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 also why I believe it is ultimately 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