Earlier this week, Fed chairman Jerome Powell appeared before Congress and spoke in serious terms about the country’s debt situation. It is worth understanding what Powell said—and how that might impact your investments.
Powell’s message: “The U.S. federal government is on an unsustainable fiscal path.” Specifically, “debt as a percentage of GDP is growing, and now growing sharply, and that is unsustainable by definition.”
Powell’s remarks mirrored those of the Congressional Budget Office (CBO). In June the CBO reported that, “Under current law, federal debt held by the public is projected to increase sharply over the next 30 years” to 152 percent of GDP. “That amount would be the highest in the nation’s history by far.” To put that in perspective, the CBO explained that interest payments alone would grow to equal what we spend on Social Security, the government’s largest budget item.
Why dwell on these grim figures? It is important, I believe, because ultimately there are only a few solutions to this problem—and one of them is to raise taxes. In fact, it isn’t just that taxes might go up; they are actually scheduled to go up. In 2025, most of the favorable 2017 tax rate changes are set to expire. Unless Congress acts to prevent it, personal tax rates will then revert to 2017 levels.
To be clear, my goal is not to worry you—and things certainly could go the other way. If economic growth is better than expected or interest rates are lower than expected, our debt would grow more slowly, and Congress might delay the increases.
But no one has a crystal ball, so it makes sense to prepare. What planning steps can you take today to protect yourself against higher tax bills down the road?
For the most part, your tax bill in any given year is simply a function of your income. Yes, you can make adjustments around the margins—with charitable contributions and tax-deferred savings, for example—but you don’t have a whole lot of options from year to year. Where you do have more control, however, is with your future tax rate, in retirement. But it requires planning. Here are some steps to consider:
Build tax-free savings
There are a few ways to build tax-free savings, but the most efficient is a Roth account, which allows your investments to grow entirely free of capital gains tax. If you can build up assets in a Roth account, there is a double barreled benefit: Roth withdrawals are tax-free, and because of that, you may end up with a lower tax rate on all of your other income. There are at least four ways to build Roth savings:
1. Roth 401(k): Some employers offer a Roth option within their 401(k) plans. While some might opt for traditional 401(k) contributions—to capture the tax deduction—this is where I would bear in mind chairman Powell’s comments. If tax rates are higher in the future, you might be better off foregoing a deduction today in order to build tax-free assets for the future. If you’re not sure, I would at least consider splitting the difference, putting half of your contributions into a Roth.
2. Roth IRA: Even if your employer doesn’t offer a Roth option in your 401(k) or 403(b), you can still contribute to a Roth account on your own, via a Roth IRA. Depending upon your income level, you might have to contribute via the “back door” method, but everyone (with income) is eligible. The annual contribution limit is now $6,000 per person.
3. Roth conversion: If you have accumulated IRA assets, you always have the option to convert a portion to a Roth IRA. The catch is that you’ll have to pay tax this year on the amount you convert. But depending upon where you are in your career, if tax rates rise in the future, you might be better off paying taxes at today’s rates. It’s not an easy decision to voluntarily trigger a tax bill—especially a big one—but it’s worth considering before 2025.
4. Super-funding: If your employer doesn’t offer a Roth option, and you’re not satisfied with the $6,000 IRA contribution limit, there is another approach that might work. In an article last fall, I described a method for “super-funding” a Roth IRA via after-tax contributions to a 401(k). If your employer permits it, this is a powerful way to build a substantial Roth balance.
Don’t overlook taxable savings
If you’re in a high tax bracket, you may feel compelled to contribute as much as possible to tax-deferred accounts. In general, this makes sense, but don’t overlook the value of saving in a taxable account. This will allow you to further diversify your sources of income in retirement. Depending upon your particular mix of income and assets, this may allow you to better control your tax rate over the years, especially after age 70.
Don’t forget about estate taxes
Following the 2017 rule changes, estate taxes are no longer much of a consideration for most people. The exclusion—meaning the amount one can pass on to heirs tax-free—doubled to more than $11 million per person, or $22 million for a married couple. Many people took this as an opportunity to cross estate taxes off their list of concerns. But keep in mind that estate tax rates historically have seen more frequent and more significant change than income tax rates. So it’s entirely possible that a future administration might bring the exclusion back down. For that reason, if you have assets greater than $5 million, I would still consider taking steps to reduce your potential estate tax burden.