I try very hard to avoid political discussions on Money360 because it often winds up in partisan bickering, but I feel that a discussion about the future of taxes and their impact on your personal finance decisions today is vital.
First of all, why is it important to think about future tax rates? Yesterday’s discussion about Roth 401(k)s was a very clear illustration of this. In an effort to keep the post from turning into a political discourse, I tried to avoid any discussion about tax rates and their future by making up arbitrary ones for the present and for the post-retirement era. The result? Comments like this from Eugene:
The difference happens when you have enough money to max out the 15.5K 401K limit. If you can’t hit this limit, that means taking a tax hit on the contributions means you can put less in a Roth 401K. If your tax is 25%, the choice is between 10% in a 401K or 7.5% in a Roth IRA. Not 10% versus 10%. And yes, because multiplication is commutative, applying the 25% reduction before contribution/before growth or at widthdrawal/after growth gives you the same result.
Now you also have to consider the impact of tax bands and how money is used during retirement. While working, 401K contribution money sits ontop of your income minus deductions. During retirement, the 401K withdrawals sits ontop of social security minus deductions. I suspect for 99% of people, social security will be a much smaller amount so you end up paying less overall effective taxes during retirement.
And this valid criticism from MossySF:
Trent, you are letting the tax tail wag the dog’s body. The specific tax amount now or later is irrelvant — it’s how much you have after taxes. Paying $2800 now versus $14K later? I have no idea what is better without knowing all the details. If I have to pay more tax because I earned more, hell yes I’d pay more tax. Do not report the tax bill as the final result — report the after-tax gains.
After reading a lot of this, Luke cries out for help:
Is here not ONE example that can be used to make this scenario bullet proof? My head is spinning, but not nearly as much as the arguments that say taxes will change in the future. It’s like hitting a moving target. If someone brings to the table a discussion about Roth IRA’s and 401k’s and someone starts to tear it down because what will happen in 2043 with taxes, how can everyone get on the right page if everything is a variable?
So, is there just a simple example that spells out which one is better without getting into taxology 40-years from now and a ton of what-if scenarios?
Thankfully, Erika came to the rescue with this stellar comment:
1. Legally, choosing between a Roth and normal 401k is not an all or nothing decision. If your employer lets you, you can contribute a bit to both (combined contributions still cannot exceed the maximum for any given year).
2. Tax rates are not terribly stable (see the graph at the bottom of the Top US Marginal Income Tax Rates, 1913–2003 page). Your tax rate, regardless of your bracket, may be much higher than it is now or it may be lower.
Combining these two points, deciding which 401k plan to contribute too depends on how you want to manage risk. If you contribute to a normal 401k, you are banking on the belief that you will pay less in taxes when you retire. If you contribute to a Roth 401k, you are banking on the belief that you will pay higher taxes when you retire.
Trying to minimize your total payed taxes is a risky business that involves predicting the future. My opinion is that you should diversify. If you contribute to both types of 401k, you will not end up paying the minimal amount of taxes, but, by paying some now and some later, you will amortize your tax burden across both your working years and your retirement years, and you will reduce the risk of your prediction of the future being wrong.
What can we learn from these comments? Future tax rates are incredibly important in determining which investment is right for you.
The problem is – we can’t predict the future. Or can we? Take a look at the data on historical income tax rates and then look at national debt as a percentage of GDP. Compare the two. Notice that income taxes are high when the national debt as a percentage of GDP is going down, and income taxes are low when the national debt as a percentage of GDP is going up. Notice also that current levels are trending upward and are also at their highest point since income taxes began (excepting World War II). This is expected given that taxes are so low, but at some point, that direction must change – it’s no different than getting your credit card in the bill each month and noticing that the debt is slowly getting closer to your salary.
Eventually, we will have the money to change the trend there, whether through smaller government or more taxes. Since both parties continue to propose plans that revolve around big government to solve our problems right now, it’s inevitable that taxes are going to head back up at some point in the next two decades. That’s the conclusion I draw, anyway.
What does that mean for my wallet? If you believe that taxes are going to eventually have to go up from where we’re at right now, then Roth IRAs and Roth 401(k)s are a very good deal, because you’ll effectively pay the low tax rate now and avoid paying the higher taxes that your future self would have to pay in a normal 401(k) plan.
What if I don’t agree with your conclusion? Many people believe that taxes will remain at the same level in perpetuity, and there’s some reasonable validity to that argument, though I don’t believe it. If that’s the case, then your taxes will probably be lower in retirement than they are right now and Roth IRAs and 401(k)s aren’t that good of a deal.
In general, when describing scenarios on Money360, I’ll lean towards believing that I’ll be paying more taxes in the future than now, all other things being equal.
As always, I welcome comments, but please keep partisan political posturing out of it. You can state your view on the direction of America in the future, but kindly refrain from name-calling and other such hallmarks of online political discourse (I’ve read far too much of it over the last few years).