There is a lot of debate about whether to raise taxes, lower taxes, or keep them as they are.
Whether you are a Democrat, Republican, or neither, you’re also an investor. One of the biggest choices many investors make is whether to put their money into a 401k or an IRA.
The 401k lets you invest tax-free now, but imposes taxes on you later. IRA contributions are only made after you’ve paid taxes, but your withdrawals are tax-free when you reach retirement age.
Assuming that you are not able to max out contributions to both plans every year, you are left with a strategic choice: pay taxes now, or pay taxes later.
To make a good decision, you need to analyze two questions:
- Are taxes going to be higher when I reach retirement age, or lower?
- Will I have more taxable income when I reach retirement age, or less taxable income?
You may be tempted to analyze the first question (will taxes go up or down) by considering present-day politics. The problem is that, depending on your age, you probably have a long while to go before you reach retirement age. What is happening today in politics says nothing about the future.
What might indicate the future of our taxes is two considerations:
- Historical tax rates
- The debt
Let’s talk historical tax rates. If you click here, you’ll see an interactive table featuring historical tax rates for every year since 1942 until 2015.
From 1951 until 1963, the top marginal federal income tax bracket was a whopping 91%. If you made more than $200,000 per year, you were paying 91% income taxes on everything over $200,000.
Whether you want tax cuts or tax hikes, the fact is that taxes used to be higher than they are today. I am not saying that means they should be higher. I’m not saying anything about my personal views. I’m just stating an empirical fact. Top-bracket marginal income taxes used to be more than double what they are today.
Now let’s consider the Federal debt. The original Federal Debt was accrued during the American Revolution. The Continental Congress borrowed heavily from the French and Spanish Governments, and supportive Dutch Jewry. After the revolution was won, the Congress debated whether to pay back its debts or not.
In the end, Alexander Hamilton convinced the Continental Congress to pay its debts in order to establish good credit. However, Hamilton warned in 1790, the debt should “be remoulded into such a shape as will bring the expenditure of the nation to a level with its income. Till this shall be accomplished, the finances of the United States will never wear proper countenance.” Meaning, the fledgling Republic needed to structure its debt to be affordable.
Hamilton’s words were prophetic. America’s present debt is far too high to “wear proper countenance.”
Don’t believe me? Click here to see America’s debt clock: http://www.usdebtclock.org/
America’s unfunded liabilities total over 106 TRILLION DOLLARS. That’s an $883,248 liability for each and every taxpayer. Meanwhile, the average taxpayer has $404,189 in assets. Improper Countenance, indeed.
There are two ways to pay down the debt: incredible and unprecedented economic growth for a few decades, inflation, or higher taxes. Which combination will it be? I can’t predict the future, but I wouldn’t be surprised if it comes down to a combination of higher taxes and inflation.
Now let’s consider your personal taxes. Will you have a higher effective personal tax rate when you reach retirement age, or a lower one?
Most people think their taxes will be lower when they reach retirement age (especially if they plan to actually retire). However, that is not always the case. As you age, you may find that losing certain tax deductions and opening up new streams of investment income actually raise your effective personal tax rate, even if you are no longer working.
In summary, no matter your political leanings, and no matter what happens to taxes in the short run, it pays to consider the possibility that your taxes will increase significantly in the future and plan accordingly.