How to Prepare Your Finances for Higher Taxes

by Kevin on July 13, 2009

Last week I told you that taxes in America must eventually go up. Today I’m going to give you some tax ideas to help you best prepare for that new future. I’m not a tax professional so take these ideas with a grain of salt, but I hope you’ll see that most of them as common sense.

Realize America’s Tax Situation

Obviously first you must assess our tax situation for yourself. You need to know how taxes are affecting you today, and how they might affect you in the future. This may seem simple, but put some thought into what size portfolio you are attempting to build or how much money you plan to withdraw each year during retirement. These would affect what tax rate you might get hit with.

Avoid Tax-Deductible Retirement Accounts

This may seem insane, but I would stop contributing to my tax-deductible retirement accounts. In fact I’ve done just that. For the average American these tax-deductible retirements accounts are traditional 401k and traditional IRA accounts.

Here’s how these tax-deductible accounts work. Your paycheck is typically $1,000 before taxes and fall in the 25% tax bracket. Normally you would pay $250 in taxes and you would net $750. Now if you put $100 into your tax-deductible account your before-tax amount would fall to $900 and your taxes would drop to $225. You would net $675. You just saved $25 in taxes.

That sounds great, right? You just saved $25 for free.

But you’ve got to pay those taxes when you retire and start withdrawing those funds for your annual income. That’s all well and good if your tax rate is the same or less than it was when you initially put the money into the account.

Remember, tax rates have to go up eventually. Our government cannot continue to print IOUs. We, as a nation, have to bring in additional income to pay for our deficits. What if your tax rate is 30%, 40%, or 50% when you retire?

You had the option of paying at 25% and knowing what the cost would be. Waiting may turn out in your favor… then again with our budget deficits it may not. I’d rather pay now and know that I won’t have to pay again.

Don’t Forget to Get Your Match

Don’t drop your 401k completely. You still need to get any employer match offered. Unfortunately in this economy many employers have slashed or eliminated their match so perhaps this isn’t as big of a deal for you.

But if you’re still getting a match make sure you continue to contribute just enough to get the full match. Otherwise you are leaving money on the table.

Other Investment Options

Roth IRA

Primarily you will be looking at after-tax retirement options. The best option available to almost everyone is the Roth IRA. I say almost everyone because your ability to contribute to a Roth IRA is limited by your income. As a single person if you make less than $105,000 per year you’ll have no problem contributing the maximum amount of $5,000 per year ($6,000 if you are age 50 or above). From $105k to $120k your ability to contribute is slowly reduced. From $120,001 on up you won’t be able to use a Roth IRA.

Your Roth IRA is funded with post-tax money, so you’ve already paid tax on it. This means you won’t pay federal income tax on the money ever again. (Although I’m not holding my breath. I’m sure they could figure out some new way to tax you on it again!)

No need for fancy accounting to figure out how much your portfolio is really worth after taxes. Just look at the total. That’s how much it is worth. (State tax situations will, naturally, vary by state.)

Roth 401k

The Roth 401k is slowly growing in popularity. Unlike the Roth IRA you can’t give yourself this option. You must wait (or encourage!) your employer to adopt it.

What’s the difference between a Roth 401k and a Traditional 401k? The same as the difference between Traditional IRAs and Roth IRAs. A Roth 401k is a post-tax retirement account. Money is deposited directly from your paycheck into the account and your employer picks who runs the account.

My employer offers this option and it is what I use. (Unfortunately since our 401k match is pathetic I only contribute enough to get the match.)

Prepare for Tomorrow… Today

It is easy to mentally dismiss your tax planning for retirement. For many of you that is 10, 20, or 30 years down the road. But just as with any other type of financial planning the steps you take today will make your life that much easier tomorrow.

Even if tomorrow is in thirty years.

{ 1 trackback }

Carnival of Personal Finance #214: United States Presidents Edition
July 20, 2009 at 6:54 pm

{ 14 comments… read them below or add one }

SavingDiva July 13, 2009 at 8:15 am

I have a Roth IRA, so I think it’s worth the gamble. However, I do worry that the government will end the tax break on withdrawal for Roth accounts if the situation gets too dire.

Reply

Kevin July 13, 2009 at 8:19 am

@SavingDiva: I worry about this, too, but essentially that is double taxation. I can’t imagine that flying… but you never know.

Reply

Liz July 13, 2009 at 9:36 am

You’ve failed to consider a few things:

1) Roth limits on joint income are even lower, when you consider what each individual would need to make to qualify. So for married couples, if each is making $80,000, the Roth IRA is not an option.

2) Limits on Roth contributions are far lower than limits on 401k contributions.
If someone can save the full $15,500 allowed per year, and doesn’t have a Roth 401k, you are basically telling them to keep it in a taxable account. This isn’t good advice for many people, as they’ll have to pay taxes on annual distributions. Isn’t a 401k better than a taxable account, for money available AFTER a roth has been fully funded?

Reply

Jane July 13, 2009 at 9:45 am

The US tax structure is filled with instances of double taxation. The technique doesn’t have to be anything exotic or even as obvious as a direct tax on money taken out of retirement accounts. Think of increased general sales taxes, targeted excise taxes on an ever expanding list of “luxury goods” like big cars or houses or services like travel, or a national Value Added Tax (VAT). What you save on income taxes could easily be lost by later tax increases on spending.

Reply

Boris Vanharlingen July 4, 2011 at 5:49 pm

What an ridiculous collection of nicely finished articles, it looks like now-a-days everyone is simply copy/pasting and stealing content material all the time, but I guess there’s still hope in trustworthy blogging.

Reply

PT Money July 13, 2009 at 10:09 am

“But you’ve got to pay those taxes when you retire and start withdrawing those funds for your annual income.”

Correct me if I’m wrong, but to be more precise, you’d only have to pay taxes on the earnings from the initial contribution. The initial contribution will never be taxed. And that’s instant tax savings, in the bank!

Great post, Kevin. I agree. Taxes will likely be higher in the future. I like to try and encourage both routes though: take advantage of the 401k max now and Roth IRA max now. Hedge yourself.

Reply

Kevin July 13, 2009 at 12:04 pm

@Jane: But wouldn’t this apply to both Roth and Traditional funds? That is your traditional funds will still be taxed at an income rate, and then your spending of those funds will as well. (Unless you think they will drop the income tax in favor of the VAT completely, but I highly, highly doubt that will ever happen.)

@PT Money: My understanding of a traditional 401k is that you pay taxes on everything including contributions. Otherwise you would be completely skipping out on paying taxes on the money — something the government isn’t too fond of.

For example imagine you had a 401k that you funded with $15,000 in one year and nothing else again. When you go to retire the fund is only worth $14,000. You withdraw the funds for income. if you didn’t pay taxes on the money itself, but the earnings, then you wouldn’t pay any taxes.

Instead I think it works where you would pay taxes on the $14,000 when you withdraw it whether or not it had earnings or losses with it.

I could be wrong…?

@Liz: You’re absolutely correct. In fact I meant to mention the lower income requirements for married folks and the lower amount you can put in.

So yes, after you max out your Roth options then a traditional 401k is not a bad option especially with the larger amount of money you can set aside. Thanks for mentioning these two.

I guess personally I missed the married income requirements because I don’t know many people who make $100k, not to mention a dual-income family that makes $160k.

Reply

Liz July 13, 2009 at 7:29 pm

Depends on where you live. In some areas, $160,000 is chump change. Where we live, two teachers that have been working for a while could make that much, especially if they have activity stipends or work during the summer. Starting salaries for teachers in our area are over $40k.

I actually max out my 401k and my husband does the same, because it’s the only way to get our income low enough to allow us to make a Roth contribution. We’re right near the limit.

As for taxation of contributions, you are right. In a traditional IRA, any contributions that were not taxed on the way in are taxed on the way out. (So if you have a non-deductible traditional IRA, the contributions are not taxable.) However, in a Roth IRA, only the earnings are taxed upon withdrawal.

Reply

Jake July 13, 2009 at 7:53 pm

@Liz

I believe that under the Roth system, your income is taxed at your regular rate when you contribute, but then grow tax free, meaning that if you contribute $20k that balloons to $1 million by the time you are eligible to take distributions you have $1 million free and clear, having only paid your standard income tax rate on the initial $20k when you put it in.

I could see the gov’t taking away this benefit in the future, but rather than sticking it to the funds already in the accounts just saying that you can no longer contribute in that manner and letting the issue work itself out. At least, that’s what my wife and I are banking on with both Roth IRA’s and Roth 401(k)’s!

Reply

Liz July 13, 2009 at 10:16 pm

Jake, you’re right, I misspoke (mistyped), and of course I know how it works. I must have been thinking of the ability to withdraw contributions without penalty. THANK YOU for making the speedy correction so that people know how it really works.

I agree that it would be unlikely for the government to retroactively take away the benefit, so I think you and your wife are being very wise!

Reply

Kip July 14, 2009 at 7:27 am

I would like to take your advice, but am stuck. My employer match is 25% of up to 10% of my income. The only way I get full match is by contributing 10%. I am worried of the increased tax rates and have come to the troubling delimma of trying to predict how much the tax rate will increase as to whether to continue to fund the whole amount. I have already maxed my RothIRA this year and would just be dumping this money into mutual funds of my choice (probably an array of the ones Fidelity offers).

Reply

CLB July 15, 2009 at 9:10 am

I struggle with the Roth IRA versus 401K question and would like your take on this thought process. I like that in the 401K the government’s money works for me until years later, when I give them a cut. More money early on has more time to compound so that even if I pay more taxes later (very likely!) I have a larger pool of money take from. Putting in, say, 1000/year pre-tax vs 750/yr post tax means a larger pot at retirement. Since I’ve no plans to withdraw it all at once, that larger pot continues to grow at a faster rate then the post tax dollar fund, making up for the larger withdrawals needed to pay my taxes. I also hope that I don’t outlive the funds in my 401K, meaning when I die, there will still be funds that I haven’t withdrawn and paid taxes on.

Reply

Kevin July 16, 2009 at 9:52 am

@Kip: If you are already maxing out the Roth IRA option, then keep utilizing that employer match. So you’re saying if you contribute 10% they will contribute 2.5%? I would keep on doing that. Never turn down free money. (That’s like getting an instant 25% return.)

@CLB: I’ve actually heard of it the opposite: let’s say the max of your 401k each year was the same as the max of the Roth IRA (it isn’t, but just go with me). Let’s say you can only put $5,000 into each.

So you put $5,000 into the Roth IRA and $5,000 into the traditional 401k. You’ve technically put the same amount of money in, but really the Roth IRA has more money in it. How is that possible? Because the $5,000 in the 401k hasn’t had taxes come out of it yet. So even if your tax rate was 15%, that $5,000 is now worth only $4,250.

Now in your example of $750 vs $1,000 is a different situation. In fact you’ve given me inspiration for a post. I’ll post it up tomorrow.

Reply

The Tax Club September 10, 2009 at 5:10 am

Kevin, I think you are right in replying to CLB with the calculations. Any further insights on the same? This discussion is quite helpful, BTW!

Reply

Leave a Comment