Updated on 09.11.14

The Future: Where Will Tax Brackets Go In 30 Years?

Trent Hamm

I try very hard to avoid political discussions on The Simple Dollar 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:

Two things:

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 The Simple Dollar, 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).

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  1. Alex says:

    I feel that the tax rates will have to go up to pay for the costs in lost tax revenue and increased government spending associated with the Boomer’s retiring.

  2. Jim Wang says:

    Actually, there’s one more thing about traditional vs 401k iras that you haven’t considered yet.

    If you’re already maxing out your traditional 401k, roths actually allow you to save MORE money right now, as the 15k cap is applied to after tax dollars rather than before tax dollars.

  3. 60 in 3 says:

    Well, it’s more than just taxes. You need to look at the future of politics to see what’s going to happen to every aspect of your financial life, not just your 401k. For example, and I am being as nonpartisan as possible here, if current trends continue, social security seems to be an endangered species. That makes 401k and Roth accounts seem more attractive if you can’t rely on the government to support you post retirement. High national debt might also mean devaluation of the dollar which has interesting effects on which stocks to buy and so on.

    In general, I think people underestimate how much impact the federal government financial decisions have on them. A little bit of research will quickly dispel that belief.


  4. I think it also must be considdered that there are other factors that, along with correcting the national debt, that could increase taxes, but never decrease (like social security bail out, prescription drug coverage)

    For managing risk, you can acctually manage it from year to year and get tax savings. Say you have $10k in a ROTH IRA and $10k in a traditional. If rates go up, you can convert the ROTH (or part of it) to a traditional and take a tax deduction for the ammount. Then, you can convert back if and when rates fall.

    My personal view is that rates will go up. So, I am getting as much as possible in ROTH accounts. Then, if rates are high at later points in my carreer, I can convert to traditional to get big tax breaks.

    I discussed this in a post on Taxation Diversification a couple months ago – http://broknowrchlatr.mypfblogs.com/2007/03/09/taxation-diversification/

  5. Mike says:

    I prefer the Roth IRA (and the Roth 401K if I had that option) because at this particular moment in time I can afford to contribute the higher (after-tax) amounts. I suspect that may not always be the case. I think it’s prudent to make the maximum tax-advantaged investment I can. Given that I don’t know what future taxes will look like, I don’t let the present vs future tax levels argument sway me.

  6. Hm. My earlier comment vanished in the ether…

    I meant to forward this link to you last night, but forgot:

    Roth IRAs and possible future changes in tax laws at the Diehard forums…

  7. lorax says:

    I agree with Trent that tax rates will go up. I suspect that the rates that I will be in during retirement will got up. But I don’t think they will be more than the rate I pay now.

    Others may be in different circumstances. Someone may have enough untaxed income (eg gifts) that their investments will leave them in a high bracket when they sell. That’s not me, I’m sad to say.

  8. Bill says:

    You aren’t taxed on gifts you receive.

    Long-term investments (e.g. mutual funds) are taxed at 15% maximum – I’d expect that to go back to 20%, but nowhere near the rate on ordinary income.

    >Someone may have enough untaxed income (eg gifts)

  9. Engineer says:

    I believe that marginal tax rates will go up. And much sooner than 30 years. The bill for the profligacy of Bush and the Republican congresses of 2001-2006 will soon come due. This will be true even if the boomers don’t retire because of inadequate savings.

    But I also believe that then as now there will be standard deductions and personal exemptions roughly indexed for inflation. I believe that you should have part of your retirement savings on a tax-deferred basis, since the amount of tax-deferred savings that you pull out each year in retirement that’s less than your personal exemption and standard deduction is not taxed at all. Doesn’t make sense to have all your retirement savings in Roth IRAs on which you paid taxes at your marginal rate if your income in retirement is less than that on which you would actually have to start paying taxes.

    How much should you save tax-deferred? In 2007, a person over 65 will not be taxed on the first $9800 of taxable income. So assuming 15 years in retirement, spreading $150K of tax-deferred income over that period would be $10K/year or being taxed on only $200. If you’re more optimistic about your life expectancy, and follow the 4% withdrawal rule-of-thumb, then $250K of tax-deferred income at retirement would be appropriate. That’s per person, a married couple could have twice that amount. I would not try to assume a particular inflation rate, just assume indexing with future inflation. See how far you are from this goal Vs how far you are from retirement, and your tax-deferred savings this year should be pro-rated accordingly.

    If you’re a boomer and have less than $50K in retirement, then all of your retirement savings should be on a tax-deferred basis. On the other hand, if your tax-deferred savings are $300K or more, time to hit the Roth. Personally, I find my tax-deferred savings are adequate and am converting 401K money to Roth IRA, as my employer doesn’t offer a Roth 401k. And I’m contributing to the traditional 401k to the IRS limits, to make more funds eligible for conversion.

    On the other hand, if you’re in your 20’s or 30’s, I recommend that you contribute to both tax-deferred and Roth vehicles (whether Roth 401k or Roth IRA). If your employer offers the Roth 401k with a company match, take that as the company match will be tax deferred anyway. If your employer only offers a traditional 401K, get in that up to the point of getting the employer match (don’t want to pass up free money), then contribute to your Roth IRA.

    And keep your eye on the tax situation Vs your personal savings and situation and be ready to adjust your strategy.

  10. Titika says:

    Here’s another view on this. I’m a single mom of three kids. I have a great education but am currently making a very modest income because I have just returned to work in a new field after homeschooling for seven years. Having fixed hours and working very close to home justify the lower income for now. Learning to live very frugally has had unexpected rewards, and I have managed to pay off all debt except my mortgage.

    In April, I was pleasantly surprised to get a significant amount of money back from the government; as a single head of household with three kids, I unexpectedly qualified for the earned income credit. Basically, I got back everything I had paid into Social Security and Medicare. Not only did I pay off my debt, but I developed a tidy little savings account overnight.

    When I reach my one-year anniversary in November, I will become eligible for my company to match 5% of my salary in a 401K. It’s a no-brainer for me to put the remainder of my salary that’s available for savings into a Roth IRA (as soon as I finish saving six months of expenses). You can’t beat no taxes no and no taxes later!

  11. Sledgehamner says:

    Wouldn’t it be nice not to have to worry about how personal income tax rates affect any investments in the future? That’s how it should be and could be with the FairTax. Check it out at FairTax.org.

  12. Gail says:

    I am 56 with all my retirement funds in both Roths and traditional IRAs. I am working on a 10 year plan to complete converting all my traditional IRA funds to Roth IRAs by the time I qualify for regular Social Security. Why? Two reasons, neither very complicated. First, regardless of tax rates, I prefer knowing that I won’t have to worry about paying taxes at a time in my life when I may not be able to afford it as easily as I can now. (Same reason why I paid off the mortgage on the house). Second, assuming my investments outperform me, my children will not need to pay taxes on the Roth when they inherit and begin withdrawals.

  13. Bill says:

    yes, that will help the kids, espeially if one thinks tax brackets will be higher in the future.

    I am the beneficiary of an inherited IRA and get to pay ordinary income tax on the mandatory minium withdrawals (based on my remaining life expectancy)

    Within a few years, the minimum withdrawal will likely be enough by itself to push me into the next higher tax bracket, affecting all my earnings (at the margin)

    bravo for gail for considering the tax impact on her heirs!

    >my children will not need to pay taxes on the Roth when they inherit

  14. Engineer says:

    Gail, please read my reply above very carefully before you convert ALL your traditional IRA money to Roth. No, saving a tax burden on my heirs in case I die is not a priority. But not becoming a burden to them if I live is a priority. The less I pay in taxes the more probable it is that I can meet my goal.

    But in case you decide to ignore the point I expressed in my earlier post, as a taxpayer I’d like to thank you for paying more than your fair share. Maybe if you can persuade enough others to your point of view, then maybe we could have another tax decrease, and I would pay even less taxes.

    Bill, now that you have mandatory distributions from the IRA you inherited, did you consider whether your 401k plan would allow you to increase your contributions to cancel out the distributions?

  15. Bill says:

    Can’t divert any more income to regular IRA/401K.

    I’d be willing to pay a significant penalty (e.g., 25%, no withdrawals before age 65) if I could convert this to some form of Roth.

    Treasury would get more money, a lot sooner.

    If I withdraw it all now, it costs me 45%.

    Had the opportunity to convert it to Roth 10 years ago, when you could spread out the taxes over years.

    Because of the uncertainty of what would happen if they died before the 4 (or 5) years of the Roth, didn’t do it.

    That was a major mistake I won’t make for my kids – as much as we plan, the fact remains that there are some conditions where we won’t be able to take care of ourselves, for a decade or more before we die.

    Usually it is our heirs who have to take on that responsibility.

    Since they may well have to curtail their career to take care of me, as I did for my relative, I’m going to make sure mine don’t lose a third or more in taxes by favoring Roth plans over regular IRA/401K

    Most would not be as lucky as me to be able to work for a relative.

    Otherwise I’d likely be competing with recent college grads after so long working around my relative’s medical needs.

  16. Engineer says:

    Bill, if your relatives had converted their tax-deferred funds to Roth, then they would have had to pay taxes on that money. So while you would have inherited money tax free, you would have inherited less money. Whether or not it’s a disadvantage depends on their marginal tax rate Vs yours.

    Also, if they had converted ALL their tax-deferred retirement to Roth, then they would have had less money to cover their own expenses during their last few years of life, and less money to leave to you. They would have had to pay taxes on all these funds at their marginal rate, effectively paying taxes on all of it when part of it would have been untaxed anyway due to standard deductions and personal exemptions.

    So I doubt that you are worse off for them not having converted to Roth. Quite possibly you are better off. Reading between the lines, sounds like you may be under-employed. If so, get your career back on track and find an employer with a good 401k plan, one which will allow you to contribute the IRS maximum of $15.5K plus an additional $5K if you’re over 50. Then contribute an appropriate amount plus add an equal amount according to what the distributions from your inherited IRA is. Only if your tax-deferred savings is going to exceed $250K ($500K if married) in equivalent 2007 dollars should you worry about Roth conversions.

  17. Frank Kelly says:

    I think that taxes will be higher in future but the reason I really want to max out my Roth is my personal taxes will almost CERTAINLY be higher at age 65 regardless of what Govt does.

    1) By the time I’m 65 my mortgage will be paid off – no tax deductible there. I’ll probably invest the rest and be taxed on any gains/dividends!

    2) No dependents – kids had better be out of the house and my Wife who is a homemaker now, will probably work outside the home in a few years too

    Between those two big deductions going away my Federal tax rate will be quite a bit higher than it is now. That’s why I’m very happy to pay taxes now rather than later.

  18. Dawn says:

    There is also a major consideration of how MUCH you are being taxed on. As a gardener, I will use that as the comparison…do you want to be taxed on the seeds, or the harvest? When you are young with decades ahead before it’s time to pick the fruit of your savings efforts, the seeds cost a lot less than the harvest will eventually return (in the far-off future). You have to not just compare tax rates, but remember that early in the process, you are being taxed on a lot less (the deposits) than you will be later (the growth). The question just gets murkier as you get closer to retirement…comparing my 17 y.o. daughter (who is not yet paying taxes anyway, so a Roth is a PERFECT solution, i.e. no taxes at all) to myself and my husband at 51 and 53 years of age respectively. As you have less time for that growth to happen, the seeds are a greater share of the eventual harvest than when you started earlier.

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