I’m very concerned about taxation. I believe the current administration will not only raise taxes on households making $400,000 per year, but on many more households making much less. With all the money going into these giant stimulus bills, I’m having hard time believing tax rates will ever go back down. How can I properly prepare for this idea from a financial perspective?
Michael; Chattanooga, Tenn.
If you’re right about tax rates going up and never coming back down, Michael, the Roth IRA is about to become the most popular financial concept. And so will every financial vehicle that resembles Roth IRAs.
To form a proper tax strategy as it relates to your investments, it’s important to understand the three primary types of taxes you can be subject to from a timing perspective, and more importantly how to avoid them:
- First there’s the tax you pay on your income now, and your ability to avoid it via traditional retirement plan contributions.
- Next there’s the tax you pay on investment gains throughout the year, which you can avoid with a handful of investment vehicles.
- And finally there’s the tax you could be subject to upon withdrawing money from retirement accounts as you use the money to live.
How NOT to spend your stimulus cash: Avoid purchases that require future payments
Determining your own long-term tax strategy is incredibly important, and to do it properly you do need to consider both the short and long-term direction of tax rates. While it’s incredibly easy to assert “tax rates will go up forever now,” the truth is historical tax rates offer a different reality.
To be wealthy and alive in 1913 meant your tax rate capped-off at 7%. Which is a lot better than being wealthy and alive in 1944 when the top bracket taxed people at a 94% tax rate. The 1950s, 60s, and 70s all had tax brackets north of 70%. And while we can certainly look at the data and surmise how Americans felt about those tax brackets, I’m not sure I can completely get my head around a 94% tax rate.
The good news is you can invest for the future in a tax sensitive way, based on what direction you think tax rates are headed.
Essentially, you need to decide whether you’d rather pay taxes at your current tax rate or some future tax rate, which would be determined by both your future income and the future tax rate.
► For those people who’d rather get a tax benefit now and pay taxes later, a traditional 401(k) or traditional IRA is generally the path. Investors get to deduct their contribution to these accounts from their income during tax filing, avoid the obligation to pay taxes on the accounts as they grow untouched over the years, and then simply pay taxes on all the money at withdrawal.
The government ensures you participate in this last part of the equation by requiring you to withdraw money once you reach your 70s, thus receiving the tax money they’ve patiently waiting for.
► However, if you feel like astronomical tax rates are making a comeback, and will be part of your reality throughout your retirement years, then a Roth 401(k) or Roth IRA is likely the better retirement vehicle to satisfy your tax rate predictions.
In other words, pay taxes on your income now, make after-tax contributions to one or both of these Roth vehicles, avoid the obligation to pay taxes on the accounts as they grow untouched over the years, and enjoy tax free withdrawals at retirement. The idea of tax free withdrawals is always appealing, but it’s downright euphoric if the tax rates you’re avoiding are sky-high at withdrawal.
If you’re in the Roth camp and still need more ways to generate tax-free income at retirement because you’ve maxed-out your Roth 401(k) and Roth IRA contributions annually, various permanent life insurance plans can be an option when structured and utilized appropriately.
The final little piece to the puzzle involves Health Savings Accounts (HSA).
HSAs are the most tax advantageous vehicle out there. You can deduct the contributions from your taxable income now, avoid the obligation to pay taxes on the accounts as they grow untouched over the years, and then make tax-free withdrawals to pay for health care as needed.
No matter your belief on what direction tax rates are headed and for how long, there’s a way you can properly invest to take advantage of your belief. You should absolutely talk to a tax professional and a financial planner about how to properly make these types of decisions, and how you can even convert previous traditional IRA accounts to Roth accounts if appropriate.
Peter Dunn is an author, speaker and radio host, and he has a free podcast: “Million Dollar Plan.” Have a question for Pete the Planner? Email him at AskPete@petetheplanner.com.
The views and opinions expressed in this column are the author’s and do not necessarily reflect those of USA TODAY.
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