In 1983, a great surprise came to many as they discovered that up to 50% of their Social Security would now be subject to taxation. This was one of the federal government’s first displays of its desperation to deal with the financial burden of its decades’ worth of overpromising. It didn’t stop there: The Deficit Reduction Act of 1993 further expanded the taxation of Social Security benefits to add an additional bracket where up to 85% of Social Security benefits could be taxable. What was once a tax-free source of income for retirees now became taxable. This is one indicator that showed the federal government’s inability to stay solvent with this federal program and its eagerness to get its hands on more tax dollars. With millions of baby boomers retiring (nearly 10,000 per day), the federal government is grasping at straws to find ways to keep Social Security solvent.
This is only the tip of the iceberg. There are 448 federal agencies that collectively consume trillions of tax dollars each year. 91% of our tax dollars are consumed by just a few of those 448 agencies: health care (Medicare, Medicaid), Social Security, income security (veterans’ benefits, food and housing assistance, federal employee retirement, and disability), National Defense, and interest on our national debt. This leaves the federal government witha remaining 9% to fund the other hundreds of federal programs and agencies.
The congressional budget office projects that if no changes are made to Medicare, Medicaid, and Social Security, the tax rate for the lowest tax bracket would have to increase from 10% to 25%, the tax rate on incomes in the current 25% bracket would have to be increased to 63%, and the tax rate of the highest bracket would have to be raised from 35% to 88%. This tsunami of spending has prompted individuals of high political importance to speak out. David Walker, comptroller general for 10 years under President Bush and President Clinton, held a serious role in our government. As comptroller general, David Walker was the nation’s chief accountability officer and head of the U.S. Government Accountability Office (GAO). In reference to our government’s deficit spending, he stated, “Regardless of what politicians tell you, any additional accumulations of debt are … basically deferred tax increases. … Unless we begin to get our fiscal house in order, there's simply no other way to handle our ever-mounting debt burdens except by doubling taxes over time.”
According to the Center on Budget and Policy Priorities, in 2018, the federal government spent $4.1 trillion on services it provided — $3.3 trillion coming from federal revenues, while borrowing the other $779 billion. Stated word for word on their website and in reference to the $779 billion dollar 2018 deficit, “future taxpayers will ultimately pay this deficit.”
Some individuals find it difficult to believe that taxes can go as high as 88%, but our highest historical tax bracket soared to 94% for the highest income earners in the early 1940s. In fact, Ronald Reagan tells a story in his biography of only being able to create two films a year as an actor due to skyrocketing taxes. A second film would have pushed him to the 94% bracket. By creating a third film, all of his earnings would be taxed at 94%, leaving him with 6% — but the state of California would have gobbled up that 6%.
And why did the federal government raise taxes so high, you might ask? Because of our national debt. Once it was brought under control, taxes were lowered. So this begs the question: With our debt skyrocketing today, where are tax rates headed?
The usual argument that is brought up in response to the 94% tax rate is that “only the highest income earners paid those higher amounts.” This is true, but the middle income earners paid the price too. Those earning $6,000 or more in 1944 ($86,632.07 in today’s dollars), were subject to a 33% tax bracket, married filing jointly.
So, why are we discussing taxes and retirement? It’s simple: tax rate risk. Tax rate risk is the risk associated with the potential for tax rate increases in the future. And why are we talking about IRAs and 401(k)s with tax rate risk, you might ask? Because every dollar that comes out of these plans counts as ordinary income. Is the lightbulb starting to come on? With your qualified plans, your distributions may be taxed at much higher rates if the federal government decides to increase taxes. It may be safe to say that the trapped dollars in your qualified plans could be subject to inordinate amounts of taxes.
So what can be done to help alleviate the potential onset of taxes coming down the road? Roth conversions.
As of 2010, the federal government lifted the cap on the amount of qualified funds that can be converted to a Roth. This allows an individual to convert the IRA to a Roth and pay taxes on the conversion at today’s tax rates. Why convert? First, we have one of the most favorable tax rates in our history. By converting today, you may be able to take advantage of a tax rate we may never see again. Also, once part or all of the IRA is converted to the Roth, growth and interest is not taxable. Not even a penny. Nor does any bit of growth or income from the Roth affect or trigger taxation on means-based programs such as Social Security and Medicare. Nor do you have to take withdrawals from the Roth if you don’t want to. It can truly be a tax haven for investors.
This content was brought to you by Impact PartnersVoice. The information provided regarding tax minimization planning is not intended to (and cannot) be used by anyone to avoid paying federal, state or local municipalities taxes. Consult a tax professional for further information.Adam Wright is a Registered Representative of and offers securities through Center Street Securities, Inc, member FINRA/SIPC. Investment advisory services offered though Center Street Advisors, Inc. Insurance and annuities offered through Adam Wright, AZ Insurance License #17407832. DT924781-0820
