How Being a Parent Changes the Traditional vs. Roth Calculus
Every once in a while I receive an email that makes me scratch my head. So for this week’s post, I present to you:
“We have 3 children under 18 and pay significantly less in taxes now than we will 12 years from now. This makes the tax savings from Traditional accounts less impactful during my ‘child-rearing years.’ I know with personal finance one can't take every factor into account. However, I presume a respectable number of your readers will have a 17-year stretch in their investing lives that the math behind their taxes and the benefits of Traditional vs. Roth are significantly shifted. I wonder if you've considered this factor before and if it would change your analysis for someone grossing around $100,000 and qualifies for 1 or more child tax credits.”
At first glance, my gut reaction was, “No, probably not.” Why? Because I’d never seen anyone address it before—even the big F.I. math guys who have multiple children themselves.
But the more I thought about it (and then attempted to read about it), the more I realized it may call into question a broader theme: If you’re getting tax credits for any reason (including things like purchasing an electric vehicle and getting the $7,500 tax credit), whether for children or not, it’s worth taking a second look.
And turns out, one of the most popular tax credits is for children—the thing (sorry, should I not call children ‘things’?) that most people will have at some point in their lives.
First, let’s do a quick refresher on how tax credits work.
Y’all know how I frequently get hot ‘n bothered about the tax deductions one can claim from making a pre-tax contribution to a 401(k)? Well, a tax credit is like a tax deduction on speed.
While a deduction allows you to “eliminate” income in the eyes of our Boiz at the IRS, a credit is a direct refund of the tax you owe.
For example: A $10,000 deduction would theoretically save someone in the 24% tax bracket about $2,400. A $10,000 tax credit would save someone $10,000, regardless of their bracket.
In short: Tax credits are bae, because they directly lower your tax bill (while a deduction indirectly lowers it).
So what’s the deal with child tax credits?
Here’s the deal, my dudes: I spent three hours reading articles on IRS.gov, TurboTax, and more, and I still had a hard time understanding exactly how the rules work (since each source seemed to have slightly different numbers, including discrepancies even within IRS documentation). Go figure.
I assume the different articles were referencing different tax years, but all that to say, I’ll link my sources where applicable.
Here’s the overall breakdown:
In 2021, the American Rescue Plan expanded child tax credits by almost 100%—but in 2022, things are going “back to normal,” so to speak. In 2021, child tax credits increased from $2,000 per child to $3,600 for kids under six and from $2,000 to $3,000 for kids ages 6-17. This means you may get a tax credit worth up to $2,000 per child, with the money distributed as a single end-of-year tax credit (basically, it’ll reduce your tax bill by $2,000 per kid).
Apparently, children must be aged 16 or younger to be eligible. I saw some sources that randomly said 17 instead of 16, so take your pick, babes!
The upper income limit is $150,000 if you’re married and filing a joint return (or if filing as a qualifying widow or widower), $112,500 if filing as head of household, and $75,000 if you are a single filer or are married and filing a separate return. (Source for all three: this flowery IRS Fact Sheet.)
I also found this handy-dandy tool for finding out if your child/dependent qualifies, which took a hilariously long time to fill out and felt like a personality test.
My first call-out? Married couples who earn more than $150,000 seem to be out of luck for the full credit, but it seems as though the phaseout reduces the credit by $50 for each $1,000 your income exceeds the income threshold.
In other words, if you’re a married couple making $250,000, you’re “over” the income limit by $100,000 (or 100 “thousands”), so 100 * $50 = $5,000. Aaaaand, yeah, it doesn’t appear to me that you’d receive a tax credit. Again, though, I’m not entirely sure, as I’m not an accountant—use the tool linked above or send your friendly neighborhood CPA a litany of questions if you think you’re excluded because of your high income. (I will play my tiny violin for you in the meantime, dear High Earner.)
How do child tax credits affect the Traditional vs. Roth calculation?
Well, in short, my entire thesis around the general superiority of Traditional for most (and especially high earners) revolves around the upfront tax savings—in other words, if you’re in the 32% marginal tax bracket and you contribute $20,500 to a Traditional 401(k), you’re lowering your tax bill by ($20,500 * 32%) $6,560.
Two married people in the 32% bracket who both contribute the maximum? They lower their tax bill by a whopping $13,120—all because they’ve contributed $20,500 each to their respective Traditional 401(k) plans.
Now, this particular couple in this example likely wouldn’t qualify for a child tax credit at all (and if they do, a significantly reduced one) because the 32% bracket for married peeps starts at around $340,000, and the child tax credit income limit phases them out.
But what if you’re on the cusp? What if you’re in the 22% bracket, like the person who emailed me, with a joint income of $100,000?
Well, now your calculation looks a little different.
The quick ‘n dirty way to assess whether or not the child tax credit impacts your Traditional vs. Roth analysis will likely hinge on (a) how much of the tax credit you qualify for based on how many chicken nuggets you’ve got running around your house and (b) your marginal tax bracket.
Because your marginal tax bracket tells you about how much you can expect to save on your taxes from making a Traditional 401(k) contribution, I went ahead and threw together the tax savings associated with the popular marginal rates.
12% bracket = $2,460 per $20,500 contribution
22% bracket = $4,510 per $20,500 contribution
24% bracket = $4,920 per $20,500 contribution
32% bracket = $6,560 per $20,500 contribution
(I’m not going to bother doing the next few, because after that point, the “tax credit” thing is entirely moot.)
Those numbers above can also be reframed as their equal and opposite: Yes, they’re the savings you earn by contributing to a Traditional 401(k), but they also represent the tax cost of contributing to a Roth 401(k).
In other words, if you’re in the 22% bracket, your tax bill on a $20,500 Roth contribution is $4,510. (To be clear, it’s no different from just taking the money as income—you aren’t taxed more or penalized in any way for contributing to a Roth account, you’re just not saving anything upfront.)
The tax bracket where your tax credits would cover the “costs” of your Roth 401(k) contributions
If you’re a single or married earner in the 12% tax bracket with two young children, the chances are pretty good that you’re going to get a $2,000 tax credit per kid ($4,000 total).
At that rate, both earners in the 12% household could contribute $20,500 to Roth 401(k)s, generating a “tax bill” of $2,460 each (or $4,920 total) that’s almost entirely “paid” by the $4,000 child tax credit they received.
Since a tax credit offsets taxes owed, it can make contributing to a Roth account “cheaper.”
Moreover, my original Traditional vs. Roth analysis hinges on creating more investable income by contributing to a Traditional 401(k)—that by contributing to a pre-tax account, you’re creating a deduction that lowers your taxable income, keeps more money in your pocket, and allows you to invest even more.
When we introduce things like tax credits to the picture, that effect is amplified—as our original reader noted, his tax liability (as someone with three children) is much lower now than it will be when the kids are grown because he’s receiving (I assume) $6,000 in tax credits every year.
That’s an additional $6,000 that can stay in this individual’s pocket and be invested as well.
All things considered…
It seems to me that most people with multiple children who are in the 12% bracket would almost certainly be best-served by contributing to Roth accounts during the years they receive child tax credits, both because they’re already in a “cheap” enough marginal tax bracket and the tax credits they’ll receive will likely offset most (or all) of the “tax bill” for contributing to a Roth account.
The 22% tax bracket seems to be one that could go either way depending on other factors, and I think my original “Traditional is better” analysis stands for those in the 24% or above, since at that point, they’re already in the phaseout for child tax credits anyway.
To quote the original email:
“I know with personal finance one can't take every factor into account.”
At the end of the day, these types of sweeping best practices are intended to be considerations and starting points for your personal analysis. Have a pension? Planning on inheriting $10 million? Retiring at 80 years old? Myriad other factors can impact which choice is best for you, and that’s why the tax diversification play is the most fool-proof move—a little Traditional, a little Roth, a little taxable, and a lot of money waiting for you at the end of the retirement rainbow.
