In a 1789 letter, Benjamin Franklin wrote, “our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” It makes one wonder if Mr. Franklin could have imagined the varied tax rates that would apply over the coming centuries. Today, as the US federal budget deficit continues to grow, projected to reach $1 Trillion in the coming years, we consider how tax rate risk, or the potential for rates to increase from current levels, can affect your savings plans. How can we save strategically in light of the potential for higher federal tax rates to close projected budget deficits?

Investors have two main options for retirement vehicles: traditional accounts and Roth accounts. Their characteristics are described in the table below:

If we knew future tax rates, deciding which account to use would be easier. Many investors saving for retirement expect to be in lower tax brackets when they stop earning wages, so they prefer the current tax deductibility of traditional accounts. On the other hand, many younger workers, who may earn less and find themselves in lower tax brackets, prefer to pay the taxes today and access their savings tax-free in the future. Readers might be thinking, “it can’t matter that much, the difference between the top two tax rates is only 2% today.” Let’s consider where income tax rates have been throughout history.

Tax rate risk should be considered as future tax rate regimes cannot be perfectly known. For example, a married couple with income of $100,000 would have experienced a marginal rate of 1%-43% since the introduction of income tax in 1913. In addition, a person’s level of income in retirement is also unknown. Though some income in retirement such as Social Security or pension may be predictable, investment income forecasts are not as accurate. Traditional retirement vehicles require minimum distributions once the owner reaches age 70 ½. If these savings grow larger than anticipated, the distributions may become large enough to push you into a higher marginal rate. What if you’re already in the highest bracket? Surely you’ll be in a lower bracket during retirement, right? Not necessarily. Historically speaking, the top marginal rate is relatively low at 37%. Throughout the 50s, 60s, 70s, and most of the 80s, the top marginal rate was between 50%-92%. During WWII, the top marginal rate was 94%.

In light of tax rate risk, it is even more important for both low and high earning individuals to plan accordingly. Contrary to conventional wisdom, both traditional and Roth accounts have benefits to almost all investors. Because the US tax system is progressive, traditional accounts benefit the lower to middle bracket earners as well as high earners. As investors approach a higher marginal rate, they can limit their income through traditional contributions. Likewise, a high earner can hedge against tax rate risk by diversifying their contributions be- tween traditional and Roth accounts.

A study, “Tax Uncertainty and Retirement Savings Diversification”, by David C. Brown, Scott Cederburg, and Michael

  1. O’Doherty, looks at ending portfolio value outcomes by simulating a progressive tax system with varied future rates and a million different return outcomes. Surprisingly to some, even the highest tax bracket benefited from using both traditional and Roth accounts. The study concluded by suggesting the following simple heuristic for allocating savings between traditional and Roth accounts:
  2. Households in low brackets (15% or below) should in- vest 100% of their savings in Roth
  3. Other households should consider allocating their (age + 20)% of their retirement savings in traditional accounts, with the remainder in Roth For example, this rule of thumb would suggest a 30 year old split savings 50/50 between a traditional accounts and Roth accounts.

Though this “rule of thumb” works for most investors, some don’t intend to spend all of their savings in retirement. Investors planning to pass on their wealth may benefit from funding Roth accounts as they pass tax-free to heirs. This creates significant savings for the heir as Traditional IRA distributions would be treated as income. In this scenario, we would want to use the heir’s age to help determine contribution allocation.

Proper planning can be a difference-maker for achieving retirement goals. As deficits continue to grow and tax rates continue to change, it is important to prepare for varied future scenarios. Sometimes the best choice may not be as obvious as it first appears.