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Higher Taxes?

Adam M. Grossman

FEDERAL RESERVE Chairman Jerome Powell appeared before Congress late last month and spoke in serious terms about the country’s debt situation. It’s worth understanding what Powell said—and how that might impact your investments.

Powell’s message: “The U.S. federal government is on an unsustainable fiscal path.” Specifically, “debt as a percentage of GDP is growing, and now growing sharply, and that is unsustainable by definition.”

Powell’s remarks mirrored those of the Congressional Budget Office (CBO). In June, the  CBO reported that, “Under current law, federal debt held by the public is projected to increase sharply over the next 30 years” to 152% of GDP. “That amount would be the highest in the nation’s history by far.” To put that in perspective, the CBO explained that interest payments alone would grow to equal what we spend on Social Security, the government’s largest budget item.

Why dwell on these grim figures? It’s important, I believe, because ultimately there are only a few solutions to this problem—and one of them is to raise taxes. In fact, it isn’t that taxes might go up. Rather, they’re currently scheduled to go up. At the end of 2025, most of the favorable 2017 tax rate changes will expire. Unless Congress acts to prevent it, personal tax rates will revert to 2017’s levels.

To be clear, my goal isn’t to worry you. If economic growth is better than expected or interest rates are lower than expected, our debt would grow more slowly and Congress might delay the increases. Still, no one has a crystal ball, so it makes sense to prepare. What planning steps can you take today to protect yourself against higher tax bills down the road?

For the most part, your tax bill in any given year is simply a function of your income. Yes, you can make adjustments around the margins—with charitable contributions and tax-deferred savings, for example—but you don’t have a whole lot of options from year to year. Where you do have more control, however, is with your tax rate once you’re retired. But it requires planning. Here are three steps to consider.

First, build tax-free savings. There are a few ways to build tax-free savings, but the most efficient is a Roth account, which allows your investments to grow entirely free of income and capital gains taxes. In fact, if you can build up assets in a Roth account, there’s a double-barreled benefit: Roth withdrawals are tax-free and, because of that, you may end up with a lower tax rate on all of your other income. There are at least four ways to build Roth savings:

  • Roth 401(k) plans. Some employers offer a Roth option within their 401(k). While some might opt for traditional 401(k) contributions—to capture the immediate tax deduction—this is where I would bear in mind Powell’s comments. If tax rates are higher in the future, you might be better off foregoing today’s tax deduction to build tax-free assets for the future. If you aren’t sure, I would at least consider splitting the difference, putting half of your contributions into a Roth.
  • Roth IRAs. Even if your employer doesn’t offer a Roth option in your 401(k) or 403(b), you can still contribute to a Roth account on your own, via a Roth IRA. Depending upon your income level, you might have to contribute via the backdoor method, but everyone is eligible, as long as they have enough earned income. The annual contribution limit is now $6,000 per person.
  • Roth conversions. If you have accumulated IRA assets, you can convert a portion to a Roth IRA. The catch is that you’ll have to pay tax this year on the amount you convert. But depending upon where you are in your career, if tax rates rise in the future, you might be better off paying taxes at today’s rates. It isn’t an easy decision to voluntarily trigger a tax bill—especially a big one—but it’s worth considering before 2026’s scheduled tax increase.
  • Super-funding. If your employer doesn’t offer a Roth option, and you’re not satisfied with the $6,000 IRA contribution limit, there is another approach that might work. In an article last October, I described a method for “super-funding” a Roth IRA via after-tax contributions to a 401(k). If your employer permits it, this is a powerful way to build a substantial Roth balance.

Second, don’t overlook taxable savings. If you’re in a high tax bracket, you may feel compelled to contribute as much as possible to tax-deferred accounts. In general, this makes sense. But don’t overlook the value of saving in a taxable account. This will allow you to further diversify your sources of income in retirement. Depending upon your particular mix of income and assets, this may allow you to better control your tax rate over the years, especially after age 70½, when you’ll be required to take minimum withdrawals from your traditional retirement accounts.

Finally, don’t forget about estate taxes. Following the 2017 rule changes, federal estate taxes are no longer much of a consideration for most people. The exclusion—meaning the amount one can pass to heirs tax-free—doubled to more than $11 million per person, or almost $23 million for a married couple. Many people took this as an opportunity to cross estate taxes off their list of concerns.

But keep in mind that, historically, estate tax rates have seen more frequent and more significant changes than income tax rates. It’s entirely possible that a future administration might bring the exclusion back down. For that reason, if you have assets greater than $5 million, I would still consider taking steps to reduce your family’s potential estate tax burden.

Adam M. Grossman’s previous articles include Moving TargetNo Free Lunch and Private Matters. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Michael1
Michael1
2 years ago

Thanks for this article (and the link back to your October one). So many articles about whether one should contribute to Traditional or Roth ask the reader to think about whether their future tax bracket will be higher or lower. This is the bigger picture few appreciate and that’s more relevant – whatever my bracket, my taxes are likely going up.

Editing to admit I only came to this realization recently and had previously been contributing to a Traditional 401k, but better late than never.

MLAATMTB
MLAATMTB
2 years ago
Reply to  Michael1

Michael not sure if you will see this but I agree with you. I understand the math behind the traditional IRA argument but that assumes you will be in a lower bracket in retirement. Its likely that many, especially those reading articles like this, will end up in a high bracket even after retirement through investment income, withdrawals, pensions etc.

My decision to fund my 401k as a roth is more a bet on myself. From there its just a hedge against future tax increases. I’d rather lock my rate now and not be exposed to the progressive political agenda

james mcglynn
james mcglynn
2 years ago

Still have till April 15 this year to contribute to a Roth IRA for 2018 as well.

Mik Barbasol
Mik Barbasol
2 years ago

If you think taxes are bad now just wait till the socialists take control…ouch !!

Chris Rush
Chris Rush
2 years ago
Reply to  Mik Barbasol

At least with the socialists (i.e., people in favor of democratic interests instead of what’s best for the upper part of the 1%) we might get something for the money. Isn’t it time for “Red-baiting” to be retired for sensible economics for all?

Mik Barbasol
Mik Barbasol
2 years ago
Reply to  Chris Rush

If you believe socialism is a better answer please show us the proof ??

greenman7612
greenman7612
2 years ago
Reply to  Chris Rush

Everyone loses in Socialist economies. The lower rungs are hurt the worst. Capitalism provides the only path for climbing the economic ladder. I’m living proof!

David Powell
David Powell
2 years ago

Good advice and nice to have that clarity. A similar thing might be said about the certainty of social security benefits getting some adjustment, either starting age for all based on updated U.S. demographics and longevity statistics, or monthly amount based on career income. Thinking about that possibility, and modeling likely income from 401K+IRA in retirement, led me to start a taxable retirement account some years ago.

Liz
Liz
2 years ago

We contribute to both a Roth (mine I do not work) and a traditional. We have really increased our traditional contributions this year to take advantage of the earned income credit and it pups us into the 20% retirement savers credit. I forgot my exact number but it was somewhere around a 3k increase our 2019 tax return. Sometimes traditional makes sense when your incomes pretty low and you have kids.

kevin@39months
kevin@39months
2 years ago

I find it funny when people talk about raising taxes when the deficits become killers. Over the past 100 years, when taxes were at 90%, 70%, 28%, whatever, the share of Federal taxes wound up around 18% of GDP +/- 1%. If they raise taxes back to 70%, they’ll just have folks not earn as much, shield their taxes, or the economy will crater. You are not going to get more than around 18% no matter what you set the tax rate at. Better to keep them lower and try to grow our way out of this mess.

Of course the real solution is to reduce spending, but that never seems to get mentioned.

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