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The 15% solution

I recently read a question from a fellow blogger Briana, who posts at How’s Married Life asking how much she should save to her retirement account each year. As I saw comments come in, for me the larger question wasn’t how much, but simply ‘how.’ Should she save pretax, or post? In the big picture, this question might take second place to the first, after all, the question of how much is such a large factor toward retirement success.

Let’s look at my concern, how she should handle the tax status issue. In her question, she shared her gross salary is $33K.  In 2013, the 15% bracket runs from a taxable $8,925 to $36,250. With no mortgage (yet), I’ll trust she’s taking the standard deduction  of $6100 along with an exemption of $3900. Pretty neat, this adds to exactly $10000 that comes off the top. At this stage of her life, I’m expecting good things in her future, and that includes a higher income.

I suggest that she start now with the Roth 401(k) and Roth IRA for the money she’d like to save. The Roth 401(k) to get the full match her company offers, and the Roth IRA for any more deposits above that. It will take some time before she’s starting to hit the 25% bracket. After all, she would need an income above $46,250 for that to occur when the standard deduction and exemption are included.

As time passes, and she sees her income rise, I suggest monitoring that line on her 1040, “taxable income,” this is the line that tells you what bracket you’re in, and as she slips into the 25% bracket, it’s time to take advantage of the pre-tax retirement accounts as well. Say, she’s finishing her return one March and sees the taxable income is $1000 into the 25% bracket. That’s the time to deposit exactly $1000 into the pre-tax IRA, and start using the pre-tax traditional 401(k) as well just for a portion of her deposits. Say she’s decided to target 10% of her income towards the retirement accounts. It will take $51,389 gross income and a pretax deposit of $5,139 to net that $46,250 I mention was the gross cutoff for the 25% bracket. Keep in mind, that’s in today’s dollars, with today’s tax brackets and current standard deduction/exemptions. These numbers are all inflation adjusted each year and this combination will help shift that target 15% limit as Briana’s income rises. It may take as long as a decade or more for this to occur, which is fine. Ten years of saving post tax money in these accounts before making the shift to pretax savings means her tax burden after retirement will be that much lighter.

The story doesn’t end here. If, and when, she has a new addition to the family, there are more tax deductions that come with the new bundle of joy. Briana may have spent a bit of time fighting off a 25% tax rate only to take a bit of time for maternity leave and drop back to 15% again that year. The good news is that with a bit of planning each year for the year to come you may find the 15% solution works to keep your taxes low while your working and then at retirement when you find your funds have a decent share as post tax Roth flavored money.

On a final note, recent changes in the tax code permit a conversion of 401(k) funds from the pre-tax account to the Roth 401(k). Since matched deposits always are deposited to the pretax traditional side, you’ll still accumulate pretax money over time. If you have extra money you’d invest for the long term and the 401(k) fees are reasonable, it may make sense to do the conversion if you will still be in the 15% bracket. There’s no recharacterization option, so plan wisely.

Briana, I wish you health, happiness,  and wealth. Best of these to you!

  • Matthew March 13, 2013, 8:51 pm

    You seem to have a flawed understanding of how the tax brackets work. Going one dollar into the next bracket does not mean your entire taxable income is now taxed at the higher rate, it just means that one dollar is taxed at the higher rate. Most Americans have the same understanding you do, and I did, too, until I looked it up.

  • JOE March 14, 2013, 7:30 am

    I’m sorry you read the article and concluded this. If you’ve read my blog for a while, you know I’m well aware that’s not the case. Simply put, the marginal rate is the rate applied to the next dollar of taxable income, and does not affect the prior (lesser) dollars. If Briana navigates to a taxable $36,250 in 2013, her last dollar of income would have seem a 15% tax rate, but the next $50K or so would be taxed at 25%. I wrote a full article discussing Marginal Rates last year.

  • Steve February 12, 2016, 8:03 pm

    Is there an equivalent e.g. 25% Solution? Though the difference between 25% and 28% is far less drastic.

  • Joe February 18, 2016, 9:02 pm

    Not that I’ve written, but the strategy would be similar. If you realize you will cross the 28% bracket and have year left to work, a bit of planning to go pre-tax on 28% money with help smooth your bracket a bit.

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