The Higher Future Tax Rates Mythology
Our nation’s debt is growing to uncomfortable, if not unsustainable, levels (I’ll let your politics dictate the adjective), driving a recommendation to forgo the tax-break provided by tax-deductible retirement contributions and contribute to Roth accounts instead.
Quick reminder: Roth contributions are with after tax dollars, grow tax-free, and are withdrawn tax-free. Traditional contributions are usually tax-deductible, grow tax-deferred, and withdrawals are taxed as ordinary income.
And the conviction that those ordinary income tax rates will be higher in the future is driving the Roth accounts recommendation.
I’ll pass. Here’s why:
- Solving our debt problems doesn’t automatically mean higher tax rates
- Higher future tax rates doesn’t mean your rates will be higher
Simpson-Bowles
Back when Congress almost worked we had bipartisan commissions to attempt fixing major issues. I say almost because one such commission generated a lengthy deficit fighting report in 2010 that went nowhere.
Why mention it?
Because its framework would’ve reduced the deficit and future debt to GDP ratio while lowering rates.
Fantasyland?
Nope. Tax revenues would’ve increased by ending over a trillion in tax breaks to more than offset lowering rates to 12%, 22%, and 28%. This flatter tax structure works for retirees who tend to have fewer tax breaks than when they were younger.
If tax reform or deficit fighting comes with flatter tax rates, you’ll have made a mistake giving up your tax break now.
Your Tax Rate
Higher future tax rates doesn’t mean you’ll be in a higher bracket. The top two rates tend to move around, but brackets below them have remained steady. I just don’t see middle class tax brackets increasing dramatically, and if they don’t, I find that most HNW retirees avoid being taxed consistently at the top bracket given strong planning opportunities, lower income, and sequencing withdrawals.
So, now what?
Nothing here is meant to predict future rates, but the certainty that rates will be higher filtering into your wealth management decisions is misplaced, particularly when it leads you to pay higher taxes now.
Take that tax break, use techniques like back-door Roth IRAs to grow your tax-free bucket, and work with your wealth manager and tax advisor to avoid taking taxable retirement account withdrawals at the highest brackets through strategic withdrawals at lower rates, Roth conversions, using your IRA for charitable contributions, etc.
I know it’s not easy and we frequently see DIY’s missing these planning opportunities, but taking your tax break when you’re at the highest rates and paying taxes on that money when you’re at lower ones is a great long-term strategy worth working with someone to implement. A good financial plan can show you your future projected income and help you decide which type of retirement account contribution is best for you.
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