I do a fair bit of financial mentoring for fun. I’d like to open this up to the readers of this blog. If you’d like me to publicly dissect and optimize your finances, send me an email at **professorfrugal@gmail.com**. I’ll make a blog post out of it so others can learn as well.

In order for me to properly assess your situation, I’d like you to provide the following info:

- Fill out three-months worth of info on “financial update” spreadsheet
- Balance Sheet
- Income & Expenses
- “Where Did Savings Go?”
- Portfolio Allocation
- Expense Ratio Analysis

- Demographics
- Age
- Marital status
- # kids at home
- # kids 16 or younger

An example of the mentoring I did this past month was for a reader who is anticipating a large promotion next year. Her 2016 salary is $65k and her 2017 salary is projected to be $100k. She has 2 kids, both of which are younger than 16. Below are screenshots from my tax calculator tool.

At 65k of income, her EFFECTIVE marginal tax rate (EMTR) is 15%. Her main question was whether she should opt for a Traditional vs Roth 401k. Here is my general rule for Roth vs Not.

**If your effective marginal tax rate is >= ~18%, do traditional 401k.**

**If your effective marginal tax rate is < ~18%, do Roth 401k.**

As you can see from the chart and the table, her EMTR is 15% from $51k-$104k in income.

You can shelter $18k/year in a 401k. The first $14k of contributions would bring her taxable income from $65k to $51k. Over this region, her EMTR is 15%, (as confirmed by the table and chart above) so she would end up saving $2,100 in taxes on her first $14k in 401k contributions. This can be directly observed in the table, as the tax liability for $65k in income is $2,503 and the tax liability for $51k in income is $403, the difference between these two numbers is unsurprisingly the same as the $2,100 we had calculated earlier.

*The tax code is not magic people, it can be learned and strategized around.*

To get to the max contribution of $18k for the year, she could have contributed an additional $4k to the 401k, bringing her taxable wages to $47k and reducing her tax bill by an additional $1,265 since her average EMTR over this region is 31% ($4k * 31.4%).

If we managed to get her taxable income down from $65k to $47k, a natural question is whether we can further reduce her taxable income with traditional IRA contributions. After all, she is married so she could contribute $11k total to TIRAs. And if you look at the tax table above, this is precisely where her EMTR is highest at around 31%. If you continue to naively use my spreadsheet as we have above with the 401ks, you will be sorely disappointed because TIRA contributions are treated different from 401k contributions.

401k contributions reduce your earned income, and thus can be used to hack the EITC. TIRA contributions, on the other hand do nothing to lower your earned income. As a result, to understand properly the effects of the $11k TIRA contribution, you enter the $11k TIRA contribution into my spreadsheet.

Once you do so, you will see that at $47k of taxable wages, this only reduces the tax burden by $1,100, or a mere 10% of the contribution, from a refund of $854 to a refund of $1,954. The picture on the left (top if viewing on mobile) is with $0 TIRA contributions (as we had before), whereas the picture on the right (bottom if viewing on mobile) is with $11k TIRA contributions.

Thus, while a naive analysis would assume that the TIRA contribution would be extremely lucrative due to high EMTR, a more sophisticated analysis reveals that the TIRA contributions only reduced taxes by 10% of the contribution amount, which fails my rule of thumb of 18%.

So after performing the above analysis, my prescription for the reader was:

- Contribute to Roth 401k up to company match
- Max out HSA
- Max out limited purpose FSA up to what you will use this year
- Max out 11k of Roth IRAs (why? b/c Roth IRAs are more versatile than Roth 401k)
- Max out remaining Roth 401k contributions
- Stick the rest of it in a taxable brokerage account (though a 529 might be an interesting option as well)

For the following tax year, I redid the above analysis with the full year’s income of $100k and nothing changed. EMTR remained at 15%, so the decision to do Roth now remained.

For those unfamiliar with the Roth vs Traditional debate, it all comes down to one simple calculation. Do Roth if your EMTR today is less than your guess of EMTR when you retire. Do Trad otherwise. If the two EMTR are identical, it doesn’t matter, as shown below.

FV of $1 contributed to 401k = FV of $1 contributed to Roth 401k

(1-EMTR_in_retirement)*[$1 labor income today] * (1+R)^N = [$1 labor income today * (1-EMTR_today)] * (1+R)^N

The two are equal if EMTR’s are the same. If EMTR_in_retirement > EMTR_today, do Roth. If EMTR_today > EMTR_in_retirement do Trad.

The decision of Roth vs Traditional is among the most important decisions someone can make in their financial lives, and can amount to hundreds of thousands of dollars difference in wealth in retirement due to tax savings. It’s not hard to think about this decision strategically, as shown above. There is no magic. It’s just a straight-forward application of my tax analyzing tool or Turbotax’s TaxCaster.

Great article. Not all that relivent to your situation but would love to get your take on taxes and ESPP.

Jason, sorry to disappoint but I know practically nothing about ESPP. Let me read up on this and give you a proper response.

Good stuff! Just curious, why the 18% rule of thumb for EMTR? How did you come to the conclusion of 18%?

It’s a somewhat arbitrary number. The current tax code has a huge jump in MTR from 15% to 25%, which is quite a doosey. For me, I’d much rather be on the left side of this cut-off than the right side. 18% is somewhere in the middle. If I could guarantee my income be taxed at less than 18% today, I’d do a Roth in a heart beat. Above there, I have my doubts. GCC himself essentially has a 0% tax rate if you read his stuff carefully. Even if tax rates go up considerably, you can counter by simply living on less. GCC only withdraws standard deduction + 2*personal exemption every year (or 3 now that he has a kid). This is completely tax free regardless of tax rates. Brilliant strategy and pretty life changing if you ask me.