A lot has been written about future
tax rates and what you should be doing now to lessen the impact of potentially
higher taxes in the future. Common
strategies include Roth conversions, accelerating stock option income, or
delaying tax deductions like charitable gifts.
We seldom want to pay tax earlier or wait on a deduction longer than we
have to, but if rates are going to be higher in the future, then it may make
sense. Unfortunately, this decision is
not as simple as “taxes are probably going up, so pay the tax now at a lower
rate.” It’s possible that your taxes
will go up, but your rate may not.
The reason is based on effective vs.
marginal tax rates. In plain English,
your effective tax rate is the average tax rate you pay on all of your income,
and your marginal tax rate is the tax rate you pay on the next dollar of
earnings or the amount you save with the next dollar of deductions. It’s very common for a married couple earning
$400,000 to have a 40% marginal tax rate, while having an effective tax rate
closer to 25%. The effective rate is
always lower because of personal exemptions, itemized deductions, and the
progressive nature of our tax system.
When we do tax planning, we focus on
the impact of the next dollar, the marginal tax rate, because most of your tax
bill is already determined by reoccurring events like your salary, portfolio
income, or distributions from retirement accounts. Our elected leaders view your tax bill a lot
differently. They don’t really care
about the tax rate on the next dollar of income; rather, they are more
concerned with your total tax bill on all of your income.
How can your total tax bill increase
if your rate does not? There are a lot
of ways: 1) Reduce deductions and
loopholes; 2) Increase the tax base (tax municipal-bond interest, tax capital
gains at ordinary rates, etc.); 3) Increase payroll taxes.
These are not new ideas. Options 1 and 2 have been used repeatedly in
the past and were included as part of the bi-partisan Simpson-Bowles
proposal. Option 3 occurs every year
when the Social Security wage base increases.
As the chart below shows, marginal rates have been falling since the
1960’s while tax revenue as a percentage of our economy has remained pretty stable.
The fact is our future tax code is
uncertain. There are two things that
must be done to combat this uncertainty:
1) Make holistic decisions – income tax
planning must be weighted with your estate tax situation, diversification
needs, philanthropic goals, etc. Even if
you knew your rate was going to be lower in the future you may still
want to do a Roth Conversion or exercise additional stock options now.
2) Build a number of different “buckets
to tap” including a taxable account, tax-deferred account (401(k), IRA, 403(b),
etc.), and Roth IRA. This will give you
multiple ways to generate cash flow and allow for more flexible tax planning.
If you have any further questions
about your unique circumstances, please don’t hesitate to contact us.