The tax-deferred vs. tax-free debate is likely to heat up in 2016 as candidates duke it out for the title of Commander in Chief. Perhaps you’ve noticed a fair amount of polarization among your friends and family behind their particular political party? We have, and we are always looking for ways to strike a common chord with our extended family–our clients.
Here’s a topic that always gets people talking: taxes. Ask your friends or colleagues a simple tax question and you will probably get a consensus answer: What do you think future tax rates will be–lower, the same, or higher?
We’ve posed that question to thousands of people over the years. The vast majority agree that future tax rates are likely to be higher. Only a handful are optimistic enough to believe future tax rates will be about the same. Nobody has ever told me they think future tax rates will be lower.
History bears this out. Taxes are cyclical and we are at a low point. Put simply, taxes are on sale today. How long will this continue, particularly given our expenditures and the growing liabilities associated with an aging population?
Let’s look at three reasons tax deferral might not always be the best solution. First, the unifying pessimism that I just mentioned: We believe future tax rates will increase, not decrease. Holding the invested dollars flat–assuming no growth or loss–a client who believes future tax rates will increase will do himself a disfavor by choosing an investment that defers taxes until later.
If we agree that future tax rates are likely to be higher rather than lower, and if we choose a tax-deferred investment vehicle, are we not choosing to pay more in taxes than we have to?
The second critical mistake we make is this: As our tax-deferred investments grow, so do our taxes. Tax-deferred essentially means tax-compounded. It has to be, or you have not grown your money. How can this be? If you hold taxes constant, and you grow the overall asset pool, then you’ve grown the total tax bill. The hope, of course, is that we fall into a lower tax bracket in retirement.
But let’s be honest, we accumulated money in tax-deferred qualified plans and most people spend this money at about the same rate at which they spent money before they retire. It’s a minority–admirable as they are–who find a way to increase their quality of life and decrease their taxes. But this should be the goal!
Third, we lose income tax deductions as we age. The home mortgage interest deduction disappears at the conclusion of a 30-year mortgage. For many wage earners, a mortgage deduction and standard deduction are their best friends. Furthermore, empty-nesters no longer claim their children as dependents. Retired folks, by definition, are no longer contributing to a pre-tax 401(k) or claiming tax deductions for another retirement plan. Finally, business owners who retire lose the benefits of a business tax shelter.
The goal of a good accountant is to save taxes today. But the goal of a financial advisor is to increase and preserve wealth over the long haul.