A few weeks ago I tweeted the following, which caused a bit of controversy on Twitter/X:

Hot take: Maxing out your 401(k) when you are younger is almost always the wrong choice. The extra 0.5% per year isn’t worth locking up your wealth until old age.

While I won’t rehash the argument in full (which is nuanced and can be found here), this tweet led to some fruitful discussions about taxation. In particular, one commenter noted that my argument on maxing out a 401(k) wasn’t taking into account the difference between marginal and effective tax rates.

So, I want to explore this argument a bit further, explain where it’s right, and why I believe it will ultimately be wrong. To start, let’s review the difference between marginal and effective tax rates so that we are all on the same page.

## The Difference Between Marginal and Effective Tax Rates

If there is one topic that confuses more people than anything, it’s taxes. More specifically, the difference between *marginal* and *effective* tax rates. Your marginal tax rate is the tax rate that you pay on your *last* dollar earned. Your effective rate can be thought of as the “average” rate across all the dollars you earn.

To illustrate this, below are the 2024 U.S. federal tax brackets and rates for single filers:

- 10% on the first $11,600 earned
- 12% on any income above $11,600, but below $47,150
- 22% on any income above $47,150, but below $100,525
- 24% on any income above $100,525, but below $191,950
- 32% on any income above $191,950, but below $243,725
- 35% on any income above $243,725, but below $609,350
- 37% on any income above $609,350

Note that this is *not* how tax brackets and rates are traditionally presented. They are typically presented like this:

- 10% for incomes of $11,600 or below
- 12% for incomes above $11,600
- 22% for incomes above $47,150
- 24% for incomes above $100,525
- 32% for incomes above $191,950
- 35% for incomes above $243,725
- 37% for incomes above $609,350

However, I find this more confusing because the wording can make it seem like the tax rate you pay on your *entire* *income* goes up when you earn more. This is not the case. Only the dollars in that bracket are taxed at that rate. Let’s demonstrate this with a few examples.

First, let’s assume that you’ll earn $11,601 in 2024. If we ignore deductions, credits, etc., then you will owe the IRS 10% on your first $11,600 in earnings (or $1,160) and 12% on the remaining $1 above that (or $0.12). See the first set of brackets above for these percentages and amounts. In total you would owe $1,160.12 on your $11,601 in income.

In this case, your marginal tax rate is 12%, which represents the $0.12 paid on your last dollar earned. This marginal rate has *no impact* on how your first $11,600 in earnings are taxed. Whether you earn $11,600 or $11.6M in 2024, that first $11,600 generates a tax bill of $1,160 (ignoring deductions).

So, if 12% is your marginal tax rate, then what is your effective tax rate? To get that, we just divide your tax owed by your income. In the real world we would use your *taxable* income, which takes into account deductions, but let’s ignore these for now to keep it simple. In this simplified case, your total tax was $1,160.12 and your income was $11,601. So, your effective tax rate is approximately 10% [$1,160.12/$11,600 ~ 10%]. Your effective rate is ~10% since most of the tax you paid were on dollars earned in the 10% bracket.

Now let’s do this again but using an income of $20,000. In this case you will still owe 10% on your first $11,600 in earnings (or $1,160). That doesn’t change. However, in the 12% bracket you earned $8,400 above $11,600 instead of just $1 above $11,600. And since you owe 12% on these earnings, that means you will owe $1,008 [$8,400 * 0.12 = $1,008]. So, in full you will owe $2,168, which is $1,160 from the 10% bracket and $1,008 from the 12% bracket.

Once again, your marginal tax rate is 12% as that is the tax rate you paid on your 20,000th dollar. But what is your effective tax rate? 10.84%! This is equal to $2,168/$20,000. Your effective tax rate went up because you paid more tax in the 12% bracket than you did when you only made $11,601. You can think of this as your “average” tax rate going up because you paid more tax in the higher bracket.

That’s the difference between marginal and effective tax rates. The marginal rate applies at the end, while the effective rate averages out your tax across all of the brackets you are in. **As a result of this, the effective tax rate is almost always lower than your marginal tax rate, especially as you earn more. **This difference is why some argue in favor of maxing out a traditional 401(k). Let’s explore why.

## How Traditional Retirement Accounts Benefit from Effective Tax Rates

Imagine you earn an income of $100,000 and contribute to a traditional 401(k). Every dollar you contribute to the account reduces your taxable income by $1 and your tax owed to the U.S. government by $0.22 (since $100,000 would put you in the 22% tax bracket in 2024). Though you earned the money that you contributed to your traditional 401(k), the U.S. government acts as if you didn’t earn it…for now.

So what happens to that 401(k) contribution after you make it? Well, it avoids a 22% marginal tax rate and grows tax-free until you withdraw it in retirement. But what tax rate will you pay upon withdrawal? Well, that depends on what tax rates are at the time of your retirement. For now, let’s assume that they remain *the same* as they are in 2024. Let’s also assume that you need to withdraw $100,000 a year in retirement.

In that case, how much would you pay in taxes? If we exclude any sort of deductions or credits, then you would owe $17,053 on your $100,000 withdrawal. This would give you an *effective* tax rate of ~17%. So, you avoided paying 22% while working to pay 17% in retirement. You saved 5%. What’s not to like? And, technically this isn’t the full benefit because we ignored deductions and credits. If we include just the standard deduction for a single filer, your effective rate would drop below 14%, which brings your total tax savings to 8% [22% vs. 14%].

This is why some argue in favor of maxing out a traditional 401(k). Because you avoid a high marginal rate on contributions to pay a lower effective rate on withdrawals. This is a *different* argument than the one I made in my “don’t max out your 401(k)” post. In that post, I assumed that you pay the *same* tax rate when you contribute as when you make withdrawals.

But, as I just highlighted, effective rates are typically lower than marginal rates. So, the tax you pay on withdrawals is likely to be lower than the tax paid at contributions. Right?

While the math here is undeniable, it relies upon one major assumption—that income tax rates don’t increase much in the future. But, I don’t think we can make that assumption. Let’s see why.

## The Coming Tax Time Bomb

No one likes higher taxes. No one wishes for them. But with the current trajectory of the U.S. government’s balance sheet, I don’t see how they can be avoided. Not only does the U.S. have more debt relative to GDP than any point in its history, but its still adding to that debt at a very high rate. As the Kobeissi Letter recently noted, “The US deficit is estimated to hit 6.6% of GDP, almost DOUBLE the 39-year average.”

How does this not end with higher taxes? We already know that after the Trump tax cuts expire at the end of 2025 that our taxes will go up. But, what’s stopping Congress from raising them even more to feed their growing spending habit? I don’t know.

I’m not the only one who is concerned either. Ed Slott, a nationally renowned expert on retirement planning, discussed his taxation concerns in his latest book

Whether your retirement is five years away or fifty, the single greatest threat standing in your way is taxes. Unlike losses experienced in the stock market, money lost to taxes never recovers.

This is why he and others have recommended paying more of your future taxes today while income tax rates are abnormally low. You can do this by making more Roth contributions to your retirement accounts or converting some of your traditional retirement accounts to Roth accounts as well. Please consult a tax professional before doing so.

And, to confirm, yes income tax rates do seem abnormally low relative to recent history. I pulled some historical data from the Tax Foundation and the Tax Policy Center and discovered that effective tax rates are the lowest they’ve been since the end of WWII:

Though I included the standard deduction (starting in 1944) and adjusted all incomes for inflation, I know this analysis is far from perfect. For example, it’s missing tax credits and exemptions, among other things.

I also know that the highest earners never actually paid many of the historically high income tax rates that were found in the tax code. So while the chart says “effective” tax rate, the lines shown more closely represent the historical *statutory* tax rates, or the rates people were legally required to pay.

Either way, if we assume that this is somewhat accurate, then you can see that effective tax rates are the lowest they’ve been in the modern era. So, if income tax rates are low and government spending is high, there are only two *good* ways out of this situation:

- The first option is that the government cuts its spending. This is unlikely since roughly 50% of U.S. federal spending is on entitlements (e.g. Social Security, Medicare). And any politician who recommends cutting these would be committing political suicide.
- The second possible way out of this is higher taxes. While this isn’t ideal, it’s much better than a world where the U.S. defaults on its debt and chaos ensues.

So, which way seems more likely to you? I think it’s taxes all the way down.

And, if this is true, then the marginal vs. effective argument from earlier won’t work anymore. After all, if effective tax rates increase by 10% in the future, then much of the benefit of avoiding a higher marginal tax rate today (as calculated in the prior section) goes away.

You might argue that effective tax rates wouldn’t increase that much, especially in the lower brackets, but you’d be wrong. If we go back 30 years to 1994, the rate on the lowest bracket was 15%. And the rate on the bracket above that was 28%. This is a bit higher than the 10% and 12% brackets of today.

This means that someone contributing to a 401(k) in 1994 got an incredible deal. They avoided a 28% marginal tax rate back then to pay a 13.84% effective tax rate today, assuming $100,000 in withdrawals and the standard deduction for a single filer of $14,600.

But what was the *effective* rate in 1994 for a similar-sized withdrawal? Adjusting for inflation back to 1994, $100,000 would have been closer to $48,000. With a standard deduction of $3,800 in 1994 (for a single filer), the effective tax rate on $48,000 would have been closer to 20%.

That’s roughly a 6% difference in effective tax rates in the span of 30 years! That’s similar in size to the 5%-8% tax benefit I calculated in the prior section when avoiding a higher marginal rate today to pay a lower effective rate in the future. And if effective rates went down by 6% in 30 years, what’s stopping them from going back up by 6%, if not more, in the next 30?

That’s the issue. Yes, the argument to avoid a higher marginal rate today to pay an expected lower effective rate tomorrow is sound *if* tax rates don’t go up much in the future. But that’s a huge “if” that doesn’t seem promising given the U.S. government’s current fiscal situation.

I rarely make forecasts. However, if I may misquote the great Benjamin Franklin, I would say this:

Nothing is certain except debt and taxes.

Thank you for reading.

**If you liked this post, consider signing up for my newsletter.**

This is post 413. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data