It’s impossible to appreciate the tax equivalent return of any investment until you know your effective tax bracket. You also need to know how you should file: individual, head of household, married filing jointly or married filing separately. For some married couples, filing jointly or separately can usually be determined quite quickly on most tax software. The U.S. tax code is a marginal, “progressive” income tax system. As your income increases or “progresses” from one tax bracket to the next you pay a blended tax rate of each tier, after all your tax deductions and exemptions (providing they’re not phased out) as well as any tax credits to reduce taxes owed. Once you know your effective tax bracket you can determine the value of a financial product, especially tax favored financial products.
For example, most participants in a 401(k) plan know their contributions are tax deductible. Is your tax deduction, in your effective tax bracket, worth taking? Keep in mind that by taking the deduction you’re giving up its tax-free basis, i.e. your original contributions. Your 401(k) plan will be taxed at ordinary income tax rates and be included in the provisional income test for Social Security benefit taxation. If you’re not in a high effective tax bracket today, you may be setting yourself up to pay higher taxes in retirement, just when you need your money the most.
Of course, if your employer is matching any portion of your 401(k) plan contributions; the benefit of the match will more than likely outweigh the tax consideration. Managing your taxes could reduce your income a tax bracket or two. Your stated tax goal is not to bump yourself into the next highest tax bracket. This is a real concern for Roth IRA conversions from qualified plans.
The economics of converting qualified plans to Roth IRAs needs to be determined and validated for its economic impact. You can’t just undergo a qualified plan conversion to a Roth IRA for its future tax impact; it also has to have a present day value. The goal is to convert your qualified plan to a Roth IRA without bumping you into another bracket. This is just another reason to learn the tax system. It’s your money. Be wise.