I hear it all the time: "Just use your Roth account to lock in your tax rate because taxes could skyrocket in the future." This is a valid concern, but I don't think it's one that should control your thinking. The risks of future tax increases to your tax-deferred accounts are minimal, in my opinion. Let's consider why.
Deferring Taxes Has a Distinct Advantage
Yes, it is true that we currently have historically low tax rates for the middle class in the year 2020. No, that doesn't mean that the fear of taxes going up should keep you from using your tax-deferred vehicles for saving and investing.
As I explained my last myth post, the advantage of paying an effective tax rate in retirement versus paying your top marginal rate right now is the real game-changer. There is an in-depth explanation of this idea in my last post, but the main idea is that you're taking money from your top marginal bracket and moving it to the bottom bracket.
The real game-changer: top marginal rate now versus effective rate in retirement.
What do the numbers say?
Let's run some numbers for comparison. The figure above was created by the Center on Budget and Policy Priorities. It shows how the rates for a median-income family of four has fluctuated over the years from 1955 through 2013. You can see that the highest rates for the middle class were in the early '80s. If your worry is: "What if taxes go up?", I think it's reasonable to use 1981 as a worst-case scenario because that's the highest tax rates for middle-income earners in our nation's history.
I have mentioned in a previous post that I think it's wise for middle and low income earners to defer taxes on 22% rate and above, so I asked: "What income would someone need in retirement to reach a 22% effective rate in 1981 with high taxes?"
Methods
I'm compared the federal marginal income tax rates for married, filing jointly.
I used DollarTimes' inflation calculator to adjust all the brackets for inflation from 1981 dollars to 2020 dollars.
I then took the standard deduction and personal exemption from 1981, $3,400 and $2,000 respectively, and adjusted it for inflation. It is included as the first bracket labeled "0%" since that is not taxable income. You'll notice that there are two 0% brackets in 1981. That is because the first 0% is for the standard deduction, and the second is for the actual 0% bracket that existed in 1981. The standard deduction row is marked in blue.
Then I aimed for how much income it would take to reach a 22% tax rate. Why 22%? Because of my previous suggestion based on 2020 tax rates to invest pre-tax at the 22% level and above and post-tax at the 12% level and below. So if you've been following that, then it was a good decision to defer as long as you pay less than 22% in retirement, so that's the cutoff we're looking for.
Results:
Looking at the table on the left, you can see that you would need to have an income in retirement of about $131,895 to reach an effective tax rate of 22%. So any retirement income less than $131,895 will result in a lower tax rate than 22%, and deferring at that rate was a good idea.
According to the Census Bureau, the median household income in the US in 2018 was around $90,000. So even at the highest tax rates for the middle class in history, it still looks like a good idea to defer taxes that are 22% or higher.
What do I think will happen?
First, I'll start off by saying that I do not have a crystal ball, nor am I a tax historian or tax professional. This is my opinion, so take from it what you will.
I believe that taxes will increase for the middle class over the coming decades due to growing need for things like universal healthcare, paying down our national debt, and to keep social security solvent. However, I also guess that most of those tax increases will affect the nation's top income earners. These rates may look something like the very high top marginal rates from the 1960s or '70s. Since most of the money will be taxed on the wealthy, this would give the middle and low earners some slack. That is, of course, speculation and is in no way a guarantee that that is what will actually happen.
I could definitely see middle class tax rates going back up to something around 2001 levels. This rate is higher than 2020, but not as high as 1981. Let's take a look:
The table at the right shows that at 2001 tax levels, you would need an income of $226,135 to reach an effective rate of 22%. Again, this is a much higher income than most households will have in retirement, so deferring taxes 22% or above was a good idea.
Conclusion
The fear of rising taxes, in most cases, is outweighed by the benefits of deferring your taxes at a 22% rate or above. Even if we go back to 1981 rates, which were the highest for middle income Americans, it would still take a retirement income of almost $132,000 to reach an effective rate of 22%. So do not let this fear keep you from utilizing the tax benefits of your traditional retirement accounts.
Disclaimer: I am not a tax expert, and I have no formal tax training. I'm just a mathematician who looks at the numbers and provides general information. For specific advice around your individual tax situation, contact a licensed professional.
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