“What is the difference between a taxidermist and tax collector? The taxidermist only takes your skin.” Mark Twain
In our hyper-politicized social climate few sentiments unite Americans like the desire to pay the least amount of taxes possible. This feeling is echoed among millions of Americans every April when our tax bills come due. As painful as it is for many of us to write those checks to Uncle Sam every spring, future tax bills could be significantly bigger and more painful. Could you be one of the millions of Americans sitting on a tax time bomb?
The tax time bomb threat is the result of a combination of several factors converging at the same time: expiring tax cuts, 401k and IRA account balances at or near record highs, and the specter of higher future income tax rates. High income earners and retirees with large traditional 401k and IRA balances will likely be vulnerable to the looming tax time bomb.
The most immediate threat for the tax time bombs that taxpayers face is the anticipated expiration of the tax provisions contained in 2017’s Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act’s tax brackets and rates sunset at the end of 2025 and there is a great deal of uncertainty about what will happen after 2025. If the tax cuts expire on December 31st, 2025, then the income tax environment will revert to 2017 conditions, most notably:
· The current 12% tax bracket will revert to the 15% tax bracket in place in 2017,
· The 22% income tax bracket will revert to the 25% tax bracket in effect in 2017,
· The 24% tax bracket currently in place will revert to the 28% tax bracket from 2017.
While income tax rates are looking likely to increase because of the sunsetting of the Tax Cuts and Jobs Act of 2017 401k and IRA balances are swelling. 2023 saw equity and bond markets rebound sharply from the 2022 bear market, and Americans’ retirement savings grew to record levels. According to the latest data from Fidelity Investments, traditional 401k account balances grew by 14% in 2023, while the average IRA balance gained 12%.
How much worse could tax rates get after 2025?
While a lot can change over the next two years, most signs point to higher tax rates in the not-too-distant future. In his March State of the Union address, President Biden once again repeated his familiar mantra when he called for the wealthy to pay their “fair share” of taxes. It is a good bet that if President Biden wins his bid for re-election in November his agenda will surely include higher taxes on high wage earners and the wealthy in the form of higher income taxes and other measures.
It is an interesting side note that a recent Tax Foundation analysis of IRS data from 2021 reveals that the top 10% of income earners provided 75.8% of all federal income tax revenue for the year, while the bottom 50% of income earners paid a mere 2.3% of all federal income taxes. This leads one to ponder whether the top 10% of income earners should be paying 80%, 90% or 100% of federal income tax revenues to pay their “fair share” according to Mr. Biden.
Knowing that tax increases are likely, what could the top tax rate look like after 2025? Looking at recent history, the highest tax bracket before the Tax Cuts and Jobs Act of 2017 was 39.6%. But there is a possibility that tax rates could go higher too. Many readers may recall that the top marginal income tax rate was 50% as recently as 1986.
Regardless of the outcome of the 2024 elections, there may be few alternatives to higher tax rates as the United States’ national debt has surpassed $34 trillion and something clearly needs to be done to solve the problem of rising debt.
Income taxes are not the only taxes high earners need to be concerned about. Fixing Social Security seems to be a pressing priority once again, and increasing FICA payroll taxes is an option that will surely be explored among many potential solutions. High wage earners could soon find themselves paying both higher income taxes and payroll taxes. Small business owners could be especially hard hit if payroll taxes increase because the employer’s portion would assuredly increase as well.
What can you do now to defuse your future tax time bomb?
There is still time to lessen the financial
impact of higher future taxes, but that window is closing quickly. Here are three strategies that can help
reduce your future income tax liabilities.
One of our favorite strategies is
to convert traditional pre-tax 401k and IRA assets using a Roth conversion. Traditional
401k and IRA account balances are 100% taxable when withdrawn. Since it is highly
likely that income tax rates are going to increase in the future, taking
advantage of lower income tax rates on IRA withdrawals today makes a lot of
sense today, especially for retirees at or nearing Required Minimum
Distribution age (73 or higher today). The
general strategy here is to convert amounts in your traditional 401k and IRA
accounts to take you close to the top of your current tax bracket without going
into the next tax bracket. You will also want to be able to pay the income tax
obligation from assets outside the amount converted to realize the full
benefits of conversion. Once the assets have been converted, all future growth
will be in the Roth account where future withdrawals will be tax-free.
The second option is a simple strategy
to utilize for high income workers: limit or avoid making additional pre-tax
401k and IRA contributions to your retirement accounts. While maximizing our
traditional IRA and 401k contributions has been engrained into our brain for
decades, adding more money to pre-tax retirement accounts makes lowering your
tax bills in the future more difficult. If you want to lose twenty pounds,
eating an entire chocolate cake before dieting and exercising is going to make
your task more challenging, right? The same principle applies to adding more
traditional pre-tax contributions to your existing retirement savings.
Finally, retirees may be able to
lower help themselves avoid tax time bombs using a valuable tool called Qualified
Charitable Distributions (QCDs). QCDs are available to IRA owners who are at
least 70 ½ years old and the distribution must be made as a direct transfer
from the IRA to a qualifying charity.
The major benefit of utilizing
QCDs is that they exclude IRA distributions from income, which is more
beneficial than a charitable tax deduction because an exclusion reduces
adjusted gross income. According to the IRS, about 90 percent of taxpayers take
the standard deduction, making charitable deductions much less valuable to
taxpayers in the current tax environment. A word of caution for those
contemplating adding QCDs to your tax strategy, sequencing matters. QCDs must
be completed before RMDs are taken. When QCDs are withdrawn first they will
count towards the annual RMD amount. QCDs taken later cannot offset RMD amounts
if the RMD is taken first.
Taxes are an important part of
your wealth management strategy and financial plan, and we know the tax
landscape is about to change. To make sure you are not hit with a tax time bomb
call our office today at 419-878-3934 to schedule a time to review your entire financial
picture and improve your future tax situation.
Sources: Wall Street Journal,
Investment News, Tax Foundation