Conventional wisdom says that the typical American will see their income tax rate fall in retirement, and that motivates many to use 401(k) plans and traditional individual retirement accounts to accumulate their nest egg.
For account owners older than 59.5, dollars in these accounts are taxed only once they are withdrawn as income. Because the account owner is likely to be in a lower income tax bracket in retirement compared to their working years, the tax math says that saving in pre-tax accounts is advantageous.
From the perspective of retirement planning expert Ed Slott, this is an increasingly shaky assumption when put in the broader context of American tax policy. Slott makes this case on the latest episode of the Great Retirement Debate podcast, joined by fellow planning expert Jeff Levine.
Tax rates are historically low right now, they note, while the United States is running a massive annual deficit. And among the looming holes that will need to be filled in the federal budget is the funding of vital programs like Medicare and Social Security.
So while it makes sense, Slott and Levine observe, that tax rates are much likelier to go up, and that the typical future retirees’ income is lower compared with their current working earnings, it remains an open question whether their tax bill will be, too.
“I’ve been warning people for 40 years about the debt and the deficits,” Slott said. “The whole country is running on a credit card. … As of this recording, we’re nearing $40 trillion in debt. Where is the revenue going to come from to repay that? It has to come from higher taxes.”
The real question for financial planning professionals, Levine added, is whether taxes will rise in a given client’s lifetime — and by how much. There seems to be little political will for major tax hikes, at least among the Republicans and moderates in Congress, and it seems unlikely that will change anytime soon.
“So like, if taxes go up in a hundred years, who cares?” Levine joked. “Don’t get me wrong, I worry about our grandkids and great-grandkids and their financial future. But that’s not really relevant from a financial planning perspective today for a near-retiree.”
Slott conceded the point, but at a certain moment the balance will inevitably tip. That’s what’s happened historically, he noted, for example during and immediately after World War II. The nation needed to raise significant revenues to fund the war effort and postwar spending, and the top tax rate peaked at 90%. Many wealthy Americans today find that figure hard to conceive.
Top earners might consider doing Roth conversions early in retirement even if they are in the highest tax bracket. By doing so, they will be “locking in” their current tax rate and taking the risk of a major future increase off the table.
“When I’m having this discussion with people, they often ask me whether I think Congress would move to tax Roth income in the future if the deficit picture looks so grim,” Slott recounted. “I think the answer to that is probably no, because remember, Roth contributions are already bringing in important revenue on the front end. If they started taxing Roths, that would dry up entirely.”
The duo acknowledged the uncertainty around when (and how much) tax rates could rise for workers and retirees. In fact, Levine noted, there are well-crafted arguments for why tax rates could remain the same or even be reduced.
Each financial planner and retiree, then, need to make their own call about how to proceed, he added, based on such factors as age, current income and anticipated overall retirement wealth. Many may find appeal in locking in current tax rates and therefore favor Roth-style accounts, while others may prefer to run the risk that rates increase at some point.
Pictured: Jeff Levine and Ed Slott
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