How the wrong tax planning can cost you big $

How inflation makes your tax planning even more important.

 

Everyone understands how inflation hits their pocketbook.  When gas prices double that has a tangible result on your bottom line.

A secondary effect that I believe people fail to consider is the effect that this inflation will have on the tax situation in this country in the next 30 years.

This is a problem that I have talked extensively about with hundreds of financial planning clients as it relates to their current tax strategy. The data shows and I believe the numbers bear out that the wrong type of tax planning now could cost huge amounts of unnecessary tax payments later.

Given that, relative to historical tax rates, the United States has incredibly low income taxes today in 2023 I spend a large amount of time focusing on what taxes are going to be 30 years from now and preparing my clients investments appropriately.

With the inflation and corresponding higher interest rates driven by the Fed, the original problem of a skyrocketing national debt relative to income tax rates has gotten far worse, and this is a compounding issue.

The United States must pay interest on the debt that it has issued. In the last 10 years, with interest rates near 0 the debt service on our national debt, almost $40 trillion under actual GAAP accounting, was still substantial.

That situation has now gotten worse by orders of magnitude.

Not only does continued blow put spending and an addiction to debt drive up the base debt ratio, but the interest payments on the debt necessarily will skyrocket.

In the 1950s the top marginal tax bracket was near 95%.  Today it sits just below 40%.  While our tax system is graduated the point still stands that income taxes are approximately half of their all time highs.

Where will congress take those rates when the piper comes calling?

Moreover, what other negative tax implications does this situation portend?

To give you an idea, the last congressional budget proposal essentially proposed redefining capital gains as earned income.  While the proposal failed, there are still many levers the government can pull to raise money that could ultimately cost wealth accumulators untold sums of their portfolios.

A combination of raising tax rates, compressing tax brackets, and reclassification of types of income (passive to earned, long term capital gains to earned income…use your imagination, Uncle Sam sure will) could be devastating to people who are ill prepared for the future tax situation we will surely find ourselves in if nothing changes.

How to prepare today.

My recommendation to anyone is to create as much tax-free money in as many ways as possible.

When most people are hired and being taken through HR they usually are handed a form to sign up for their company sponsored retirement plan. They will generally do a quick calculation on their employer match, what they can afford from their paycheck, and set up that savings plan.  They then put their nose down and go to work.

This can be a costly mistake.

The main and most familiar way that people have with creating tax free money is to sign up for their company Roth 401K.

Unfortunately, many people don’t even have that option. 403bs, most 457 plans, SEP IRA’s, Simple IRA’s, small business retirement plans, many private pension plans, are all taxed on a pretax basis.

Essentially every dollar in these pretax accounts will be taxed on withdraw, in the future, when taxes will inevitably be higher.  In essence, every dollar invested and growing in a pretax account is owned partly by the investor and partly by the government.

All of the pretax money that Americans are saving today in 2022 will be taxed at whatever the government decides when they pull that money out in 2052.

Moreover, even the mighty 401K only allows up to $20,500 of tax-free savings. Any other profit sharing and company matching goes into pretax buckets.

There is a “back door Roth” solutions that I implement with my clients quite often, there are other more esoteric strategies that allow for much greater contributions to tax free growth and distributions to hedge against the major tax hikes I anticipate for everyone in this country.

At some point the math dictates that everyone, at every income level, will have to pay the tax man.  The question is, how are you prepared for when that day arrives?  The below two graphs side by side tell the story and induce in me a strong need to find every way possible to create non-taxable investment strategies.