By now everyone has heard the widely abused clich?, first coined by Benjamin Franklin in 1789: “In this world nothing can be said to be certain, except death and taxes.”
Oddly enough, although these two distasteful events are unavoidable, the entire life insurance industry is built on the actual uncertainty of the first of Franklin’s certainties — namely one’s date of death. Thus, while death’s existence is guaranteed, the randomness of its timing generates a need for risk protection. A family can be left destitute by the premature loss of a breadwinner’s life.
Along these lines, I believe that the financial services industry must do a better job of identifying and managing the uncertainty of Franklin’s second certainty: income taxes during retirement. The memorable point of this month’s lesson is that perhaps the time has come to move taxes to Monte Carlo (in contrast to the people who move to Monte Carlo because of taxes.)
Allow me to explain. If someone were to ask me today to provide a forecast or predict the change in the U.S. Consumer Price Index (CPI) during the year 2020, I would reply with a range between 1 percent and 5 percent, even though it is 13 years away. This is mainly because I have confidence in the Federal Reserve’s determination to keep inflation within a reasonable target. Likewise, if I were asked to predict the total return of the S&P 500 index — or whatever it might be called then — during the year 2020, I would select 10 percent as my arithmetic expectation plus or minus 20 percentage points in either direction. Indeed, we have over 100 years of data for such financial variables, and despite the short-term volatility I am fairly optimistic about equities in the long run.
Of course, you might disagree with my particular estimates but I’m sure you accept the basic premise that inflation, interest rates and stock returns are random. And, that’s why we manage this risk by diversifying, hedging and protecting our retirement income.
However, I would argue that one of the great unexplored sources of risk and uncertainty during retirement lies in our marginal tax rate. If you think about it carefully, this randomness comes from two distinct sources. First, the codified structure of marginal tax rates is up to Congress and politicians. Second, and just as important, I am unsure as to what my particular financial situation and taxable income will look like vis-?-vis this changing schedule.
Currently, a (single) U.S. taxpayer is facing a federal marginal tax rate of 25 percent on income from $31,000 to $74,000; 28 percent on income from $74,000 to $155,000; 33 percent on income from $155,000 to $337,000; and a top rate of 35 percent above $337,000, not including the standard deduction. (All numbers are rounded to the nearest $1,000.)
Remember that a marginal tax bracket measures the income tax you will be paying on the next dollar of income you earn and is distinct from your average tax rate, which is your total tax divided by your income. One of the foundation lessons of economics is that financial and investment decisions should be based on this marginal tax rate and not the average tax rate.
Now, just as a reminder, during the 1970s and 1980s, the top marginal tax rate was over 70 percent. A taxable income of $100,000 resulted in a marginal tax rate of between 55 percent and 60 percent. Yes, we all know that taxes have declined in the last 20 years. But what will the next 20 years look like? How will the U.S. pay for its expensive entitlement programs such as Social Security, Medicare and Medicaid? Can we be certain that someone with an income of $100,000 (in today’s dollars) will continue to live in a 28 percent bracket for the next 30 years of retirement? Will entitlements become means-tested, which effectively increases the marginal tax rate?
Sure, we can use the Congressional Budget Office projections, or some other organization’s long-term estimates for tax rates. But everyone involved in this process will admit that these long-term tax rates are just estimates. In the words of economists, we face stochastic taxation. More importantly, marginal tax rates exhibit much greater randomness than average tax rates.
So what should we do about it, you ask?