Taxes have been a popular topic recently. In less than a month, voters will decide what direction the government should move on a variety of policies and taxes is always one of the important policies on the table. In addition to this, news broke recently of The President’s tax history. This news renewed the focus on our tax structure with many questions of how equitable it is. Putting politics aside, no one really likes to pay taxes and obviously it always feels better to keep more money for your bottom line. In this post, we will discuss how the current tax situation may change and how to take control of your future tax situation.
Where do we go from here?
The chart below shows historical US tax rates throughout history. As you can see, we are in a downward trend that started in 1981 with the Reagan tax cuts. Just before that legislation, in 1980, there were 15 different tax brackets with the highest at 70%. This tax rate applied to income above $107,700 or about $334,000 in today’s dollars. Today is a different story.
The Tax Cuts and Jobs Act was passed in 2017 and compared to historical tax rates, we are in a fire sale right now.
The TCJA lowered not only regular income tax rates, but also created a low rate for corporations and offers a deduction for small businesses. With such low rates, Congress decided that there had to be a timeline for this tax sale, so the TCJA is set to revert back to the previous rates if no changes are made before 2025.
To put our rock bottom low rates into perspective, the table below shows our tax revenue compared to other developed countries. As you can see, we are the fourth lowest in revenue among the 35 OECD countries.
In addition to low tax revenue, when we take a look at the other side of the Country’s cash flow statement, it is not looking so great. This summer, the US budget deficit reached an all-time high of $3 Trillion. Of course, recent spending has spiked due to the pandemic and the need for government stimulus to prop up our economy. However, in September, Jerome Powell, the Fed Chairman warned that the US deficit is on an unsustainable path.
As a financial planner, when I look at our current situation, my natural question is, where do we go from here and how can we plan ahead? I think it is safe to say that the answer to the first question is that taxes will rise. When and by how much, no one really knows. For the most part, as individuals, we don’t have a lot of say in this. We can vote and let our voice be heard, but the final numbers are out of our control.
However, there are some steps to take to gain some control over your future tax burden.
Diversify your tax savings
Traditionally, we tend to save for retirement with our current taxes in mind. We put money into pre-tax accounts like a traditional 401(k) or traditional IRA. This gives us a tax deduction today and defers our tax liability to later when we withdraw money. Keep in mind that these accounts were introduced around the same time as those 1980 tax brackets that I discussed earlier. Back then, it made a lot of sense to defer money while you were working in a high tax bracket and pay taxes in retirement when you would be in a lower tax bracket. This strategy does not necessarily work the same as it did back then. Even if taxes don’t rise in the future, the tax brackets have widened so much that many of us will be in the same or a similar tax bracket in retirement as when we are working.
This situation has incentivized the need to diversify your retirement savings into tax-free accounts. Roth IRAs and Roth 401(k)s provide tax-free withdrawals in retirement. You don’t get a tax-deduction for your contributions in these accounts, but you avoid paying taxes on your earnings as your money grows.
The advantage of having a tax-free portion of your savings is now you have a bucket of money that you can pull from to take control of your tax rate.
Control your own tax rate
It is important to know where your income falls on the current marginal tax bracket. As you can see, there are a few tax spikes to be aware of. The tax rates jump dramatically at about $80,000 of income and then again at approximately $326,000 (married filing jointly). Knowing where your next dollar is taxed can help you make decisions on where to withdraw money from for income.
Let’s say that you are using your portfolio for income and you need to withdraw $100,000 annually. This would put you in the 22% tax bracket. However, let’s say that you pulled $50,000 from your pre-tax accounts and another $50,000 from your tax-free accounts. Now you have withdrawn your $100,000 however only $50,000 is taxable. You have effectively moved yourself down into the 12% tax bracket. That is some great savings!
Adding Roth Savings has advantages
There are some other key reasons why Roth savings can be important to your financial plan. Roth accounts are not subject to a required minimum distribution. Remember with traditional retirement savings, the government requires you to begin taking withdrawals at pay taxes at a certain age or when the money is inherited. With Roth money, these rules don’t apply. Roth income also does not affect the taxation of your Social Security benefits or count toward the calculation of income for your Medicare part B or D premiums.
Keep in mind you may not be able to contribute to a Roth IRA if your income exceeds certain limits. These limits don’t apply to Roth 401(k) contributions.
Take control
There is a lot of uncertainty in our world right now. Much is out of our control. It is normal to feel anxiety and worry about how the changing world will affect you. The best thing you can do to reduce this anxiety and worry is to focus on what is in your control. Just take care of the little things that are within your circle of influence. Stephen Covey said, “Proactive people focus their efforts in the Circle of Influence. They work on the things they can do something about. The nature of their energy is positive, enlarging and magnifying, causing their Circle of Influence to increase.” I agree with this. Take action where you can. Work on what you can do something about. When it comes to your financial plan, small actions will enlarge and magnify to keep you on the right track for financial security and success.