This post is part of our Financial Myths series
You may have heard that it’s always better to defer taxes. And, on the surface, it seems reasonable. Why should you give the government your money before you absolutely must? You could be using that money. And what about this tax drag you’ve heard about? We want to avoid that, right?
Here are some factors to consider.
In a world of certainty, where you know that you could either pay $2500 in taxes today or you’ll have to pay the same amount in 10 years, it makes sense to defer the payment, especially if you have more productive uses for those funds. But we don’t live in a world of certainty. And, not only could things change before that tax comes due, for many households, it already doesn’t make sense to defer the taxes.
Lower tax bracket in retirement?
I suspect that this piece of wisdom came about when it was very likely that you would be in a lower tax bracket in retirement than during your working years. Back then, there were so many tax brackets that it was likely that even a small decrease in income would put you in a lower marginal tax bracket. In 1986 there were 15 U.S. federal income tax brackets. Today, there are only 7 U.S. federal income tax brackets (if we don’t count estates and trusts). Today, you could have a much larger decrease in income and remain in the same tax bracket. So, it is quite possible that you won’t be in a lower tax bracket in retirement.
What about the tax brackets themselves?
And, tax brackets shift and change over time. In fact, when considering U.S. Federal Income tax brackets, we are currently near historic lows. Revisiting 1986 again, the top of the 25% tax bracket for Married Filing Jointly couples was $32,270. In today’s dollars, that would be $87,387. That means that a couple with more than $87,387 in taxable income would be in a marginal tax bracket of 25% or higher. The highest tax bracket in 1986 was 50%! Today, a Married Filing Jointly couple with $87,387 in taxable income would be in the 12% tax bracket and the highest federal income tax bracket is 37%. And, in case you were thinking that I just chose an example of crazy high tax rates, in the late 1960s and 1970s, there were 25 tax brackets topping out at 70% and before that they topped out at 91%! Therefore, you should consider the possibility that federal income tax rates rise again in the future.
What about “tax drag”?
Tax drag is how we describe the effect on your investments when your portfolio loses a percentage of its value each year to taxes – which then reduces the funds you have available to put to work for you for the subsequent years. In a tax advantaged account where you defer the taxes until you withdraw the funds (presumably in retirement), you don’t have tax drag. But, how much would your tax drag actually be in practice? You don’t pay taxes on the value of your whole portfolio every year. You only pay taxes on the income you actually realized – so for most people, only on the capital gains from selling an investment or perhaps distributions from stocks and funds and maybe interest. You don’t pay income taxes on the rest of your portfolio that didn’t trade during the year. If you are actively trading your retirement account, then, yes, you could generate significant taxable gains. But if you aren’t actively trading, then the tax drag may have been minimal to start with. And, the taxes paid on long term capital gains that you might generate from trading are relatively low – likely only 15% as compared to as much 24% or 32% on ordinary income in a regular taxable account.
Losing the benefit of capital gains tax rates
Which brings us to another factor to think about. When you withdraw funds from a traditional IRA or qualified traditional 401k, 403b, or other traditional employer sponsored retirement account, you will be paying taxes at ordinary income tax rates regardless of the source of those funds. In other words, if you contributed and deferred the taxes on $50,000 over your working years but due to market gains your retirement account is now worth $75,000, all of your withdrawals will be taxed as ordinary income – even though 1/3 of the amount was really capital gain. If those investments were in a regular taxable investment account the capital gain portion of the income would be taxed at the favorable capital gains rates.
Remember those REQUIRED minimum distributions
And the last thing I would like you to consider today is that you will be required to take distributions from your qualified retirement accounts in the future. That means that you may be forced to take income, whether you need it or not, that pushes you into a higher tax bracket. But, distributions from regular taxable investment accounts and Roth retirement accounts are not required. To compound the tax effect due to forced distributions, your Medicare Part B premium is based on your taxable income and the percentage of your Social Security income subject to income tax is also based on your income. So, not only could you be in a higher tax bracket due to the required distribution, you could also end up paying more for Medicare and subjecting more of your Social Security to taxes.
There’s the myth broken down. Like most rules of thumb, it may apply to some people some of the time, but there are always exceptions. In this case, the idea is outdated at best, and flat-out poor advice for many households