Roth vs Traditional Considering the Earned Income Credit

[-Jackson-]

I searched and didn't see anything on this topic. I am not very slick with the search feature and seem to always get a lot of unrelated posts in my results. I've seen a lot of Roth vs Traditional threads, but I don't remember any that took in to account this credit. Most on this board probably make enough in earned income that they've never considered the impact of traditional 401k/403b contributions on the earned income credit. This is something my girlfriend is running in to. So I wanted to see if anyone has any thoughts or opinions.

Some background to the question:

My girlfriend makes about 35K/yr. She has a 403b available through her employer to which she can contribute as traditional or as Roth. She is firmly in the 15% tax bracket. She has one kid and alternates taking the dependent exemption and child tax credit with her ex-husband. She files head-of-household (HoH) and gets the earned income tax credit (EIC) even in years when she cannot claim the dependent. Because of all this, she pays relatively little in taxes.

Generally, it would be obvious that she'd want to do any retirement savings as Roth contributions. However, the tax savings of the traditional 403b is greater than the 15% associated with the tax bracket. The Earned Income Credit adds another ~15% to the tax reduction. Every hundred dollars she puts in to traditional 403b reduces her tax bill by 31 dollars.

If she puts in enough to reduce AGI to the 20% threshold of the Savers Credit, it has a 34% reduction on income taxes paid. If she gets the savers credit to the 50% level it has a 41% reduction in current year tax paid.

Because the Earned Income Credit is refundable, it is still a 31 or 34% difference even after the tax liability is 0. There is a point where Uncle Sam is paying her 31 dollars for every 100 dollars she puts in the traditional 403b and she pays zero taxes.

Because she is currently filing as HoH and getting the EIC, it is unlikely she will ever be paying less taxes as a percentage of gross income than she is right now. When the child, currently 11, grows up she'll likely be filing single with no significant tax credits or deductions. That makes the Roth contributions seems like the clear winner. However, she'll be forgoing a 31% "match" from the federal government if she does the Roth.

Should she be looking at this as if she's avoiding a 31% tax bracket and contribute to traditional? Or should she ignore the credits and go with Roth under the premise that she is probably paying less in taxes now than she will in the future? Theoretically she could contribute the 31% savings to a Roth IRA or increase her traditional savings by 31% and see no difference in take-home pay. Whether she would do that in practice, I can't say.

Any thoughts would be appreciated.

All of the above figures are based on 2014 tax rates and credit thresholds.

[Sunset]

Some more information would be helpful:
Does her employer match the 403b contribution she makes ?
If her employer does match this tilts it toward her continuing the 403b

How much does she have currently saved in her 403b ?
Because you are concerned about future taxes on withdrawls, it makes it easier to think in current dollars, assuming that tax rates, inflation, exception increases, all rise largely equal. You could estimate a 2% net increase in current savings for 30 years meaning you would multiply current asset value by 1.6%

Example: Say she has $100,000 saved in 403b, multiply by 1.6 now is: $160,000 so it will generate at 4% withdrawal rate: $6,400

Her taxes on that will be zero.

Since currently 15% tax rate is limited to 36,900 for Single filer (she could earn more has has standard deduction). but lets use this number for now.

She could have $922,500 (that is multiplied number by 1.6 above). in 403b before thinking of having over contributed.

So quickly using a rough number for single deduction, I get that currently as in right now in today's dollars without any multiplication factors: if she has more than $672,000 rounded off in her account this minute.
That this will put her into a higher tax bracket over 15% upon withdrawal, so until then, doing what she is doing is fine.

Someone making 35K probably does not have this issue right now.

[-Jackson-]

Quote:

Originally Posted by Sunset Some more information would be helpful: Does her employer match the 403b contribution she makes ? If her employer does match this tilts it toward her continuing the 403b.

No match. Even if they did match, she can contribute to the 403b as roth. So she could get the match either way. Her employer, a public school system, also contributes some amount to a public, cash balance type pension plan.

She currently contributes a fairly small amount to the 403b as Roth contributions based on advice from a financial advisor who administers the school's plan. She contributes nothing pre-tax at this time.

I am wondering if it wouldn't be more advantageous to contribute pre-tax to take advantage of the additional 15% tax savings provided by the Earned Income Tax Credit.

Quote:

Originally Posted by Sunset How much does she have currently saved in her 403b ?

She doesn't have any significant amount saved right now. However, with us cohabitating and sharing expenses, she will be free to increase her savings rate considerably.

Quote:

Originally Posted by Sunset Because you are concerned about future taxes on withdrawls, it makes it easier to think in current dollars, assuming that tax rates, inflation, exception increases, all rise largely equal. You could estimate a 2% net increase in current savings for 30 years meaning you would multiply current asset value by 1.6% Example: Say she has $100,000 saved in 403b, multiply by 1.6 now is: $160,000 so it will generate at 4% withdrawal rate: $6,400 Her taxes on that will be zero. Since currently 15% tax rate is limited to 36,900 for Single filer (she could earn more has has standard deduction). but lets use this number for now. She could have $922,500 (that is multiplied number by 1.6 above). in 403b before thinking of having over contributed. So quickly using a rough number for single deduction, I get that currently as in right now in today's dollars without any multiplication factors: if she has more than $672,000 rounded off in her account this minute. That this will put her into a higher tax bracket over 15% upon withdrawal, so until then, doing what she is doing is fine. Someone making 35K probably does not have this issue right now.

I see what you're saying here. At her current income level it is unlikely she will save enough to ever be in a higher tax bracket. However, even if her income never increases (in today's dollars, and everything goes up evenly with inflation), she will still pay more in taxes in the 15% bracket 10 years from now. She wont be able to file HoH or take the Earned Income Credit. These two things make a signifiacnt reduction in current income taxes vs future income taxes.
It is possible to pay more taxes in the same bracket.

Also, she works for the school system because that's where her son goes. It matches his schedule and she finds that convenience more valuable than a more lucrative job. I expect there will be a point in the future where she looks for higher-paying employment and can further increase her savings.

[kaneohe]

Perhaps these simple models might help:

1) Assume 15% tax bracket now and later. 1000 income (you can scale)

a) TIRA : Tax on income 0 TIRA has 1000
EITC 150
b)Roth : Tax on income 150 Roth has 850

After N yrs, the accounts double
c) TIRA value 2000, tax 300 ; after tax value 1700
EITC value 300, tax 22.5; after tax value 277.5
Total value 1977.5
d) Roth value 1700 which is less than TIRA + EITC invested
************************************************** *
2)assume 15% tax bracket now and 25% later. 1000 income

After N yrs, the accounts double
e)TIRA value 2000, tax 500; after tax value 1500
EITC value 300, tax 37.5; after tax value 262.5
Total value 1762.5
f) Roth value 1700 which is sl. less than TIRA + EITC invested
If the EITC were spent and not invested the value of TIRA + EITC spent
would be 1650 which would be slightly less than the Roth
************************************************** *****

In the conventional analysis (ignoring EITC); if tax rates are same now and later, TIRA and Roth are the same so adding EITC helps the TIRA. Even if EITC is spent instead invested, TIRA + EITC is still better.

If taxes rates are higher later, TIRA ends up worse (ignoring EITC) so adding EITC helps close the gap and even surpasses Roth if EITC invested.