In as little time as 30 years, tax brackets in the United States have changed completely. During the early 1980s, the top tax bracket was paying 70% federal tax on every dollar earned – which was two for the government and one for you. Today, the top tax bracket pays just half that rate, or 35% of every dollar earned. In just a few decades, the tax brackets have dropped like a rock, while US government spending has grown uncontrollably. It's time to start thinking that tax hikes are on the horizon, and they’re only going to get worse as you near retirement.
Tax rates have fallen dramatically
During the years of Reagan, and of course Reaganomics, the government moved to lower taxes to spur economic growth. And the philosophy worked. Sans the 1987 crash, the growth of the stock market from 1980 to 2008 was strong. This growth was also encouraged by a large drop in capital gains taxes, from their highs of 28% to today’s level of 15%.
No presidential candidate will ever run on an administration of higher taxes, which means that we’ll run into a problem where the government outspends itself, putting future Americans into further debt. Chances are that the debt will come due long before you get a chance to collect on your retirement portfolio; therefore, planning now for higher taxes can only put you in a better long term position.
Social security will bring higher taxes
In many ways, we’re planning to cash in every month with social security programs. However, before we reach the golden years, the baby boomers will eat up every dollar in the social security coffer within a few short years. The National Center for Policy Analysis conducted great study on the economic effects of social security and our medicare systems, and they concluded that 76% of all tax dollars in 2050 will be dedicated to these two programs – leaving little money for the rest of government expenditures. Even if tax rates are doubled across the board, these programs will still require 38% of all tax dollars, and thus, it's easy to bet that your long term tax rates will be substantially higher than it is today. This is a fact of life for which every investor should start planning.
How to shelter your money
There are many ways to shelter yourself from taxes. Of course, there are tax evasion and overseas bank accounts, but unless you’re Al Capone, you might not favor these two propositions. For the law abiding citizen, sheltering your retirement dollars from taxes is made easy by instruments that will help you multiply your gains and draw money tax free.
Roth programs help save you money
Roth IRAs and the newer Roth 401ks are a great way to prepare for higher taxes while still growing your retirement portfolio. Both the Roth IRA and 401k are after-tax deductions, meaning you’ll be paying taxes before you deposit, but you will not be subject to federal income tax as you withdraw. You’re paying good ol’ Uncle Sam a small portion now to protect the bulk of your money in the future. Unless tax rates drop again, which its almost mathematically impossible with current government spending, investing in a Roth IRA or 401k is a perfect way to start.
Roth IRAs have different requirements than a 401k; you’re only allowed to contribute if you have a single income of less than $116,00 per year or $169,000 per year as a married couple filing together. The bulk of Americans fit in with the current guidelines, and the government assumes that if you’re earning more than those two figures, you can afford the tax. Not exactly fair, but when it comes to the government, the rule of law is to take what you can get.
Roth IRAs allow a contribution of up to $5,000 per year or $6,000 per year if you’re over the age of 50. Remember this number is after tax, so you will take a hit of roughly $2000 in taxes if you’re in the 28% tax bracket to contribute $5,000 to an IRA. This all pays off in the end, however, as you won’t owe a dime in federal taxes when you hit retirement.
Roth 401k is a great substitute
For those who might not qualify for a Roth IRA, the Roth 401k opens some doors. Roth 401ks have no caps on income and allow a contribution of up to $15,500, or $20,500 if you’re 50 or older. Just like the Roth IRA, your portfolio grows tax free, and you’ll owe nothing in federal income taxes when you do decide to retire. You’ll be able to save up to $20,500 or $26,500 (over 50) combined in both Roth programs as long as you do not exceed the limit in each program. This is a hefty sum to save for retirement and will be sure to grow into a nice nest egg when the time comes.
Higher taxes are a fact
The laws of probability say that higher taxes are on the horizon; it's just a matter of which politician is willing to stick his or her neck on the line to make the government’s budget balance. Preparing yourself now for higher taxes in the future is just another way to squeeze every penny out of your retirement portfolio, while giving Uncle Sam the cold shoulder from the money you’ve worked hard for.