IRAs and 401(k)s today are the main source of retirement funds for new retirees. These have replaced the defined benefit pension plans that your parents and grandparents relied on upon to fund their retirements. Unfortunately, many avid savers in IRAs and 401(k) plans may not realize they are setting themselves up to pay huge tax liabilities when they are forced to take mandatory withdrawals when they turn 70 1/2. Even with the lower tax rates enacted in December 2017, some married retirees will pay an effective incremental tax rate of over 40% even though their taxable income is less than $50,000.
Debt, Taxes, and the (Future) US Budget
Today we have some of the lowest tax rates in history, which is good. However, it is hard to ignore the current amount of US public and entitlement debt: $20T Public debt + $29T Unfunded Social Security + $33T Unfunded Medicare. That’s $82 Trillion, which excludes credit card, student loan, and municipal and state debt! Yikes!
So let me ask: With this level of debt, do you think that federal tax rates in the future will go down, stay the same, or go up? Hold that thought…
The Argument for Saving through IRAs and 401(k)s
The big selling point with IRAs or 401(k)s is that you put money into these plans during your peak earning years when your tax rate is high, thereby saving you a lot of taxes up front. Then, when you pull your money out when you are over 70 and retired, you pay tax “tomorrow” at a much lower tax rate. But there are two problems with this analysis:
Still pondering which way future tax rates will go? Regardless of which party sits in the White House, tax rates will likely have to be raised at some point to pay for the ballooning entitlements of Social Security and Medicare. In this case, the benefit of #2 goes away (other than the time value of money) and you are a Tax Hostage. You could find yourself in a situation where you are over 70 with an inflated IRA and are forced to take distributions and pay tax at rates approaching 50% or more.
Pay for the seeds today or for the produce tomorrow
Since I have quite a large vegetable garden each summer, I can attest that buying seeds is much cheaper than buying the lettuce, tomatoes, and basil later (and there is no comparison when it comes to taste). Of course, you have to buy the seeds months in advance and then hope the weather (and bugs and airborne tomato blights) don’t destroy your garden. Well, buying seeds are like investing in a Roth IRA/401(k). You “pay” for it up front since you don’t get a tax benefit for your contributions. But, you pay nothing when you make your withdrawals (harvest the produce) later.
Here are two strategies you can implement today so you can ignore the taxman tomorrow:
Take advantage of these low tax rates, as they will not stay this low no matter which party controls in the future. If you can limit your retirement income to Social Security and Roth distributions, you will minimize your concerns about future tax rate increases. I just wish I could provide you with similar strong advice on how to avoid that nasty tomato blight!
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