Roth vs Tax-Deferred: Should I Look At Marginal or Effective Tax Rate?

A reader writes in, asking:

“When choosing between a Roth 401k and regular 401k, people always talk about marginal tax rate. Does effective tax rate play into the decision as well? I expect to have a very low effective tax rate in retirement due to a lower income level and the tax advantaged nature of Social Security. Is that a point in favor of using a regular 401k rather than Roth?”

For those who are unfamiliar with the terms: Your “effective tax rate” is the average tax rate on all of your dollars of income within a given year (i.e., total tax, divided by total income). In contrast, your “marginal tax rate” refers to how much additional tax you would have to pay on an additional amount of income (i.e., additional tax, divided by additional income).

To answer the reader’s question, no, your effective tax rate doesn’t really play into the Roth-vs-tax-deferred decision. Your marginal tax rate (i.e., the tax rate on only the dollars of income in question) is what matters here.

This is, by the way, a general rule about economic decisions — they’re made at the margin. That is, we want to know, “if I make decision X, how will [something] change?”

• If I sell more units, how does my revenue change (i.e., what is my marginal revenue)?
• If I produce more units, how do my costs change (i.e., what is my marginal cost of production)?
• If I buy more of this product, how does my happiness change (i.e., what is the marginal utility of this product)?

And when it comes to retirement accounts, we want to know: If I contribute to a tax-deferred account (as opposed to a Roth account), how does the amount of tax I have to pay this year change, and how does the amount of tax I have to pay in the future change when I take money out of the account? Marginal, not effective, tax rates are what answer these questions.

That said, there are a few important points that need clarification, as there’s more to the question of marginal tax rates than just, “what tax bracket am I in now, and what tax bracket will I be in later?”

First, it is important to account for the fact that there can be multiple applicable marginal tax rates within a given year, if the deduction/income in question would push you under/over a given threshold.

Second, it’s important to remember that your marginal tax rate is not necessarily the same as your tax bracket. For example, due to the way in which Social Security is taxed, it’s very common for retirees to have a marginal tax rate that is significantly greater than the tax bracket they’re in.

Finally, it’s important to note that it’s quite difficult to accurately predict your marginal tax rate decades into the future. This is, in itself, a good reason to hedge your bets by making sure that you have some money in Roth accounts and some money in tax-deferred accounts.