Roth vs. Tax-Deferred: The Critical Concept of Filling the Brackets | White Coat Investor (2024)

By Dr. James M. Dahle, WCI Founder

Tax-deferred accounts are frequently derided by three types of people:

1. Those trying to sell whole life insurance as an awesome investment because you can borrow against its value (just like your car, home, or investment portfolio) tax-free, but not interest-free.
2. Those who have a serious fear of dramatic increases in future tax rates, and
3. Those who simply don't understand how tax brackets work.

When Not to Use a Tax-Deferred Account

Although the Roth (tax-free) versus traditional (tax-deferred) 401(k)/403(b)/457(b) contribution question can be quite complex (especially since the right answer depends on variables that are unknown and unknowable), the rule of thumb is to use tax-deferred accounts as much as possible during your peak earnings years and tax-free accounts in all other years. For a typical doctor, those other years include the following:

• Pre-med years
• Medical school
• Residency
• Fellowship
• The year you leave training
• Sabbaticals
• Extended maternity/paternity leave
• Working part-time at any point in the career

Filling the Brackets

The key principle to help you understand WHY the rule of thumb is usually correct is a concept I call “Filling the Brackets.” People who don't understand how the tax code works sometimes worry about being “bumped up into the next tax bracket.” That's stupid. While there are a few rare places in the tax code where having slightly more income really does dramatically increase your tax burden, for the most part when you make more money, only the additional money made is subject to being taxed at the higher rate. Thus, your effective tax rate (total tax paid/total income earned) is typically significantly less than your marginal tax rate (the % of the next dollar earned that goes to the tax man.)

Let's use an example to demonstrate just how powerful a tax-deferred account can be. Let's imagine a doctor who didn't start saving for retirement until mid-career. She used a 401(k) and put $50K in it per year for 15 years from age 47 to age 62. It earned 5% real (and we'll use real [after-inflation] numbers, the 2019 tax brackets, and a 0% state income tax rate throughout this post) and thus added up to

=FV(5%,15,-50000,0,1) = $1,132,875

She is single and was earning $350,000 during her career, so her federal tax rate was 35% throughout her peak earnings years. She has no pension, no rental properties, and is delaying Social Security to age 70 like a good white coat investor. So her only source of taxable income when she retires at age 62 is that 401(k).

She decides she is going to withdraw 4% per year. That would normally be adjusted up with inflation each year, but we're using real numbers so we don't have to make an adjustment there. So when she put her money into the account, she saved 35% on taxes on it.

Now, what happens when she withdraws the money? What tax rate does she pay on it? Well, let's assume her only deduction is the standard deduction. She is withdrawing 4% * $1,132,875 = $45,315 per year

• The first $12,200 she withdraws comes out at 0%. That's the standard deduction. Save at 35%, pay at 0%. Very much a winning combination.
• The next $9,700 comes out at 10% for a total of $970 in federal tax. Save at 35%, pay at 10%. Pretty sweet deal.
• The next $45,315 – $9,700 – $12,200 = $23,415 comes out at 12% for a total of $2,810. Save at 35%, pay at 12%. Still awesome.

What is her effective tax rate? It's ($970 + $2,810)/$45,315 = 8.4%. Save at 35% and pay at 8.4%. That's a heck of a deal. This is why maxing out tax-deferred retirement accounts is such a good idea. You get to save money at your marginal tax rate when you contribute the money.

It grows tax-protected for decades–no taxes due on dividends, distributed gains, or gains from exchanging funds. In most states, it also provides powerful asset protection and estate planning benefits. Then, when you withdraw the money, you get to use it to fill up the brackets, usually providing an effective tax rate lower than the rate at which you saved the money during your peak earnings years.

In fact, the worse of a saver you are, the better a deal that a tax-deferred account becomes. If the doctor in our example only had a $300K IRA, her 4% withdrawal would have been completely tax-free.

Here's an illustration from my book, The White Coat Investor's Financial Boot Camp. It illustrates just how beneficial a tax-deferred contribution can be, as a result of filling the brackets.

Increased Tax Rates Don't Change the Basic Formula

Let's now talk about what would happen if tax rates DID increase dramatically in the future. Before we get into this, there are some people out there who have some crazy ideas about future tax rates.

If you truly, in your heart of hearts, believe that tax rates are going to DOUBLE in the future (i.e. the 12% bracket becomes the 24% bracket and the 37% bracket becomes the 74% bracket) then yes, you should be doing Roth contributions and Roth conversions as much as possible now.

However, let's get real for a minute. The reason most of these wackos think rates are going to double is usually based on the federal debt. There are three reasons that even if the country and their elected representatives decide to do something about the federal debt, doubling tax rates is a very unlikely solution. There are simply better ways to deal with it.

1. The federal debt issue isn't about the absolute size of the debt, but the percentage of GDP that it represents. While relatively high right now compared to historical figures (although it was higher in WWII), it isn't ridiculously high. It's basically the equivalent of a family with a mortgage the size of their gross income–very much affordable.
2. Raising taxes is VERY unpopular, particularly when done to the middle class. Go ahead, try to name 51 senators who will vote to raise taxes. Go ahead. I'll wait. Now try to name 51 who will vote to DOUBLE tax rates. Case closed.
3. Inflation is a stealth tax. It basically steadily erodes the value of everything you earn and own. But you know what a great hedge against inflation is? Nominal debt. As inflation increases, that debt becomes easier and easier to pay. Now, some of the federal debt IS indexed to inflation (TIPS) but it's only about 8% of the debt, so on a real basis, inflation reduces the national debt. Inflating the debt away is far more viable politically than doubling tax rates.

So let's get real. Let's assume EVERY tax bracket goes up 5% RIGHT AS OUR DOCTOR RETIRES and run the numbers again. 5% is a DRAMATIC increase. That is MUCH different than reversing the Trump tax cuts, where the largest change was reducing the top bracket from 39.6% to 37%. We're basically talking about a change twice that big in the opposite direction.

• The first $12,200 she withdraws comes out at 0%. That's the standard deduction. Save at 35%, pay at 0%. Very much a winning combination.
• The next $9,700 comes out at 15% for a total of $1,455 in federal tax. Save at 35%, pay at 15%. Still a great deal.
• The next $45,315 – $9,700 – $12,200 = $23,415 comes out at 17% for a total of $3,981. Save at 35%, pay at 17%. Still a big difference there.

What is her effective tax rate? It's ($1,455 + $3,981)/$45,315 = 12%. Save at 35% and pay at 12%, even after a dramatic tax increase. Certainly, the “solution” to this problem offered by whole life salesmen is wrong. Not only do you end up paying for unnecessary insurance and get a low returning investment, but you miss out on this huge tax arbitrage.

What About Other Retirement Income?

The best argument AGAINST using a tax-deferred account is not the fear mongering done by those with little knowledge of financial history or who are trying to sell you insurance-based investing products like whole life insurance. The best argument is that most people, particularly super-savers which we will deal with next, will have other sources of taxable income in retirement. These sources include pensions, Social Security, rental income from real estate properties, royalties, dividends, capital gains distributions, and interest.

The critics are absolutely right–the more of these you have, the less beneficial a tax-deferred account is going to be. However, it would be very rare that going 100% Roth with your retirement accounts (if it were even allowed, since the match and other employer contributions are always tax-deferred) would be the right move. Let's run some numbers again, then I'll discuss each of these sources of income.

Let's assume that our doc not only is going to take $45,315 from that 401(k), but also is going to receive $30,000 in Social Security (85% of which will be taxable), $10,000 a year from a rental property, $10,000 a year from bond interest, and $10,000 per year in qualified dividends/long-term capital gains. Her gross income is going to go way up (from $45,315 to $105,315). Her tax bill will also rise at an even faster rate than her income. But as you will see, she still benefits from filling the brackets.

How much taxable income does she now have? Well, the $45,315, 85% of the $30K in SS ($25,500), the rental income (let's assume half of it is covered be depreciation, so $5,000 there), and $10,000 in interest for a total of 85,815 taxed at her marginal interest rate and another $10,000 at the qualified dividend/LTCG rate. We'll first look at the ordinary income.

• The first $12,200 she withdraws comes out at 0%. That's the standard deduction.
• The next $9,700 comes out at 10% for a total of $970 in federal tax. So far so good.
• The next $29,775 comes out at 12% for a total of $3,573. Not too bad.
• The last 85,815 – $29,775- $9,700 – $12,200 = $34,130 comes out at 22% for a total of 7,509.
• Add 15% * $10,000 = $1,500 for the qualified dividends.

Total tax bill is $970 + $3,573 + $7,509 + $1,500 = $13,552. Given her total income of $105,315, that's a 12.9% effective tax rate, dramatically lower than what was saved by contributing to the 401(k). Although to be fair, the real calculation is

($34,130 * 22% + ($45,315-$34,130)*12%)/45,315 = 19.6%

Obviously saving at 35% and paying at 19.6% is a still a pretty awesome deal. Certainly one shouldn't do Roth 401(k) contributions just because they'll have some Social Security, rental, interest, and dividend income. They'll need to have A LOT of other income, like nearly as much as they were earning during their peak earnings years.

Let's go through the various sources of income that could fill lower brackets and make a few comments about each one.

6 Sources of Income to Fill Lower Brackets

#1 Social Security

This one will be an issue for most people eventually, but since the right move for the vast majority of those noodling on this tax-free versus tax-deferred decision is to delay to age 70, it probably isn't an issue for a number of years. If you retire at 55 and don't take Social Security until 70, that's 15 years that you can use withdrawals from tax-deferred retirement accounts (and maybe even Roth conversions) to fill the lower brackets. Don't worry about the Age 59 1/2 Rule, since early retirement is one of the exceptions to paying the penalty on early withdrawals so long as you follow the Substantially Equal Periodic Payments (SEPP) rule.

Another issue with Social Security is that all of it isn't taxed. In fact, for a very low earner, very little of it is taxed. But most readers of this blog, and particularly those thinking about Roth versus traditional 401(k) contributions, should expect to pay taxes on the maximum 85% of it. Still, 15% of it is tax-free.

#2 Pensions

Pension payments fill the lower brackets, so if you're expecting one or more pensions, particularly large ones, then Roth contributions are relatively more favorable.

Imagine a two military doc couple, for instance. They might enjoy a relatively low marginal tax rate during their working years because they are likely residents of a tax-free state, a significant chunk of their pay consists of tax-free allowances, and their salary is on the low side for physicians.

Then in retirement, they could enjoy a combined pension ranging from $84K to $136K. Even for a married couple, that pension alone will fill the 0%, 10%, 12%, and a decent chunk of the 22% brackets. This is one of the reasons why almost every military member should be making Roth TSP instead of tax-deferred TSP contributions. But what percentage of docs are expecting a pension, especially a large one? I'd guess fewer than 5%.

#3 Rental Income

Here's another big one. If you have a ton of rental income, then Roth contributions and conversions can make a lot of sense because the rental income fills the lower brackets.

However, there are a few considerations. First, one or two small rental properties aren't going to fill enough brackets to make a difference. Imagine a paid-off $100K cap rate 6 rental property. That's only going to kick out $6K in income, and that's assuming it is already fully depreciated. It would take four of those just to fill the “0% bracket” for a married couple. But if you've got a dozen doors under management and they're mostly paid off or a million or two in real estate funds or syndicated properties, then that might fill two or three of the lower brackets. Bear in mind that depreciation and large mortgages may very well reduce the amount of taxable income there dramatically such that you lose very little of the lower bracket space to your rental income.

#4 Royalties

This one technically belongs on the list, but let's be honest here. Most of us don't have a lot of royalty income now and probably won't have much in retirement either. I do have a substantial amount of royalty income from my book, but as time goes on, fewer and fewer people buy it and if I wasn't constantly plugging it on a blog and a podcast, very few would buy it. But sure, if for some reason you've got $200K in indefinite royalty income, then you probably want to do more Roth contributions and conversions than someone who doesn't.

#5 Qualified Dividends

Qualified dividends and long term capital gains enjoy their own favorable tax brackets. The 2019 qualified dividend/LTCG brackets are as follows:

Remember the incomes in the table aren't JUST the dividends/capital gains, but your entire taxable income. But still, most doctors in retirement are going to have their qualified dividends and LTCGs taxed at 15%, and some may even slip a few into the 0% tax bracket. You would have to be a REALLY successful investor to have $434K+ (in today's dollars) in taxable retirement income.

However, I don't really consider dividends and LTCGs to be filling the brackets and forcing tax-deferred retirement account withdrawals to be taken in higher brackets since they're on a completely different tax bracket scale. I view your dividend/LTCG taxes as being added AFTER you have applied the ordinary income tax brackets to those withdrawals.

Besides, all those tax losses you've created from tax loss harvesting over the years (especially if combined with the practice of donating appreciated shares to charity) reduce that income even further (and may even reduce your taxable ordinary income up to $3,000 per year.)

Don't forget that, depending on your basis, a large part of the value of the shares you sell may not be taxable at all. Just like a Roth IRA or bank account withdrawal, that is money that doesn't even show up in this equation.

#6 Bond Interest

If you have a ton of taxable bond interest, that could also fill some of the lower tax brackets. However, given that bond funds are currently only yielding 3-4%, you'll need a lot of money in taxable bonds for this to really fill up much of a bracket. Even $500K in taxable bonds is only going to kick out $15-20K in taxable interest. You can also use muni bonds and not pay federal (+/- state) income tax on that income at all.

What About Super Savers?

Another group of people that ought to at least think about doing more Roth contributions and conversions during peak earnings years are super savers. By super savers, I mean people who save a large percentage of their income, like 30-50%+ and yet still work a full or nearly full career. These folks not only max out retirement accounts, but usually have a significantly sized taxable account and maybe even rental properties.

The good news for these folks is that they've won the game. I mean, the worst case scenario for these folks is that they pay a little more tax than they need to. It's not that they won't have all the money they ever need to spend in retirement — with plenty left over to ruin their kids and maybe even their grandkids. On the other end of the spectrum, we have people who have not saved enough or have barely saved enough. The less you save, the more useful a tax-deferred account is. So it makes sense that as you save more, the less useful a tax-deferred savings account becomes. The withdrawals plus other income simply get you much closer to what your peak earnings marginal tax rate was. In fact, if you really save a ton, you could even theoretically pay at a higher marginal rate in retirement than you saved during your peak earnings years, especially if tax rates rise a bit.

Another important effect to understand is that if you are also investing in a taxable account, then if your contribution tax rate and your withdrawal tax rate are equal, you would be better off using a Roth account. The reason for that is easily seen if you adjust everything for taxes. If the government really owns 1/3 of your tax-deferred money, then a $1M IRA + $333K in a taxable account is precisely equal to a $1M Roth IRA. But as time goes by, the Roth IRA becomes more valuable because all of its growth is protected from tax drag, whereas only part of an IRA + taxable combination account is protected from tax drag.

Let's run some numbers to show just how much of a super saver you can be and still not have to worry about this.

Super Saver Scenario

Let's say a couple of super savers earn about $300,000 together and save half of it, 1/4 in tax-deferred accounts and 1/4 in a taxable account and do that for 35 years. They're in the 32% tax bracket during their peak earnings years. Their investments earned 5% real over that time period. We'll assume a little tax drag on the taxable account. After 35 years, they've got a $6.8M IRA and a $6M taxable account of which half is basis. If they decide to spend 4% of each account, their income looks like this:

• $40K from Social Security
• $272K from the IRA
• $120K from the taxable account at qualified dividend/LTCG rates
• $120K basis from the taxable account

Total spendable cash each year: $552K

Total taxable income: $432K

How much do they pay in tax?

• The first $24,400 is taxed at 0% due to the standard deduction.
• The next $16K is taxed at 10%, for $1,600. That is all from Social Security and has filled up the 0% and most of the 10% bracket. There's still a little room in the 10% bracket for that IRA withdrawal though.
• $3,400 of the IRA withdrawal is taxed at 10%, for $340.

• 

  The next $59,550 (all IRA withdrawal) is taxed at 12%, for $7,146.
• The next $89,450 (all IRA withdrawal) is taxed at 22%, for $19,679
• The last $119,200 (all IRA withdrawal is taxed at 24%, for $28,606.
• The $120K dividends/gains from the taxable account is all taxed at 15% for $18,000 in tax due.
• The $120K of basis incurs no tax burden.

Total tax paid on that $432K in taxable income and $552K in spending cash is $73,771, 17% and 13% respectively. But the important question is what is that IRA withdrawal taxed at? Remember they saved 32% on the money going in.

$340 + $7,146 + $19,679 + 28,606 = $55,771

$55,771/$272,000 = 20.5%.

So even these super savers come out way ahead by using a tax-deferred account during their peak earnings years. Even if tax rates increased 5% across the board they're STILL going to only pay $69,469 on that withdrawal, or 25.5%.

A Change in State Tax Rates

One other way that using a Roth 401(k) during peak earning years can help is if you spend your career in an income-tax free state (such as Alaska, Washington, Nevada, Texas, Florida, South Dakota, Tennessee, or New Hampshire) and then retire to a high tax state such as California, New Jersey, or New York. You could be adding 7-10% to your withdrawal tax rate and that could push you into a situation where you're paying more at withdrawal than at contribution. But even that probably has to be combined with one or two of the other three factors: increased tax rates, significant other income in retirement, and super-saver tendencies. I think this is a pretty rare situation. Most people stay put in retirement and those who move tend to move to lower income tax states than where they spent their career (i.e., New York to Florida, Illinois to Texas, Minnesota to Arizona, Montana to Nevada).

Careful with Spouse Life Expectancy

Another factor to be aware of, especially if your spouse is much older or sicker than you, is that once your spouse dies you go from using married tax brackets to single tax brackets. If that's just a couple of years at the end of your life, no big deal. If that's your last 20 years, you may have wished you had done more Roth contributions or conversions. For example, a married couple with $250K in taxable income is in the 24% bracket, but a single person with the same income is in the 35% bracket.

The year your spouse dies may also be a good year for a big conversion too.

Beware the 199A Deduction

If you are self-employed and qualify for the 199A deduction, be careful using tax-deferred employer contributions as they reduce your ordinary business income that your 199A deduction is calculated from. You may be better off making Mega Backdoor Roth IRA contributions instead like we are this year.

Drawing Conclusions

As you can see, the rule of thumb to use a tax-deferred account during peak earnings years is persistent despite numerous factors that would seem to reverse it. That leads me to believe that when someone is arguing for Roth 401(k) contributions or Roth conversions during peak earning years they are either:

1. Ignorant, or
2. Trying to sell you something

There are at least two well-known people in my local area making this argument on the radio or in their books. No surprise that both of them make their living by selling cash value life insurance. I've also had a fair number do it in the comments section of this blog. Each time I challenge them to actually run the numbers themselves. They never seem to want to do so. They either change tactics and start arguing for some other benefit of whole life insurance, or (more likely) launch into ad hominem attacks. As you now know because you've run the numbers, it's unlikely that this rule of thumb is going to be wrong for any but a tiny percentage of investors. In fact, it's probably more likely that the other rule of thumb (invest in a tax-free account during non-peak earnings years) is wrong, but that's a post for another time.

What do you think? Did you understand the concept of filling the brackets before this post? Have you been mistakenly making Roth 401(k) contributions? Which type of account do you contribute to and why? Do you think whole life selling agents actually believe they're helping you reduce your taxes and reach your goals when they say you should avoid using your tax-deferred accounts and buy whole life insurance instead? Comment below!