Anticipating a tax increase

[Gumby]

I have become convinced that marginal tax rates will soon increase regardless of who becomes our next president. Assuming that to be true, how does that affect my choices with respect to tax deferred investments such as 401k's and IRA's? Currently, I'm in the 28% bracket. Based on current brackets, I expect to be in the 25% bracket upon retirement. If things stay the same, it would therefore be sensible to go with the 401k today, saving 28% now and paying back only 25% in the future. But if rates increase, the combination of equal or increased marginal rates in the future and the conversion of capital gains to ordinary income might make it wise to forego the tax deduction today and simply invest the money after tax. This assumes no matching for the 401k.

Has anyone calculated the break even point on this scenario?

 

[LOL!]

Didn't Jonathan Clements just publish the answer to your question in today's WSJ? Getting Going - WSJ.com

 

[Rich_by_the_Bay]

Don't the income ranges for the tax brackets also ratchet up every year? That will go a long way toward neutralizing the impact of rising tax rates on tax sheltering.

Example: Married, jointly, 28% bracket for 2007 applies to income of $128,500 - $195,850. In 2004 the 28% bracket was $117,250 to $178,060.

So your household income of $120K in 2004 had you at 28%. The same income in 2007 would put you in the 25% bracket.

So without even including the tax deferral on earnings, I figure I'll be best off just continuing to shelter what I can. No one knows for sure, but between the lower income in retirement and the upward creep of the tax bracket boundaries, this still seems the best tactic for me.

 

[Gumby]

Thanks. By my calculations, if I earn the money now, pay taxes at 28%, then invest the remainder in a stock that brings me capital gains of 10% per year that I harvest in 5 years and pay 15%, I will net roughly the same as if don't pay any taxes now and instead invest the full amount inside a 401(k), then pay taxes on the full amount at 25% in five years. The real unknowns are whether the 15% capital gains rate will hold and how much marginal rates will increase. I can see that shorter periods also will lessen the attractiveness of the 401(k). Also, if the investment is one that throws off dividends versus capital gains, the 401(k) is more attractive.

 

[blessed]

We have a taxable account that we are pulling money out of and letting our IRA's compound. Since it will be almost 9 years before even my husband has to take money out. The tax code now allows us to deduct mortgage interest and charitable contributions and that shelters taxes to the point that we will never be out of the 15% bracket. I believe in sheltering yourself from taxes as long as you can and after inflation paying in dollarettes (less valuable dollars).

 

[OAG]

Blessed are you not trading less taxes for bank (mortgage) interest at least to some extent? Moving (adjusted) tax brackets, increased standard deduction for age, movement of T-IRA to ROTH, should all mitigate to keep you in the 10% and then 15% tax bracket (assuming these are still there) much better than paying mortgage interest (assuming you do not have a 4% or less rate). I have no intention of starting another "pay off the mortgage or not" thread.

 

[blessed]

R.Wood,
If you have enough other deductions,(over 10,500), then having a mortgage makes sense. I have a 6% mortgage; however, my balanced taxable account will generate more than that over the years. If you have no other deductions, I agree paying off the mortgage probably makes sense if you have plenty of money to fall back on in emergencies.

 

[MichaelB]

Only one sure bet

The only sure thing is the tax you don't pay today using a 401(K). That is real money. Everything else is a bet - especially future tax policy.

Note - I concur with you on the likelihood of higher future tax rates. I have no clue which, where and how high, and am only confident on one thing - taxes will be more complex in 5 years.

Michael

 

[blessed]

True, nothing is sure but death and taxes. However, as long as we are alive, the Lord encourages us even with one talent to invest it. I believe too much of your net worth just sitting in your house is not the best financial move. Investing for the long term with safety guards (we have a pension and 50k in emergency fund) is not gambling. Just my view

 

[RonBoyd]

The only sure thing is the tax you don't pay today using a 401(K). That is real money.

I agree.

I believe in the old Saw about a man who was condemned to death for a crime he had committed. He begged the king for a year's reprieve during which time he said he would teach the king's horse to talk. He explained to his friends that at least he would have another year of life, and that in a year the king might die, or the man might die, or the horse might die. Or the horse might talk.

(Am unsure who to attribute this parable to.)

 

[walkinwood]

Thanks. By my calculations, if I earn the money now, pay taxes at 28%, then invest the remainder in a stock that brings me capital gains of 10% per year that I harvest in 5 years and pay 15%, I will net roughly the same as if don't pay any taxes now and instead invest the full amount inside a 401(k), then pay taxes on the full amount at 25% in five years. The real unknowns are whether the 15% capital gains rate will hold and how much marginal rates will increase. I can see that shorter periods also will lessen the attractiveness of the 401(k). Also, if the investment is one that throws off dividends versus capital gains, the 401(k) is more attractive.

If you pay taxes now, you're paying 28% on the whole amount. What will your deductions be after you take early retirement? That may make the net tax on your 401k withdrawal less than 25%.

Also, do you need to withdraw from a 401Kin 5 years? Best practice is to deplete your taxable accounts first, then use your tax-deferred accounts. Google article by William Reichenstein called Withdrawal Strategies to Make your Nest Egg Last Longer

 

[mathjak107]

Thanks. By my calculations, if I earn the money now, pay taxes at 28%, then invest the remainder in a stock that brings me capital gains of 10% per year that I harvest in 5 years and pay 15%, I will net roughly the same as if don't pay any taxes now and instead invest the full amount inside a 401(k), then pay taxes on the full amount at 25% in five years. The real unknowns are whether the 15% capital gains rate will hold and how much marginal rates will increase. I can see that shorter periods also will lessen the attractiveness of the 401(k). Also, if the investment is one that throws off dividends versus capital gains, the 401(k) is more attractive.

i believe in planning for what is and what the long term trend has been. i never plan around what if's for my tax planning. for at least the baby boomer generation i plan around certain facts i still assume to be true:

taxes have been dropping for 40 years.

the tax brackets have been increasing allowing more and more income thru every year with less taxes for 60 years

thats what i plan around, thats why im so against roths for 95% of americans, especially baby boomers who for most will not be in a higher tax bracket when the paycheck stops coming.


i just dont see a political party telling 182 million voting baby boomers we are raising your income taxes.


i do see medicare taxes and social security taxes going thru the roof for the rest of the working stiffs .

i do see sales taxes, real estate taxes and any other tax they can come up with going up, but income taxes are taboo

 

[chinaco]

I have become convinced that marginal tax rates will soon increase regardless of who becomes our next president. Assuming that to be true, how does that affect my choices with respect to tax deferred investments such as 401k's and IRA's? Currently, I'm in the 28% bracket. Based on current brackets, I expect to be in the 25% bracket upon retirement. If things stay the same, it would therefore be sensible to go with the 401k today, saving 28% now and paying back only 25% in the future. But if rates increase, the combination of equal or increased marginal rates in the future and the conversion of capital gains to ordinary income might make it wise to forego the tax deduction today and simply invest the money after tax. This assumes no matching for the 401k.

Has anyone calculated the break even point on this scenario?

OK Gumbo... in a recent melee you commented that you and I are not paying enough taxes. I thought you were all for paying more taxes?

Sorry but I could not resist.

 

[Buckeye]

I decided to go with the Roth 401(k) at work. I miss the tax break (ouch!) but I still put in the max. No worse off than putting the money in taxable accounts but the future is tax free. Do you have that option?

 

[Gumby]

OK Gumbo... in a recent melee you commented that you and I are not paying enough taxes. I thought you were all for paying more taxes?

Sorry but I could not resist.

+1 for Chinaco. I try to play the hand I am dealt as well as I can, regardless of the fact that I believe the game needs to be changed.

 

[megacorp-firee]

... i plan around certain facts i still assume to be true:
taxes have been dropping for 40 years.

the tax brackets have been increasing allowing more and more income thru every year with less taxes for 60 years
...
thats what i plan around, thats why im so against roths for 95% of americans, especially baby boomers who for most will not be in a higher tax bracket when the paycheck stops coming.

i just dont see a political party telling 182 million voting baby boomers we are raising your income taxes.
... but income taxes are taboo

Mathjak, I think you 95% estimate may be a little high. There are some fortunate boomers who have a substantial amount of money in their 401Ks/IRAs.

While w*rking, I was in the 28% marginal tax bracket. After retirement, I will be in the 15% bracket. I am also fortunate enough to have a pension (which is what pushes me towards the upper end of the 15% bracket).
If one has $1M in their 401k/IRA, and do nothing (i.e. no roth conversion), they could find themselves in the 28% bracket at age 70 1/2 rmd time.
If I systematically convert over to say a 12% effective tax rate (25% marginal), until 70 1/2, then my overall tax burden will be less (going forward) and my Roth account will be the bulk of my sheltered funds, growing and coming out tax free.

So you may want to be a little careful waving everyone off of doing Roth conversions.

 

[mathjak107]

yes it may be less if you have a roth but not as less as having had taken that deduction in your earning years.


i dont think im to far off with 95%. i dont know anyone myself included that would be in a higher bracket not working. there is obviously some but i think its quite few in comparison to the masses. 1 million would give you about 40,000 a year plus ss. even if it was all taxable after deductions and the 3% a year increase in bracketing you still would be low. the first 35,000 is only 1500 in taxes

 

[Gumby]

If you pay taxes now, you're paying 28% on the whole amount. What will your deductions be after you take early retirement? That may make the net tax on your 401k withdrawal less than 25%.

Also, do you need to withdraw from a 401Kin 5 years? Best practice is to deplete your taxable accounts first, then use your tax-deferred accounts. Google article by William Reichenstein called Withdrawal Strategies to Make your Nest Egg Last Longer

Actually, I recall reading a thread on here that advocated using tax deferred withdrawals up to the top of the 15% bracket and then using the after tax accounts as a means of reducing the overall tax impact.

 

[figner]

thats what i plan around, thats why im so against roths for 95% of americans, especially baby boomers who for most will not be in a higher tax bracket when the paycheck stops coming.

It makes a difference whether you're comparing Roth to IRA, or Roth to taxable account. Roth will pretty much always win vs a taxable account, which is the decision many high-earners (who don't qualify for a deductible IRA) are faced with. However, I agree that if deciding between IRA/401k vs Roth/Roth401k, the IRA/401k is likely to be better for mid-high earners, especially since the withdrawals probably won't all be taxed at your marginal rate.

 

[FIREd]

I have become convinced that marginal tax rates will soon increase regardless of who becomes our next president. Assuming that to be true, how does that affect my choices with respect to tax deferred investments such as 401k's and IRA's? Currently, I'm in the 28% bracket. Based on current brackets, I expect to be in the 25% bracket upon retirement. If things stay the same, it would therefore be sensible to go with the 401k today, saving 28% now and paying back only 25% in the future. But if rates increase, the combination of equal or increased marginal rates in the future and the conversion of capital gains to ordinary income might make it wise to forego the tax deduction today and simply invest the money after tax. This assumes no matching for the 401k.

When it comes to 401K Vs. taxable accounts, my position is that it is almost impossible to predict what taxes will look like in 3+ years (though I tend to agree that taxes will probably go up for most of us). So many things can change about your personal situation and the tax code is so fluid that trying to make accurate tax predictions for the long term is futile IMHO. So I think that it is sensible to be tax-diversified. I personally have about half my money in tax-deferred accounts and half in taxable accounts right now (though for us the decision is pretty easy since we already max out our retirement accounts and therefore have no choice but to put the rest in taxable accounts).

 

[mathjak107]

the tax code hasnt done anything but drop taxes for over 40 years. why you would suddenly plan on them rising is more a speculation than on dropping which has been the pattern

 

[FIRE'd@51]

As I understand it, both Clinton & Obama have said they will roll back the Bush tax cuts for folks making over 250K. This would include the favorable rates on LT cap gains and qualified dividends. Does that mean that the current rate on LT cap gains and qualified dividends which fall into the 10% and 15% brackets will still be 0%, and after that 15% up to 250K?

 

[OAG]

They will "play" with the Federal Tax System - what is difficult is the RE Tax, Sales Tax and State (those that have it) Tax that is going to be going up faster now that the States, Cities and Counties are going to get hit with more and more people not paying RE taxes (foreclosures and "walk aways"), aging facilities, roads etc., that they have been ignoring of late. The LAST thing these people want to do is "cut services". Watch out for the millage rate increasing referendums popping up at the tax booth. Our county has a couple on the PRIMARY ballots that will, if passed, see an approximate 20% increase in School Taxes (which were increased a like amount 3 years ago).

 

[walkinwood]

Actually, I recall reading a thread on here that advocated using tax deferred withdrawals up to the top of the 15% bracket and then using the after tax accounts as a means of reducing the overall tax impact.

I thought that was the case if you had some of that tax bracket left after funding your annual budget from your distributions & sales from the taxable account. In that case, withdraw IRA/401K funds up to the top of the bracket and move it to a Roth IRA. That's my understanding.

If someone has a clearer notion of this, I'd like to hear about it.

 

[tuixiu]

That makes sense.

It's one of the things I most often see misunderstood when in discussions with others about 401k vs. Roth vs. taxable... the concept of a tiered tax system. For some reason people often think in absolutes, as in they are in a 25% bracket so pay 25% of their wages as tax. You can almost see the light bulb come on when they get it and see how much it impacts retirement planning.