. 36
BG Says:

#33) My employers 401k contributions (the match) is considered part of the traditional-401k, so I’ll be paying income tax on that portion of the 401k in retirement.

As for discussion about brackets/exemptions/etc changing by the time I retire (30 years from now), you are right — the future is very uncertain, especially that far out.

But I do know one thing for certain, 30 years from now I will not have the personal exemptions and child-tax credits (for my two kids) that I have today. It is those credits that are mainly influencing my decision to go with a Roth right now. When they are no longer qualifying, then I’ll need to revisit the Roth/Traditional debate.

As for the comment: “your Roth contributions are taxed at your marginal rate” — that is true if you pretend that my current deductions/exemptions/credits do not affect those ‘last’ XX dollars. The way I approach this is to look at my effective rate, which is 12% today (12 cents on every dollar is tax), contributing to Roth. It would be something like 8% (don’t have the exact figures in front of me) if I instead went traditional/tax-deferred plan.

The question now becomes, what is my assumed effective rate in retirement? If it is 18% (or higher**) in retirement, then I’m better paying taxes at 12% today (Roth). If it is less than 18% in retirement, then I’m probably better going with traditional, paying 8% taxes (today), investing the difference, and pay the taxes in the future.

But in Floridians case, at their 3% effective rate currently (3 kids, etc), I don’t see how anyone could say traditional is better for that family. I may be close to the fence, but in their case, it’s a no-brainer.

(**these numbers are rough guesstimates and highly depends on savings rates, expected retirement income, and all kinds of other assumptions).

37. 37
Floridian Says:

No BG, you really should be looking at the Roth vs Traditional at the MARGINAL rate. Reason being, if you made \$5,000 contributions to a Traditional, instead of ROTH, then your tax liability for 2009 would be \$1,250 less (25% of 5,000). (don’t believe me? do a “what if” scenario on your 2009 taxes switching your ROTH to a Traditional contribution).

In my case, since we are still in the 15% bracket now, \$10K to a traditional instead of ROTH would lower our tax liability by \$1,500. But what keeps us in the 15% tax bracket are the exemptions for the kids (at least for now, I reevaluate this each time our situation changes â€“ e.g. one more raise could very well bump us up into the 25% tax bracket if the bracket income levels donâ€™t change). But in retirement, I fully expect we will be in a higher tax bracket and/or tax rates will increase for each bracket (how can they not increase given all the debt and entitlement programs â€“ current and in the works â€“ that need to be funded??), so if we are in the 25% tax bracket in retirement, any withdrawals we make (above pension and 401Ks) will be taxed at 25%.

But, BG, you have something on your side that Dan is not taking into account â€“ TIME. Yes, you are â€œpayingâ€ 25% for your ROTH contributions now, but those contributions have a long time to grow. A \$5K contribution this year can grow to over \$23K in 30 years (conservatively) â€“ and all earnings in a ROTH can be withdrawn tax free! So the tax rate comparison isnâ€™t the only factor that goes into ROTH vs Traditional decision, and in your case, your time horizon and the fact that you will already be drawing from taxable investments (401K) in retirement make a ROTH the way to go (IMHO).

38. 38
BG Says:

#37 Floridian & Dan) I do get what you are saying about the marginal brackets on the last XX dollars. You are absolutely correct, but at the same time, so am I. We are talking about the same coin, just two different sides in regards to effective & marginal.

You are saying my last XX dollars are taxed at 25%, whereas I’m saying that the last XX dollars causes me to pay slightly more taxes on _every_ dollar I’ve earned (the effective average goes up) — and in Floridians example, the tax bill is different by \$1,250 either going with your way to calculate it, or my way, it’s the same number.

I’m just trying to make things vastly less confusing by saying: pay taxes today at an effective average rate of 3%, instead of paying taxes in the future at some vastly larger effective tax rate (15%?). You will arrive at the same conclusion if you dig into the marginal brackets, exemptions, and all the other hoopla, which I can comfortably ignore and just treat the whole thing as one big black box.

The effective average rate takes into account all of the marginal tax brackets, credits, social security stuff, deductions, standard deductions, exemptions, and any all other things that you can put into a 1040.

In the end, all that really matters is:

TaxesNow == IncomeToday * EffectiveRateToday
-vs-
TaxesLater == IncomeRetirement * EffectiveRateRetirement

and see which ones is better off in all the various scenarios you can think of (Roth -vs- Tradition is the current one under discussion). Of course you need to calculate out what the effective rates are now and will be in retirement, because it is different depending on if you go with Roth or Traditional. Same goes for everything else in the 1040 (ie; no kids in retirement).

But, either way, I think we are saying the same thing. It is a good idea to use a tax program to try this stuff out with. Floridian: when you are doing your 09 taxes, just delete the 3-kids and you will see a rough idea of how much higher your effective tax rate will be in retirement…

As for the ‘growth’ potential of Roth -v- Traditional, there is no difference. If we had a flat-tax that didn’t change between now and then: \$1,000 in a Roth, growing x% (tax free) is exactly the same as investing \$1,100 in a traditional (you invest more to keep your takehome pay the same), growing x%, and then paying taxes later. But since we don’t have a flat-tax, then this does get complicated quickly (which is why we are having this debate)

39. 39
BG Says:

#37 correction) technically you need to invest \$1111.11 in a traditional to equal the \$1000 in a Roth (for the takehome pay to be the same). If you do this, then they grow exactly at the same rate, and after paying taxes on the Traditional, you have the exact same balance as the Roth account. (If we had a flat-tax).

40. 40
BG Says:

#37 Floridian) just to clear up the confusion, here is a good example. Assume I’m octo-mom and my taxable-income (\$58k) is in the 15% marginal bracket. Since I’m octo-mom, I have 8 kids : )

You would say that I will pay \$15 on the next/last \$100 I earn (because of the 15% marginal bracket), where in reality my tax bill is still \$0 because I have \$8,000 of tax_credits that easily eliminates all taxes: meaning my effective tax rate is 0% (pay nothing on every dollar earned), even though I’m officially in the 15% marginal bracket.

If you only look at the marginal brackets, you are not accounting for the credits. This example is a little contrite, but it should get the point across — thanks.

41. 41
Dan Says:

BG,

I get what you’re doing, because I use similar examples. But I think you’re messing up and getting confused over what the effective rates really mean. Sorry, just my humble opinion (Also, I think you’re mistaken when calculating the credits in with the effective rates. The child tax credits don’t affect your bracket, but the dependent exemptions do. The credits are taken AFTER calculating your taxable income whereas the deductions are considered BEFORE.)

Just so you see my point a bit more clearly, assume tax rates and brackets never change, and the Roth contributions are capped at \$5k/year like they are now. How many dollars will you send to the tax man? In the 15% bracket (pick the bracket you are in AFTER accounting for all deductions and exemptions) you would have to earn \$5882 and send \$882 to the tax man. Over ten years, you’ve paid \$8,820. Assume 5% growth. You’ve had to earn \$58,820 (15% bracket), and at the end, you only have \$62,889.

As above, to have a post-tax \$5000, we had to earn a pretax \$5882 each year. But this time, we’re investing it in a 401k. You want to withdraw the entire balance in a single year, and it represents all of your taxable income. Again, assuming a 5% return, that \$5882 in 10 years is worth \$73,983.

Let’s look at taxes. You’re MFJ, no other exemptions except you and your wife. Your standard deduction is \$11,400. Two exemptions are \$3650/ea, for a total of \$7300. \$73,983-\$11400-\$7300 = \$55,283 in taxable income. Your first \$16,700 is taxed at 10%, and the remainder at 15%. Your bill is \$1670+\$5787=\$7,457. The net balance is \$66,525.

Floridian is right. In my example earlier, I neglected to consider compound earnings over time. So I took those into consideration. Now, let’s talk about effective rates like you do. In this example, your effective rate is 14% (\$8823/\$62889) and my effective rate is 11% (\$7458/\$66529). Here’s the kicker — my effective rate is lower than yours AND I have a larger balance.

And check this out — my example was conservative in my favor. Tax brackets, deductions, and exemptions are indexed for inflation. That means I would have less taxes and even more money, yielding a lower effective tax rate.

You can run this example with your own data, but you MUST use real dollars and real tax rates, because in the end, that’s what matters. You say that my way and your way are different ways of reaching the same calculation — try it my way and let me know. The reason I think your argument isn’t compelling is because the 15% tax bracket is very wide — it encompasses taxable income from \$16,700 to \$67,900. For an MFJ with two kids, you can have a gross income of \$93,900 and still be in the that bracket. (The bottom end is \$42,700.) That’s a wide range and likely where most middle class Americans fall. (I say most, because that band for singles would be a gross income of \$17,700 to \$43,300.)

In conclusion, I think the best tax strategy in retirement for an MFJ is one that generates taxable income that is the sum of the standard deduction, two exemptions, and (at a minimum) the upper end of the tax bracket of the under yours before considering a Roth. That’s \$11,400+\$7,300+\$16,700=\$35,400 in today’s dollars. If you’re not taking advantage of the standard deduction and exemptions, you *are* giving money to the tax man unnecessarily.

42. 42
Dan Says:

BG,

Octo-mom is an extreme example — I do agree that zero is zero, official brackets non withstanding. The credits themselves don’t affect the rate at which you are being taxed, just how much tax is actually due. But as long as you have at least \$1 in overall liability, your contributions are still being taxed at your marginal rate as determined on Line 43 of Form 1040 (taxable income).

Say you make \$55,250 in gross income, and you’re MFJ with 3 kids. Your taxable income is \$55,250-\$11,400(std deduction)-\$3650*5 (two adults, 3 kids) = \$25600. Your tax due is \$3009. Your three kids knock off \$3000, for a total bill of \$9. However, making \$100 more dollars increases your taxable income to \$25,700, increasing your tax due to \$3014, or \$15 more. So, you really are in the 15% bracket after deductions and credits

(In this case, you’d have \$85 to contribute to your Roth, I’d have \$100 to contribute to my 401k/traditional IRA.)

43. 43
BG Says:

#42 Dan) Heh, yes, I see what you are saying and I’m following you. The question is, why would you want to refuse to pay the \$15 in taxes now, when your effective rate is 0.027% — do you think you could get a lower effective rate than that in retirement?

Eventually, everyone must pay taxes — and it is real nice the government allows us the choice of when we want to pay them. If someone has the ability to only pay 2.7 CENTS in taxes for every \$100 they earn — then I say do that immediately. What would you want to defer taxes when you can get away with it for so cheap right now?

44. 44
BG Says:

#41 Dan) Been studying that post some more and it is starting to sink in. Avoid paying 15% taxes today, on money that will technically be tax free in retirement (deductions, exemptions, etc) anyway. So with the traditional, it’s tax free on both sides, to a certain extent.

Thanks for explaining this — I’ll run some numbers for my case and see how things look. With my employer match (traditional) that may already be filling un-taxed income already — which is what I need to check.

45. 45
Dan Says:

BG,

Quite simply, yes. Just as with your octo-mom example, I can create a scenario where I pay nothing! Remember, today, the first \$18,700 in earned income is totally tax free! Why pay that \$15 now when you can pay nothing on it later?

Oh, it just hit me why I don’t like your use of effective tax rates. The calculation isn’t linear, but you’re trying to do a linear extrapolation of it. It doesn’t work. It’s misleading, and it’s incorrect.

Let’s go back to my example in 42). My effective tax rate is \$9/\$55250, or 0.01628%! Using your calculations, on the next \$1000 I earn, I’m going to owe \$0.163, for a total bill of \$9.163, right?

In my calculations, I’m going to look up \$26,600 (\$25,500+\$1,000) in the tax table, and find \$3159. I’ll knock \$3000 off for the kids, and find that I owe \$159. Why is that? If you’re right, I should owe \$9.16, not \$159. What am I doing wrong?

Now my effective tax rate is 0.283%. In your terms, I had a 1,666.66% increase in my effective tax rate just because I made \$1000 more! Clearly, this can’t be right. I’m mean, I’m in the 15% bracket, right? How can an extra \$1000 in earnings generate an effective tax increase of 1,666.66%?

What’s really happening is that my tax bill is increasing at a rate that is proportional to my marginal tax rate. For each \$100 I earn, my tax bill is increasing by 15% of my earnings increase. So if you want to contribute \$1000 into your Roth IRA, you have to earn \$1176 to do it.

Why are you so hung up on %? It’s going to really cost you money in the long run. I’m concerned about dollars first and foremost. I earn dollars, I spend dollars, and I get taxed in dollars. I don’t earn %, I don’t spend %, and I don’t pay taxes in %. (I write uncle Sam a check.)

I guarantee you that, if we did everything else exactly the same, but you invested only through Roth and me only through a 401k, that I would have more money at the end. (And in what I described earlier, I still had a lower effective % rate than you would, too.)

It’s ok to look at effective rates when comparing the exact same income (denominator) but when that denominator changes, you can’t make any linear extrapolations. (Linear extrapolations to a non-linear function is bad math.) If you don’t believe what I’m telling you, take your income and graph effective tax percentages against increases of it. (On the x-axis, plot your income. For each inch or so you move over, add \$1000 to the previous number. So, if you make \$55k, write down \$55k, \$56k, \$57k, \$58k, etc. On the y-axis, plot your effective tax rate.) The numbers will form a curve, not a straight line. That’s why your math doesn’t work.

I can also tell you that your effective tax rate at \$57k isn’t the midpoint of a straight line between your effective tax rate at \$55k and \$57k.

In the end, if your tax strategy doesn’t take into account the benefits of the standard deduction and personal exemptions in retirement, you WILL pay more money to Uncle Sam than you should.

46. 46
Dan Says:

BG,

You posted while I was writing the last one.

One thing to keep in mind is that the brackets are indexed for inflation. In 10 years, I figure inflation will increase things by 30% (multiply by 1.3) and in 40 years, it will take a multiplier of 2.8.

Also consider right now that when you are required to start taking distributions, you must divide your whole pot by 27.4. (If you have \$1 million, your RMD is \$1,000,000/27.4 = \$36,496.) I don’t know if that 27.4 figure will change — it comes from the government’s uniform life expectancy table, which is a function of your age.

47. 47
BG Says:

#45 Dan and other) You have firmly made your point, and I agree completely. Last night I changed my 401k contributions to be tax-deferred (instead of Roth). Huge mistake I made last year. I’m really glad you guys spent the time to convince me of the error of my ways.

Since I’m barely in the 25% marginal bracket, and I don’t expect to pull anywhere near the \$137k in retirement to put me into the 28% bracket, then I’m much better off going 100% traditional. This would allow me to fill the 0%, 10%, and 15% brackets for much cheaper than my 25% today. Anything that falls within the 25% bracket in retirement is a wash (there is no benefit between roth or traditional).

Good to know that the brackets are indexed to inflation — that reassures me.

“Oh, it just hit me why I donâ€™t like your use of effective tax rates. The calculation isnâ€™t linear, but youâ€™re trying to do a linear extrapolation of it. It doesnâ€™t work. Itâ€™s misleading, and itâ€™s incorrect.”

That is correct — that was my problem. It was your quote that you’d have a lower effective rate, plus more in savings that made me stand up

I guess all is not lost for last year, since I still have the ability to open a traditional IRA and make contributions to it for last year to try to repair some of the damage…

48. 48
John Says:

In my case for 2010 my retirement investments could actually span the threshold between 15% and 25% tax brackets. In this case, my best strategy is to contribute enough to the tax-deferred plan to put my taxable income back in the 15% bracket, then put the remainder of my available retirement money into a Roth account at 15% tax rate.

I wasn’t planning it but I did half of this scheme in 2009. My taxable income was \$14 short of the 25% tax bracket threshold. Therefore nearly every dollar that I put into my 401(k)would have been taxed at 25% had I taken it home or invested it into a Roth, but I almost completely filled the 15% bracket with take-home pay. I did not invest anything into a Roth IRA so that is the other half of that maneuver that I hope to do next year.

49. 49
JackRabbit Says:

I agree that traditional is the way to go for the reasons that Dan posted, but here is one easy way I’ve found to explain it to others:
Compound interest is so powerful that by deferring the tax payments, you can earn money on Uncle Sam’s money; more than whatever high tax bracket you might have to pay in the future. For a young person like myself, the money I’m not paying in taxes now will multiply a few times, making a few percentage points’ difference in tax rates in the end rather meaningless.

On a side note, I have to disagree with the arguments I’ve seen so far against the flat tax; while I’m not saying flat tax is definitely the way to go, don’t rule it out. For instance, you could still get your deductions, credits, etc, so that lower-income folk end up with lower marginal rates just like they have now.
The tax savvy would still be able to keep more of their money, and we could avoid the ridiculously high brackets that the Adam Smith in me knows just kills the economy.

50. 50
Mark Says:

BG, an earlier comment you made directed at people making over \$200,000/year stating that somehow they pay less and less taxes is way, way, way off base. I use TaxACT software every year, and currently my taxable income is \$193,000, but have to decide whether to work my behind off to earn an extra \$70,000. Well, TaxACT does the “calculations” you claim you did…and guess what. I lose my spousal IRA deduction, my 3 child tax credits, I pay an AMT penalty, etc., etc.. I don’t have any fancy income like stocks, dividends or anything, just a job, \$180,000 in student loans (interest not deductible), 3 kids and a \$250,000 mortgage. Guess what….my federal tax rate WAS 10% of total income and is going to go up to 19% of total income. DOUBLE!!??? Yes, you got it, an extra \$70K of income is going to cost me an extra \$32,000 in federal and state taxes. Now I ask all you Obamites out there…what motivation do I have to work my tail off when the govt. keeps 46% of every extra dollar I make. FORGET IT. You are going to kill off the incentive to work, and businesses will not expand. I can’t even pay off my student loans because none of the interest is tax deductible, and definetely none of the payments are either. We so called “rich” people are torqued off for a good reason. Where I should be in the 28% tax bracket actually calculates out in the software to a 46% federal/state effective marginal tax rate. And I live in a state that ranks in the middle of a nationwide list of overall taxes….(by the way, I pay \$6000/year toward property tax for this \$250,000 rich man’s house). What a joke this country is, no wonder people move to St. Kitts & Nevis. And why not lookup global corporate tax rates on Wiki and tell me what makes you think corporations are going to want to setup HQ here in the USA? You don’t think we are losing billions in corporate taxes that could’ve come here but instead are going to Ireland?

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