rothoptimizationmainmain 1

Roth Optimization for Early Career W-2 Workers

Using Historical and Yearly Effective Tax Rate to Optimize Roth vs Traditional 401k Contributions


Should you do Roth or Traditional contributions in your 401k early in your career? Let’s talk about Roth Optimization!

Roth money is some of the sweetest money around. You have limited capacity each year to capture Roth money:

Should your yearly employee contribution in the 401k be Roth or Traditional?

The idea is you want to have optimal tax diversification during retirement. Tax diversification allows you flexibility in paying taxes in retirement. If you are a W-2 employee, you cannot control your taxes while working. Payroll and ordinary taxes will be assessed.

Using your Tax Planning Window is huge in obtaining tax diversification. You need to be retired in order to do tax planning in the tax planning window.

But what should you do if you are young and a high-income earner? Roth or Traditional?

Is there any way we can know what taxes will be in the future so we can Roth Optimize when young?

Let’s dig in!


Tax Diversification and Roth Optimization

As a reminder, tax diversification is key in retirement. There are (essentially) three types of accounts:

In retirement, controlling your ordinary income tax rate (via controlling the amount you have in tax-deferred AKA pre-tax retirement accounts) is paramount to planning. You need to have some money in each of these investment accounts in order to optimize taxes.

When you are young and working your first years in a W-2 job, how do you know if you should do Roth or Traditional deferral into your 401k? With Roth, you pay taxes now but forever thereafter have tax-free growth and distributions are ultimately tax-free as well. With Traditional, you get to take the tax break now, which can be huge if you are in the top tax brackets.

Since the goal is to pay the least amount in taxes over your lifetime, you want to do Roth when your yearly taxes are low (and thus you are in the lower tax brackets), and do traditional when you are in the higher tax brackets.

But who knows what future marginal tax rates will be!

There may be another way to think about this problem.

In order to know when you should do Roth vs Traditional, let’s quickly remind ourselves of the difference between the effective and marginal tax bracket.


Effective vs Marginal Tax Bracket and Roth Optimization

Remind yourself of the difference between effective and marginal tax bracket, if needed.

In essence, when you put away income in a traditional pre-tax account and take the deduction now, you are saving at the marginal tax rate. If you are in the 35% tax bracket, you save paying 35 cents for every dollar you defer.

Later, when you withdrawal funds, you pay taxes at your effective tax rate. Please understand this difference, as this is why it makes a ton of sense to defer income if you are going to be in the same or lower tax bracket in retirement. This also confuses many people (especially if they are into LIRPs or Real Estate, or think you lose money when the market goes down), so you are in the top decile if you understand this concept.

So it is actually your future effective tax rate that is important to know when optimizing Roth contributions to 401k plans. Is it possible to guess what your future effective tax rate will be? Hold on to your hat! But before we go there:

When you are early in your career and a high-income earner, how can you decide if your should do Roth or Traditional 401k contributions?


Roth Optimization when Young

Ok, let’s get to the point. How do you know if it is optimal to Roth vs Traditional 401k contributions when you are just starting out your career? There are a couple of ways to slice this onion.

Current Tax Bracket

What is your current tax bracket? If you are in the low brackets (10 and 12%), do Roth. If you are in the high tax brackets (33, 35, 37%) do traditional. If you are in the 22 or 24% (the medium tax brackets), well then what is your future tax rate going to be and how much tax diversification do you already have?

Hedge Your Bets

Another way to approach this is to do 50/50 in Roth and Traditional regardless of your current tax bracket. This hedges your bets for the future.

Understand the Historical Effective Tax Brackets in order to Optimize Roth

This is the idea I want to pitch you now in this blog.


Roth Optimization by Using Historical Effective Tax Rates

When you say future take rates are unknowable, it is true.

But we can understand the historical tax rates and understand the range of possibilities. We know the marginal rates vary widely, as they are 37% now and expected to go up to 39.6% (either soon, or in 2026), and have been as high as 90%.

But what about historical effective tax rates?


Using Historical and Yearly Effective Tax Rate to Optimize Roth vs Traditional 401k Contributions


Above, you can see the top federal marginal tax bracket, the average effective rate of the top 1% of earners, and the average effective tax rate for all taxpayers. These data are from 1913 through 2012.

Note despite wide swings in the top marginal tax bracket (from 70 to 25 to 90 to 35), the average effective rate of the top 1% of earners has been between 35-40% since 1970. That is a pretty tight range given all the variability seen in the top marginal rate over the decades.

And for all income earners, the average effective rate has been around 30% for the same time period.

Understand that when Congress makes changes in the tax code, they change marginal rate and deductions and other tax laws as well. Thus while we cannot predict the marginal tax bracket, the effective tax rate is much more consistent over time. 

So, if you are a top 1%er, you might consider Roth anytime your current effective rate is less than 35-40%, and if you are a median earner, anytime your current effective tax rate is less than 30%.

Of course, caveats abound with this recommendation. If you plan to retire early and will have a massive Tax Planning Window, you might consider overfunding your pre-tax accounts as you have a lot so time to do partial Roth Conversions. Conversely, if you are going to work until you are 70, you might consider Roth regardless of your current marginal tax bracket (and you may even consider debulking your IRA as well).

In addition, if your heirs will all be high income, you might consider Roth, whereas if you are going to leave it all to charity, pre-tax makes the most sense. This is why personal finance is personal.


Conclusion- Roth Optimization for Early W-2 Workers

What should you do with your employee contribution from your Job? Should you go Roth or Traditional as a young W-2 employee?

The goal is to pay the least amount of taxes over your lifetime (and the lifetime of your heirs) on that single dollar of tax-deferred income. If you can pay zero cents now (for instance, doing a Roth contribution in years where you income is less than the standard deduction), then that makes all the sense in the world!

What will you pay to liberate that dollar now vs in the future? That is the question. Remember, by deferring income, you are entering a one-sided-deal with the government. They have all the power via a variable interest rate loan on your pre-tax accounts. They can (and will) change taxes at any time.

That said, despite massive swings in the top marginal income rate, the historical effective rate has stayed remarkably constant for decades.

What is your effective tax rate? As a young W-2 employee, knowing how much, on average, you pay on taxes can inform your Roth vs Traditional decision.

Posted in Financial Independence and tagged .


  1. Great post!

    The historical tax rate information is very interesting and helpful. Based on that, I may wait on the Roth 401K for now.

    Thanks for what you do!

  2. When I compute my taxes, I have some income that is taxed at less than the effective rate (10 or 12%) and I have some money taxed at and above the effective rate and some taxed at the marginal rate. I don’t understand the statement that such-and-such funds will be taxed at the effective rate upon retirement. I particularly ask this for the high income people who are likely to have sources of income besides a Roth or Trad account.

    • Ray, thanks for the comment.

      It is pretty easy to understand that when you defer money it comes out of your top marginal bracket. But when you withdraw from pre-tax, you are withdrawing it through your marginal tax brackets, thus it comes out at your effective rate. You get to decide where you take your money out during retirement (above and beyond RMDs) so you have control of your taxes. As I said, hard to grasp but important (eventually!) to do so.

Comments are closed.