Why Tax Deferral May Be a Sucker’s Bet

Deferred Tax


in Retirement

Kevin At Out of Your RutThis 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.

But a tweet from Joe Taxpayer yesterday morning in regard to his brilliant post Roth IRAs and your retirement income on Don’t Mess With Taxes brought me out of my tax shell—at least a little.

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.

High Deficits

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.

Non-retirement savings

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

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

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Robert Muir 2010/03/24 at 9:55 pm

IMO you’re 100% right Paul! With our government spending money hand over fist, tax rates are going to have to go up in the future. This year I’m converting every traditional IRA that my wife and I have (~$30,000). Yes, that will run around $10,000 in taxes this year, (we’re in the 28% bracket), but it would be more if I split it over 2011-2012 because I know the rates are going up again in 2011. I may also move my Simple IRA over as well (~$30k by the end of the year), but I need to check with a specialist first because I want to continue contributing to the Simple next year.

My wife and I are “lucky” (after 20 years of active duty) to have a “retirement” income already coming in. So any dollars that we withdraw from tax deferred investments would be fully taxable in the future at the higher rates that are going to be in effect then. So it’s a no-brainer for us to move the money to a Roth. Likewise, if you’re planning on withdrawing Social Security, you would be in the same boat. The SS money would cover whatever standard deduction there would be and all money withdrawn from tax deferred savings would be fully taxable. (I wouldn’t be holding my breath for SS money though. Plan on it not being there.)

In fact, here are my fears:

1. Hyper-inflation – This would be devastating. It would allow the government to pay off its debts (including Social Security recipients and retired military) with devalued currency and they would blame the usual suspects. True, there’s a cost of living increase in SS and military retirement, but it is only once a year, it’s delayed, and the government is the one doing the calculating. Ask Russia’s retirees how they fared.

2. The government can change their minds on the ROTH IRA and other retirement accounts. Currently all gains in ROTH funds are tax free. That could change in the future retroactively. They could even tax all ROTH withdrawals at the new tax rate and “allow” us to deduct the taxes we paid at the “low” 2009 rates.

3. Family members who aren’t doing as well have a financial or medical problem and come to us for help. This may sound callous, but when drugs and alcohol are involved, not to mention lack of responsibility, it sure can be frustrating.

4. Personal medical catastrophe. I really need to start looking into long-term care insurance.

1 – 4 are listed in the order of most likely to occur to least likely (I hope). I’m afraid most of high inflation. If effective income drops so low that most people are focused on essentials only, our economy will be spiral into total chaos. When gas costs $20/gal and bread is $2 a loaf or higher, things will be different.


kevin 2010/03/25 at 4:19 am

Bob – Outstanding point on inflation. I’d actually thought about discussing that in the post because it’s very relevant, but it’s really a discussion all it’s own.

Should inflation take off–and I wouldn’t bet against it happening–a vast new complication will be added to retirement planning. We’d be deferring income from a relatively low inflation, low tax rate time, to one where both would be substantially higher. During the last bout of inflation in the 1970s, the stock market was flat in nominal terms, but lost a lot of value in inflation adjusted terms.
.-= kevin´s last blog ..Majoring on the Majors by Learning to Say NO =-.

JoeTaxpayer 2010/03/25 at 5:28 am

Kevin – one of the things I love about finance is that it’s one of the few areas where I find that when people disagree with me, not only do they do it very kindly, but often they are right.
In my guest post on Kay’s site, I only scratched the surface of the issue. (Minor note: my premise is that few will save their way into a higher bracket at retirement and therefore should not convert to Roth now.)
There are two extremes in this debate. Those who are part of the 43% who seem to have no savings at at (making the conversion point pretty moot) and those you note, especially as in Bob’s situation, who are aiming to retire with serious income due to good pensions in addition to the savings. There was a stretch of time when defined benefit pension plans were structured so a 35-40 year employee managed to earn a pension that was 80-100% of pre-retirement income. Not tough to see those people can be paying higher rates in retirement once that pension starts.
The only caution I have for Bob is to understand his marginal rate this year. If that $30K conversion bops him up to a higher rate, he may do better with partial conversions, although there’s no telling what 2011’s tax rates will look like.
.-= JoeTaxpayer´s last blog ..Congratulations, You’re HIREd! =-.

Robert Muir 2010/03/25 at 7:58 am

Yep, I did think of that Joe. We’re dead in the middle of the 28% bracket and it would take an unexpected windfall to bump us up to the 33% bracket even if I can convert the entire $60k over to a Roth this year.

2011 is projected to be 31% for my bracket which would be at least an additional $3,600 if I were to split the pain over 2011-2012. The earliest I could convert my Simple would be 12/16/2010 (two years after it was opened), so I have plenty of time to make the final decision/save up the money. In the mean time, I just need to add $4,200 to each quarterly tax pre-payment to be totally safe.

Paul, definitely fire up that Inflation article. I’m looking for books that cover inflation without the scare tactics and hype. Anybody have suggestions?

kevin 2010/03/25 at 4:31 pm

Robert, I’m going to lay off any inflation posts for a while. Too many variables! I do believe the current inflation situation is much more accute than is publicly acknowledged (another “issue” with writing about inflation). If you look at healthcare, education, insurance, property taxes, repair costs and utilities, all are and have been rising steadily through this “deflation” we’re in. We can only imagine what an acknowledged inflation will look and feel like.
.-= kevin´s last blog ..Majoring on the Majors by Learning to Say NO =-.

Robert Muir 2010/03/25 at 8:09 am

Oops, sorry Kevin, I didn’t see your byline above. I was thinking it was Paul’s post.

Joe Plemon 2010/03/25 at 8:14 am

Great attention getting title and clear explanation of why a tax deferral could be a sucker’s bet. You have demonstrated that “traditional wisdom” isn’t always wise. We have to continually be thinking and aware of our circumstances and the changing world around us.

Thanks for stirring my gray matter.

kevin 2010/03/25 at 4:33 pm

Thanks Joe. I tend to think that if we’re not challenging conventional wisdom on personal finance blogs then what’s our purpose? The usual stuff is already out there on the mainstream media.
.-= kevin´s last blog ..Majoring on the Majors by Learning to Say NO =-.

Budgeting in the Fun Stuff 2010/03/25 at 8:32 am

I absolutely loved this post! Am I biased, um, yep.

We save for retirement using my 401k (max matching at 6%), a Roth IRA, and a Scottrade account of high dividend stocks. We’re also starting another Roth IRA this year once we finish paying for graduate school.

We figure that no matter how our future taxes look, we can withdraw from each of these funds in a way to keep our tax bracket as low as possible.

kevin 2010/03/25 at 4:34 pm

Now THAT’S tax planning!
.-= kevin´s last blog ..Majoring on the Majors by Learning to Say NO =-.

paul 2010/03/25 at 9:20 am

This is an awesome conversation and I love that I didn’t even have to start it :-). And BTW Joe I’m officially removing my ascribed nickname of Joe “Anti-Roth” Taxpayer. Myself I’m taking the shotgun approach to retirement. Through no strategy of my own I have a traditional IRA from a 401k rollover from my previous employer, a traditional 401k from my current employer that I hadn’t been contributing to in the last year because of our aggressive debt smackdown and in the not too short future will be firing up the Roth 401k option from my employer so that I can hedge my bets. Honestly if my long term plan bears out I definitely will want my money tax free at distribution time. The horizon seems awfully bleak with new healthcare provisions and various measures in place I can’t see how our current tax structure won’t grow. Again it’s all speculation but I love the idea of knowing that some of my money is the actual money I’ll get back + interest. Thanks all for your input as well.

Robert Muir 2010/03/25 at 4:28 pm

I checked with a Vanguard conversion specialist and according to him, we are able to convert as many of my Simple IRA and my wife’s SARSEP funds as we want to a ROTH.

Transferring the traditional IRAs was an easy decision because the money was small enough ($30k total) that it made sense to consolidate them into our current ROTH accounts to give us more flexibility in our investment plans. Converting an additional $55k (the Simple and SEP total) is a scarier proposition. That would increase the current year tax hit substantially, even if I did a partial conversion to keep within the 28% bracket.

Converting a tax deferred plan to a ROTH is definitely a gamble. A guaranteed 28% tax bite now compared to an unknown bite upon withdrawal in 20-30 years.

At the point we would withdraw money from the ROTH, my wife and I will most likely have both military retirement income and SS retirement income (if SS is still around of course) that will definitely throw us up into a higher bracket than most folks might not have. (By the way, this is a problem I don’t mind having. 🙂 ) Plus I still think that in 20+ years, 28% is going to look like halcyon days of yore. Plus, plus, all the growth on that money over 20+ years would be tax free. (Unless of course they change the rules in the middle of the game.)

You picks your horse and you place your bets, eh?

.-= Robert Muir´s last blog ..New update for XP Mode allows for non-VT PCs =-.

kevin 2010/03/25 at 4:37 pm

“A guaranteed 28% tax bite now compared to an unknown bite upon withdrawal in 20-30 years.” I think you’re thinking right on this. 28% is known, what will be five, ten or 15 years from now is a complete crapshoot. This way too, you’ve cleared the accounts for tax free withdrawal later, keeping the options in your own yard.
.-= kevin´s last blog ..Majoring on the Majors by Learning to Say NO =-.

Robert Muir 2010/03/26 at 9:35 am

Something else to ponder:

Say I had $90k available to convert to a Roth
That might require ~$30K of after tax income to pay the tax on the conversion.
After that, the $90k would be available tax free in the future and all earnings and gains from the $90k would be tax free regardless of the future increases in the tax rate.

However, we also have to take into consideration the investment value of the $30K of after tax income that we paid to the tax man. That is, if we didn’t do the conversion and we had $30K available to invest, then we would have $90k of tax deferred investments and $30k of non-deferred investments growing in the market.

Back of the napkin calc 25yrs @ 8% w/3% inflation and a future tax rate of 50% would show conversion to be the winner with a an $83,000 advantage. ($294k vs. $211k) Of course the crucial variable would be the future tax rate of withdrawals.

Ponder, ponder, ponder. 🙂
.-= Robert Muir´s last blog ..New update for XP Mode allows for non-VT PCs =-.

[email protected] 2010/03/26 at 9:54 am

You’re raising a good point. Nothing we do will come without consequences–that’s why we even have these debates! 😉 I SUSPECT we can crunch the numbers–future tax rates, ROI, future value/inflation in a number of ways, so it might come down to personal preference more than anything else (wow, sounds like something a professor I had in college for a financial analysis course said!)

Here’s my preference, I’ll take the devil I do know–current tax rates–over the devil I don’t know, and take my chances on that. Again, I tend to place great value on having unqualified funds for future withdrawl.

You have to do what you feel most comfortable doing, but of course you only want to do that once you’ve considered all of the options. Really good point though Robert!
.-= [email protected]´s last blog ..Over 50 ““ No Pension, No 401K ““ What Now? =-.

JoeTaxpayer 2010/03/26 at 10:38 am

You are right in your reasoning for the select few who are doing so well.
Bob, you sound like one of them (doing well) with a decent pension, etc.
Elsewhere, we hear about people 43% of whom have virtually no retirement savings. My original post at Kay’s site was meant to point out that the say 40yr old who is now in the 25% bracket, with a few hundred thousand pretax, and saving little, has a low risk of being in a higher bracket. Future tax rate of 50%? I’ll not dispute that. But, it’s a fact that unless the system is turned on its head, there will still be some lower brackets under that, and it takes an income at retirement to fill them.
Let me flip it around to ask you both a question – Knowing how brackets are structured now, at what level of income do you see the 15% rate top off at in 10-20 years? (FWIW, in today’s dollars it’s $86,700 taking STD deduction/exemptions into account for a couple) Please answer in today’s dollars. I’ll not dispute it, even if you think the economy will be so bad and taxes so crazy it’s going to be half that figure. Just looking for your thoughts.
.-= JoeTaxpayer´s last blog ..The Limits of Frugality =-.

JimC 2010/03/26 at 11:25 am

Interesting thread, but for the most part ignoring the huge and much better defined/known benefit of tax sheltered earnings in retirement accounts. I have no idea what tax rates or inflation will be in 10 or 20 years, just like I did not know that the stock market would plunge two years ago and then soar!

For anyone with a big pile of retirement savings perhaps the best choice may be to use both Roth and non-Roth retirement accounts to split the difference and if you still have more/excess money to save invest in a non-retirement [taxable] account.

I have seen exactly this “problem” in helping an elderly retired couple do their taxes the past few years. She is a retired teacher, husband retired from local government with a pension and then worked for the Federal Government to earn a third pension [did not stop working until he was too sick at 79!]. Now they have SS times two, and three pensions, plus a bunch of retirement accounts and NO taxes are being witheld from any of these accounts so they have owed Uncle Sam a big tax bill plus a small penalty each year for not paying estimated taxes! [It is possible to shoot yourself in the foot that way, but they keep thinking they will not have to pay despite evidence to the contrary].

kevin 2010/03/26 at 12:04 pm

JimC – Your middle paragraph is the best summary/solution on this issue–well done!

The elderly couple is an example of what I’ve seen again and again, with folks in their 60s and 70s making more than they did in their working years.
.-= kevin´s last blog ..Over 50 ““ No Pension, No 401K ““ What Now? =-.

kevin 2010/03/26 at 11:56 am

Joe, My crystal ball has been malfunctioning for years, so I’ll bow out on projecting a future income level for the 15% bracket. What I will offer, and doesn’t require any input from anyone’s crystal ball, is that there are people making in excess of $100,000 who are only paying a few thousand in fed income taxes. These aren’t tax scammers, they’re regular people working with a tax code that’s extremely generous at this point. That will change, and when and to what specific degree I have no idea.

Since it seems as if our country is mostly sleepwalking through our debt issues, I’ll venture a guess that the shift will be precipitated by some sort of “sudden” debt crisis–that we’ve known about all along–that will leave little time for 11th hours money maneuvers. That’s why I like the idea of having funds in different vehicles. It’s a way of pre-positioning for circumstances, come what may. Right now, there’s an almost religious attachment to tax sheltered plans; if we follow the herd on that thinking there may be consequences, some of which are predictable. Hence, the reason for this post!

BTW, I disagree on the idea of two extremes, the 43% with no retirement savings and high earners with the big retirement postions. This debate is entirely meaningless to people in either camp, for opposite reasons of course. It’s really about the 3rd group, the vast numbers somewhere in the middle who have retirement savings and are only in the 15% marginal tax bracket. It may be that it all comes down to what tax bracket you’re in. If you’re in the top bracket (35%) you’re response should be totally different than for someone at 15%.
.-= kevin´s last blog ..Over 50 ““ No Pension, No 401K ““ What Now? =-.

JoeTaxpayer 2010/03/26 at 12:48 pm

Fair enough. We agree the 43% (can we call them the lower 50?) need not worry about Roth. If they have $10,000 saved up, they can convert in the years they pay no tax at all. Let’s call those $100K earners the top 10%. They need to do some math.
Of the remaining 40%, I suggest that the lower 30 are even close to a decision, they will retire in the 15% bracket tops. That’s why I was looking for that answer. The other 10 should plan very carefully.

The dialog concerning taxes ‘going up’ is very prevalent, yet I strongly believe it impacts few. Of course for those it impacts, they better act. Just like when i write about trusts and other advice that might impact the wealthy.

My whole point in the Roth Mania series of mine is to point out how much income it takes at retirement to be at a given bracket. Most won’t come close.
.-= JoeTaxpayer´s last blog ..The Limits of Frugality =-.

Robert Muir 2010/03/26 at 1:50 pm

I agree with what you’re saying JT. The vast majority of folks (and just a few years ago I was one of them) can’t even scrape together the funds for either Traditional or Roth IRAs. When they do, they’ll get a larger refund with Traditional and hopefully they’ll add it to the next IRA rather than spend it. And you’re right, most of these folks will probably be on the bottom rung (if any rung at all), of marginal tax rates when/if they retire in the future.

It’s critical that as many folks as possible get out of debt and at least max out their retirement deferred/Roth funds regardless. I’m just turning 50 and between Roth, Simple and SEP, my wife and I have only been maxing them out since 2008. Thank goodness the Simple is so generous. If you’re self employed, the Simple IRA is the best thing since sliced bread!
.-= Robert Muir´s last blog ..New update for XP Mode allows for non-VT PCs =-.

kevin 2010/03/26 at 7:14 pm

Bob – I agree with all that you’ve said, and I would cause I just wrote a post on it 😉

If you’re 50 or above, you really do need to get everything going in fast forward. It sounds like that’s the track you’re on. Good move with the Simple IRA too!
.-= kevin´s last blog ..Over 50 ““ No Pension, No 401K ““ What Now? =-.

GRACIELang33 2010/07/04 at 9:27 am

I received my first credit loans when I was very young and that supported my relatives a lot. However, I need the sba loan over again.

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