We just came out of an intense election season, and as always, talk of taxes was at the forefront. Raise taxes, cut taxes, increases taxes for the rich; everyone seems to have an opinion and these opinions often differ, especially across party lines. One thing that most professionals agree upon, though, is that taxes will most likely be going up in the future.
Why Do Taxes Increase?
Simply put, taxes fund government spending, and the more the government does, the more taxes are needed. With our aging population accessing Social Security and Medicare, government programs like Obamacare and federally subsidized student loans, and interest on our ever-growing national debt, our government is going to need more resources in the future. The Heritage Foundation states that at current tax rates and expenditure levels, tax revenues will be fully consumed by 2030. (1) This is a sobering figure which will necessitate tax rate hikes.
Historically Low Tax Rates
The possible rate increases shouldn’t come as any surprise because tax rates are historically low right now. Throughout most of the last century, tax rates have been much higher than what we see now. In 1945, at the end of World War II, the highest tax bracket was 94%. However, tax rates stayed elevated, with a top rate of 70% the norm well into the 1980s. Compared to that, our current 39.6% is incredibly low, which is why we can expect tax increases to come our way.
Marginal Vs. Effective Tax Rate
The figures above don’t actually mean that some people were paying 94% of their income in taxes in 1945. The way our tax system is set up, different portions of income are taxed at different rates. The highest bracket a person’s income reaches is called their marginal tax rate, while the average tax they pay overall is their effective rate.
To illustrate, let’s look at what a single person with $250,000 of taxable income would pay in 2016.
How Can You Prepare For A Tax Hike?
It’s difficult to plan for future law changes, but there are several ways to strategize when it comes to taxes.Keep in mind that while you should take steps to prepare for a tax increase, you shouldn’t make financial decisions based solely on avoiding taxes. But there are several strategic options you can take to reduce the effects of a future tax hike.
Don’t wait until the laws change to put a plan in place. Be proactive, examining multiple areas of your financial life to see where tax increases may affect you. Then work with your financial advisor to find strategies to minimize their impact. This way, when changes come, the uncertainty won’t cause you undue stress and worry.
Max Out After-Tax Accounts
When you contribute to your pre-tax retirement accounts, you save income tax right away. Unfortunately, that means you’ll pay taxes on the money when you withdraw it. While your income may be less when you are retired and draw on those savings, taxes may also be even higher at that time.
A smart choice is to invest in a Roth IRA to achieve tax-free growth, which allows the taxpayer to prepay taxes and lock in current rates. This will shield you from future tax rate increases. One caveat: if the tax system changes and new taxes are added, such as a consumption tax, then the Roth tax vehicle does not protect against them.
Contribute To A Health Savings Account
Medical expenditures are inevitable, even if you are healthy. Most insurance plans include high deductibles so even routine appointments and care can cost you. A Health Savings Account (HSA) lets you put pre-tax funds aside. As a bonus, you won’t pay taxes when you withdraw the money for qualified medical expenses.
Reevaluate Your Investments
You want your investments to grow, but some mutual funds do a better job than others when it comes to tax efficiency. Some tax-efficient options for you are index mutual funds and exchange-traded funds (ETFs). As taxes increase, make it a priority to focus on tax-efficient returns increases for your investments.
Consider Municipal Bonds
Residential municipal bonds can be tax-free investments that could ensure your income will not be affected if tax rates increase. While these bonds may not bring in as much income as taxable bonds, they may offer more protection against tax hikes in the future.
How We Can Help
In light of the recent election and historic tax rates, it would be wise to review your portfolio to see if it is prepared to weather a tax rate hike. An experienced financial professional can easily identify any weaknesses in your portfolio and recommend any improvements that should be made. If you need someone to go analyze your portfolio to see how it will fare in different tax environments, send me an email at email@example.com or call my office at (612) 746-2261.
About Jon Marker, CLU®
Jon Marker is a financial representative with Foster Klima & Company and independent financial advisor. He combines his 24 years of experience in the financial services industry with his passion for helping to create individually tailored financial solutions for business owners, professionals, and their families. Through insurance, succession planning, legacy planning, and other financial services, Jon strives to provide specialized guidance for a lifetime of financial security. As a Chartered Life Underwriter® (CLU®), he has an in-depth knowledge of the insurance and risk management needs of individuals, business owners, and professionals. A lifelong Minneapolis, Minnesota resident, he specializes in serving successful and family-oriented business owners and professionals throughout the Twin Cities. To learn more, visit www.jonmarker.com or connect with Jon on LinkedIn.