Pain Postponed

Richard Quinn

RAISE YOUR WALLET if you think taxes won’t be going up.

Is there much doubt that the federal government will seek additional revenue, given its ballooning debt and future spending on Social Security, Medicare and other federal programs? If so, should retirement savers really be deferring taxes—or, instead, should we be taking advantage of tax-free retirement savings?

The IRA was first introduced in 1974. At that time, there was a 38% tax rate on individual incomes of more than $20,000, with a maximum 70% tax rate on incomes above $100,000. Fast forward to 1980 and the launch of 401(k) plans: You had a maximum tax rate of 70% on incomes above $108,300, and a 39% rate that started at $23,000. Back then, saving on a tax-deferred basis made sense. But today, we have—I suspect—the lowest tax rates we will see for decades.

Some experts—including Prof. Larry Kotlikoff of Boston University—estimate that the unfunded liability for government entitlement programs is $210 trillion. Yup, that’s trillion. That is the difference between anticipated benefit payments and anticipated revenue to support them.

Don’t buy those very long-term projections? Consider instead the very real and growing federal debt of $21 trillion. With that kind of debt, the top tax rates won’t be the only ones going up. There simply isn’t enough money among top income earners to get the revenue needed.

Moreover, it isn’t just higher income tax rates that can hit workers and retirees. Consider that one of the federal government’s largest single revenue losers is the tax-free status of employer-provided health benefits. On top of that, in many cases, even employee contributions are made on a tax-free basis. Could this low-hanging tax fruit tempt the politicians—potentially affecting most middle-class Americans, including millions of retirees?

Despite the likelihood of higher tax rates, we still see employers encouraging their employees to fund tax-deductible retirement accounts, such as traditional 401(k) and 403(b) plans. Those traditional retirement accounts are also where any matching employer contribution ends up. Are employees being set up for steep tax bills in retirement?

The tax situation has changed greatly since 1980 and is likely to change again—and not for the better. For many folks, the chances of being in a low tax bracket in retirement are waning, especially once they factor in not only the taxes owed on required minimum distributions from retirement accounts, but also the growing taxation of Social Security benefits.

What are the implications of all this? Putting some money in tax-deductible retirement accounts still makes senses. During your working years, those tax-deductible contributions will save you taxes at your marginal tax rate—but in retirement, much of your retirement account withdrawals will likely be taxed at lower rates, because these withdrawals might account for the bulk of your income.

Bu if you’re saving more than, say, 10% of your income for retirement, you may want to rethink which account you use for those additional savings. The obvious choice: a Roth 401(k), Roth 403(b) or Roth IRA. You won’t get a tax deduction for your contributions. But once retired, everything withdrawn from your Roth accounts should be tax-free—potentially a huge plus if tax rates are indeed headed higher from here.

Richard Quinn blogs at Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Sharing It, What Motivates Me and Benefits Lost. Follow Dick on Twitter @QuinnsComments.

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