This post is from FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.
I don’t normally write on tax issues, and for the most part I’ve quietly bowed out of the Roth conversion debates springing up across the personal finance blogosphere.
It’s not that I’m clueless on the topic of taxes; I’ve done tax work for longer than I care to remember, and continue doing it now as a side job. But two things I’ve learned about giving tax advice, especially over the web:
1) the Federal Income Tax code is extremely complex, and
2) everyone’s tax situation is sufficiently different that giving general advice may be worse than worthless.
Hence, no tax advice. No tax posts.
Joe did an outstanding job of explaining why Roth conversions and contributions are unlikely to push you into higher tax brackets at retirement, and I have nothing to add to that point. But his post sparked a bigger consideration that’s been festering in my mind over the current tax season”¦
Retirement deferrals may be substantially overblown!
Ooohhh, did I utter a personal finance heresy?
Maybe, but I submit that for the majority of people, deferring too much income may prove to be a costly mistake in the future. Here’s why”¦
Low Tax Rates
What ever the popular rhetoric on taxes, by historic standards, current rates are low—very low! As Joe Taxpayer points out, for 2009, the marginal tax rate for a typical married couple is no higher than 15% on an income of up to $86,700. That assumes two exemptions at $3650 each and a standard deduction of $11,400. That fact is even more extraordinary because 1) it’s an income level nearly twice as high as the national average, 2) it doesn’t include itemized deductions and 3) it doesn’t reflect the many tax credits now in place.
The fact is that many married couples earning in excess of $100,000 are paying no higher than 15% even at the margins. Imagine deferring income—which could now be taxed at 15%–into a time in the future when your marginal rate is 30%, 40%, 50% or even more.
Think that can’t happen? Consider that up until the Tax Reform Act of 1986, top marginal rates on were at 50%. Consider also that up until the Kemp-Roth plan implemented under the Reagan administration in 1981, marginal rates on unearned income were as high as 70%. Until the Kennedy tax cuts in the early 1960s, they were as high as 90%. By comparison, the current maximum tax rate is 35%; we have no where to go but up.
For the most recent fiscal year, the federal government budget was somewhere around $3.5 trillion. For the same period, the amount of that budget that was funded by deficit spending was about $1.4 trillion. Translation: 40 cents out of every dollar spent came from borrowing. You don’t need to be an economist to figure out that such a financing scheme cannot continue much longer. Since trillion dollar deficits are now projected as far as the eye can see, it’s extremely likely that any deficit reduction plan will have to include higher taxes.
You might make more in the retirement years
It’s generally a forgone conclusion in retirement planning that we’ll make less money in our retirement years than during our working lives. But this isn’t universally true. I don’t have statistics to back this up, but I can tell you from my experience in both the mortgage and accounting fields that it isn’t at all unusual for people to earn more in their 60s and 70s that they did earlier in life. This has to do with a number of factors, including social security and investment income streams that didn’t exist earlier in life. But it’s even more pronounced among people who are self-employed or who enjoy above average career success. Earn enough money and you’ll be in a higher tax bracket in your retirement years regardless of where marginal rates go.
It’s important to remember that tax sheltered retirement plans are tax deferred, not tax exempt, meaning we will pay tax on them at some point! And the deferrals don’t continue forever; under current law, withdrawals—and the taxes they create—are mandatory by age 70 and a half.
What are the alternatives?
Now before anyone assumes that I’m in any way advocating abdication of retirement savings, nothing could be further from the truth. Because of the issues above, we may need to be even more diligent, but also more intelligent in how we go about retirement planning. As highlighted above, the worst course of action would be deferring taxes now—at 15%–in exchange for significantly higher ones in the future, when we might very well be earning more than ever before.
Retirement planners scoff at this because it isn’t earmarked for retirement. But savings are savings, and non-sheltered savings will be every bit as important at retirement as the more tax favored qualified plans. In fact, since taxes don’t need to be paid on withdrawals from traditional savings, they could be even more valuable. As a counter play to the likelihood of higher taxes in the future, accumulating significant funds in non-retirement accounts may be the single best plan of action. This isn’t to say that we should abandon tax sheltered plans in favor of traditional savings, only that we need to balance the two in long term planning.
Roth IRAs have the advantage that at least your contributions will be withdrawn tax free, since no deduction is permitted in the year of contribution. Tax-wise, this is far less risky than complete deferral, since the money contributed is being done at a time of historically low tax rates. Anyone who’s eligible to have a Roth should do so.
401Ks up to the company match
401K withdrawals will be completely taxable and therefore fully exposed to higher tax risk. But if your company offers a match on contributions, it could go a long way toward offsetting that risk. Any time someone is going to give us money, it’s a no-brainer. But contributions beyond the company match need to be carefully evaluated.
There’s no way to know what tax rates will be in the future, but we should be able to look at where we are today relative to historical trends and make some educated guesses, then plan accordingly for what may be a reasonable course of events.
What are your thoughts? Do we continue maximizing deferrals and ignore tax rates, or do we need to make certain reasonable assumptions about future circumstances?
Photo courtesy alancleaver_2000