Much has been written and said about taxes. Nobody likes paying them, but pay them we must. Few people would volunteer to have a detailed discussion about taxes, but here we are, deciding whether to keep reading or just hit delete and hope the next Weekly is of a kinder and gentler nature. In light of the un-exciting nature of tax talk, I’ll start with the headline and you can decide whether to keep reading.
Taxes are very likely to increase in the future and failing to plan accordingly may have painful financial consequences. That said, not everybody should alter their plans but some should. Like most financial matters, this is a very nuanced subject. There are very few absolutes or hard-and-fast rules here.
It’s difficult to discuss taxes without also discussing politics. And because raising taxes is a sure way to lose an election, I don’t know of a politician who wants to be associated with raising your taxes. As a result, we have this situation where tax rates have been historically low while our country’s annual spending deficit and overall debt levels have been growing astronomically. Something, it seems, has to give.
When I teach tax-focused retirement classes, I like to ask the group, “Do you think taxes in the future will go down, stay the same, or go up?” With some accompanying chuckling and sighing, all the people in the room agree that taxes will have to rise in the future. “If that’s true, does your retirement planning reflect that eventuality?”
Before we get too far here, please know that there’s no silver bullet to reducing your tax rate in retirement, unless you choose to live on less income and thus pay lower taxes. Most people, however, would prefer to have more income without incurring higher taxes. So if more income and lower taxes is the goal, does your plan reflect that? Have you considered that even if the IRS doesn’t change the actual tax brackets, you earning a higher income within those same tax brackets means your taxes are being raised without even a single cast vote? And by way of cheapening future dollars through inflation, we’re growing our lifestyles and necessary incomes and thus inflating ourselves into higher tax rates instead. Pretty sneaky.
With all of this in mind, let’s just agree for now that taxes will rise into the future. If that’s true, have you done what you can to minimize your pain? Here are just a few thoughts to consider if you believe taxes will rise going forward:
- Fund a Roth IRA or Roth 401(k) as early as you can with as much money as you can. The younger you are, the better this strategy is likely to work. Getting money into a tax-free account like a Roth means that money isn’t affected by higher tax rates in the future.
- Convert an IRA into a Roth IRA. Paying tax on the converted amount now rather than later means you’re willingly paying the tax during a time of lower tax rates.
- Consider how a life insurance policy that offers tax-free loans may provide an alternative source of retirement income during an era of higher tax rates. Life insurance with cash value has unique tax treatment and can sometimes be a valuable asset to own in a rising tax environment.
- Plan for a blended withdrawal strategy from retirement accounts of differing tax structures. For example, pulling some money from a Roth IRA while drawing some from a 401(k) may allow you to ‘maximize the lower brackets’, leaving you with a lower tax bill than if you’d pulled all your needed retirement income from a single source.
- Analyze your charitable giving. Money in tax-deferred accounts may be more efficient to give to charity than ordinary income, so you may be able to benefit from the tax advantage while also helping a worthy charity.
- Pay off debts today in a lower tax environment. If taxes are likely to be higher in the future, servicing debt will require more income. More debt requiring more income means you’re living in a higher tax environment. Using your income now to pay the debt off allows you to live on less income later.
While no single solution is likely to make all your tax burdens go away, some prudent planning may provide some meaningful benefits to reduce taxes into the future for yourself and for your loved ones in the next generation. Please let us know if we can help.
All the best,
Adam Cufr, RICP®