Tax Rate Arbitrage and Roth Planning
Tax rate arbitrage is the most important concept in retirement planning.
You must understand tax rate arbitrage to buy the government out of your retirement. When should you harvest/accelerate income, and when should you avoid/defer it?
Another way to think about this question: Should I do a Roth or Traditional 401k? Or should I do Roth conversions—pay the tax now, so I don’t have to pay my silent partner later? Should I Roth or not? This is a yearly decision!
Tax rate arbitrage means using your current and future year’s income in concert with the progressive tax rates of the federal tax code. Over your lifetime, if you “create” more income in years where you have low taxes (and thus create less income when you have high taxes), you pay less in taxes.
Remember, pre-tax retirement account contributions come off the top of your marginal tax rate. Later, the same money fills the lower brackets of our progressive tax system when withdrawn (or converted to Roth). So, even if taxes are higher in the future, there is a way to use tax rate arbitrage to your advantage and save on taxes.
Let’s begin! To understand tax rate arbitrage, we must first understand the marginal vs. effective tax rate difference.
Marginal vs. Effective Tax Rate
Let’s start by looking at the marginal vs. effective tax rate.
Neither one shows up on your tax return, but both are important concepts!
This is a great graph to help differentiate marginal vs. effective tax rates.
The left side percentages (in red) and the red line are the effective tax rate. The effective tax rate is the average tax paid on your total income. That is, you take your taxes over your total income and the percentage you pay to the government in taxes at your effective rate.
The effective tax rate (a percentage of your total income) translates into an actual dollar amount, the total federal taxes (in green). So, for an adjusted gross income of 100k, your effective tax rate is about 9%, and you pay about $9000 in taxes. For an AGI of 350k, we get 19% and $67k.
Next, the “tax brackets” are your marginal tax rate. Note—your marginal rate is the percentage of federal tax you pay on your last dollar. All other dollars must fill up the lower brackets until you earn enough to get to the next rung or step of the ladder.
Also, note along the bottom the adjusted gross income increases. See how it affects the federal marginal tax brackets as they step up irregularly? Again, this is a progressive tax code; the more you make, the progressively high taxes your marginal (last) dollar is exposed to.
The important point here: your effective tax rate is always lower than your marginal tax bracket. As you approach infinite income, your effective tax rate curve approaches the asymptote of your marginal bracket. Fun.
How to Calculate Effective and Marginal Tax Rate
Folks occasionally want to know their effective and marginal tax brackets. Good luck finding them, as they are nowhere to be seen on a tax form!
You can calculate them, however. Just take your line 9 (total income) from the 1040, and add it back to your retirement account contributions. Remember, when you are a W2 employee, your 401k contributions are taken out and don’t hit your top line. Then find line 24 (total tax) and divide 24 by 9.
Federal taxes over total income is your effective tax rate: the average percentage of taxes you pay on your income. They keep re-designing the 1040, so the lines above may not match the one you are looking at, so find the lines for total income and tax.
Next, the marginal brackets change every year, but below let’s look at an example I like.
How to Calculate Effective Tax Rate
Above, you can see the taxable income for single filers and married filing joint. See how income fits into the tax rates? I like this example because you can see how much you owe in federal taxes as you go through the tax brackets.
For instance, say you make 200k in 2022. As a single, you owe $34k and change plus 32% of the amount greater than $170,050. For a married filing joint, you owe $30k and change, and the surplus hits the 24% tax rate.
Most use computers and TurboTax to calculate their effective tax.
Okay, now that we understand marginal and effective tax rates, we need to realize that they change over your lifetime as your income goes up, then goes down, and then goes up again (when required minimum distributions start). This change in your income allows tax rate arbitrage to be effective!
Tax Rate Arbitrage over Time
Your income and effective tax rate change over time, which allows tax rate arbitrage over time.
You have a low tax rate when you don’t earn a lot of money. Thus, it is often a great time to make Roth IRAs and Roth contributions to your retirement plan at the beginning of your career. Then, at low tax brackets, go all Roth all day long.
When you start earning more money, it often pays to defer taxes until later. Then later, in retirement, you might “earn” less income and thus have access to your lower tax brackets where you can recognize the deferred income. So save high, buy low.
Let’s see an example of an effective tax rate over time.
Effective Tax Rate Over Time
Above is a graph of effective tax rates while working from 46-55, and then in retirement from 56. Note the significant change at retirement, then again at age 72 when RMDs kick in. (There is also a slight increase in 2026 when the TCJA expires.)
Also, note the effective tax rate is not zero during retirement, as there is still investment income. Remember, you might owe ordinary taxes on interest, non-qualified dividends, and short-term capital gains. If you have actively-managed high turn-over mutual funds in your brokerage account, you might owe a lot of ordinary taxes!
But also, if you have enough income, you owe 15% on long-term capital gains. Capital gains may be taxed in a parallel tax system at progressive tax rates. Remember, long-term capital gains stack upon ordinary income.
Okay, let’s talk capital gains for a second. You include taxes paid on capital gains when considering your effective tax rate. However, a separate, parallel taxation system for capital gains goes into your effective but not marginal tax rate. Remember, the marginal rate is on your last dollar of ordinary income, which does not include long-term capital gains and qualified dividends. Does that make your head hurt, too?
Back to the graph above. Taxation also includes FICA while working. You pay ½ if W2 and all of it if 1099. State taxes are also interesting to consider in retirement, as sometimes they are due on income but not on social security, pensions, and/or RMDs. Each state is a little different; is your state retirement friendly?
In this example, the effective tax rate is 30% before retirement and drops below 5% until RMDs kick it back above 20%. After that, effective tax rates will slowly increase through retirement as RMDs become more extensive over the years.
Whew, there are many moving parts to taxes over your lifetime!
Next, let’s look at the marginal tax rates over time.
Marginal Tax Rates over Time
Above, we can see the same scenario for the marginal tax rates over time.
You are above the 32% tax bracket (which becomes 33% when TCJA expires in 2026). So your marginal tax rate is 35%. So you pay 35 cents in federal taxes on the last dollar you earn.
Income on investments keeps you in the 22% tax bracket during early retirement.
Then, note that RMDs kick you back in the 35% bracket. Too bad they didn’t do Roth conversions up to the 25 or even 28% tax bracket. They would have saved a ton in taxes over time…
Speaking of saving a ton of taxes, let’s talk (finally) about tax rate arbitrage.
What is Tax Rate Arbitrage?
Tax rate arbitrage uses the tax code to pay less in taxes over your lifetime.
Understand the breakpoints and play on either side of the breaks. Money is fungible, so get it in your pocket by paying less tax. This is how you can buy uncle Sam out of your retirement.
If you will make a lot of money at some point in your career, do Roth IRAs/401k when you are young and not earning much. You pay more taxes at a lower marginal rate to save money in a tax-free account. This grows, and you can spend it later without bumping up your “income” in retirement, thus being exposed to higher marginal taxes later in life.
Then, during your peak earning years, you defer as much money as possible. This can be via a traditional retirement plan, non-governmental 457, or other non-qualified retirement plans. The income you defer comes out of your top marginal tax rate and lowers (albeit slightly) your effective tax rate.
Next, do Roth conversions (from qualified plans) or spend the money (from non-qualified plans or qualified plans if you need the money) during your Tax Planning Window. Your tax planning window is the time after you have earned income and before you have to recognize social security and RMDs as income. That’s the way to do tax rate arbitrage!
As an aside, you can also accelerate and defer income by using different sources of depreciation, such as business, real estate, or farm and ranch tax deductions with W-2 income.
How Tax Rate Arbitrage Works
To see how tax rate arbitrage works, let’s look at an example of a dollar. To defer it, you save 35 cents in taxes during your peak earning year. Sweet!
Next, you owe 25 cents in taxes to get that dollar back to spend in retirement. You saved a dime! That’s 10% of your money saved by tax rate arbitrage!
Or conversely, if you are doing partial Roth conversions in retirement, you spend 25 cents to liberate it from tax-deferred into tax-free. This might prevent you from being bumped into the 35% tax bracket in the future. So would you pay 25 cents now not to be forced to pay 35 cents later? It sounds like a pretty good deal!
This is how tax arbitrage works: Save 35 cents to defer it, then spend 25 cents to get it back later.
Or, if you will spend 35 cents to get it in the future, pay 25 cents to get it now. RMDs might force you to take out more deferred money than you need to live on if you have too much in your pre-tax retirement accounts! So, paying the taxes now (doing Roth conversions), you might spend 25 cents now so that it doesn’t cost you 35 cents in the future!
Above, you can see (in general) how to use tax rate arbitrage. You want to harvest/accelerate income when you are in the low buckets (10 and 12%), you want to harvest/accelerate income. Roth all the time. In the middle buckets (22 and 24%), you need to know how income is this year vs. in other years.
Finally, when you are in the high-income buckets (32% and up), it is likely a good idea to consider avoiding/deferring income via traditional (tax-deferred) contributions to retirement plans. Some who already have massive pre-tax retirement accounts and are scared of the size of future RMDs might want to consider paying some taxes now to hedge their tax rate arbitrage bets for the future.
Summary- Tax Rate Arbitrage
In summary, defer taxes, avoid peak income, accelerate taxes, and harvest income during low-income years. That is tax rate arbitrage!
Oh, if it were that simple! But tax rate arbitrage should make sense to you if you understand the progressive nature of marginal taxes.
Of course, it gets more complicated. Your strategy changes if your heirs are in a high vs. low tax bracket. And there are QCDs to use for charity. Don’t forget about NIIT and the capital gains tax brackets! And IRMAA.
Remember, why do you want the Roth money? What is the purpose of the money? What do you intend for it to do?
It is essential always to understand: that you need to know what you want your money to do for you before you can tell it where it should go.
But now, at least, you understand Tax Rate Arbitrage. Defer when high, and recognize when low. Save high, spend low.
Finally, let’s put tax rate arbitrage in a historical context. Can you understand how to use historical and yearly effective tax rates to optimize Roth vs. traditional contributions?
Using Historical and Yearly Effective Tax Rate to Optimize Roth vs. Traditional 401k Contributions
So, let’s figure out what taxes are “on average” to help you know what years you consider active tax rate arbitrage.
As a reminder, tax diversification is key in retirement. There are (essentially) three types of accounts:
- brokerage accounts where you pay capital gains taxes and get a return of principle
- tax-deferred accounts where you (and your heirs) always owe ordinary taxes, and
- tax-free (Roth Accounts) where you pay the tax now but get tax-free growth and withdrawals in the future
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 retirement income planning. Therefore, you need to have some money in each investment account to optimize taxes. Or, at least, it is best to have as much money as possible outside of the pre-tax accounts!
With Roth accounts, you pay taxes now, but forever after that have tax-free growth, and distributions are ultimately tax-free. 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 traditional when you are in the higher tax brackets.
But who knows what future marginal tax rates will be? Congress can change them anytime!
There may be another way to think about this problem.
To know when you should do Roth vs. Traditional, let’s remind ourselves of the difference between the effective and marginal tax brackets.
You are saving at the marginal tax rate when you put away income in a traditional pre-tax account and take the deduction now. So, for example, if you are in the 35% tax bracket, you save by paying 35 cents for every dollar you defer.
Later, you pay taxes at your effective tax rate when withdrawing funds.
Please understand this difference, as this is why it makes a ton of sense to defer income if you are in the same or lower tax bracket in retirement. However, 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 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!
Tax Rate Arbitrage 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 the range of possibilities. We know the marginal rates vary widely, as they are 37% now and expected to go up to 39.6% (in 2026) and have been as high as 90%.
But what about historically effective tax rates?
Above, you can see the top federal marginal tax bracket (blue), the average effective rate of the top 1% of earners (green), and the average effective tax rate for all taxpayers (yellow). These data are from 1913 through 2012.
Note although there are 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 in the top marginal rate over the decades.
And for all income earners, the average effective rate has been around 30% for the same period.
Understand that when Congress changes the tax code, they change marginal rates, deductions, and other tax laws. 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, your current effective tax rate is less than 30%.
Of course, caveats abound with this recommendation. For example, if you plan to retire early and have a massive Tax Planning Window, you might consider overfunding your pre-tax accounts as you have a lot of time to do partial Roth Conversions. But conversely, if you are going to work until you are 70, you might consider Roth regardless of your current marginal tax bracket.
In addition, if your heirs will all be high income, you might consider Roth, whereas if you leave it all to charity, pre-tax makes the most sense. This is why personal finance is personal.
Tax Rate Arbitrage
What should you do with your employee contribution from your Job? Should you go Roth or Traditional as a young employee?
The goal is to pay the least taxes on that single dollar of tax-deferred income over your lifetime (and the lifetime of your heirs). If you can pay zero cents now (for instance, making a Roth contribution in years where your income is less than the standard deduction), that makes all the sense!
What will you pay to liberate that dollar now vs. in the future? That is the question. Remember, by deferring income, you enter 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.
Despite massive swings in the top marginal income rate, the effective historical rate has remained constant for decades.
What is your effective tax rate? As a young employee, knowing how much, on average, you pay on taxes can inform your Roth vs. Traditional decision.
Roth money is some of the sweetest money around! You have limited capacity each year to capture Roth money:
- Yearly backdoor Roth Contribution (including spouse)
- Mega backdoor 401k to Roth IRA Rollover (if you have the option in your employer plan)
- Yearly employee 401k contribution
The idea is you want to have optimal tax diversification during retirement. Tax diversification allows you flexibility in paying taxes in retirement.
Using your Tax Planning Window is key in obtaining tax diversification. Use your time wisely and consider tax rate arbitrage when making your contribution and conversion decisions.
And finally, remember that Roth conversions are like deferred income annuity. Does that sound interesting?