Ever since I wrote The Case Against Roth 401(k), I have people telling me I’m out of my mind. They say taxes have to be higher in the future because of deficits, baby boomers retiring, higher health care costs, etc., etc.
I don’t necessarily disagree that taxes will be higher in the future. After all, the demographical trend of an aging population is clear. The entitlement programs have to be paid by taxes — the government can’t borrow an unlimited amount forever. There might be some trimming at the edges but cutting the programs dramatically is unrealistic.
However, taxes will go up does not mean that tax rates will have to go up. The decision point on Traditional vs Roth is about tax rates, not the total tax dollar amount.
How can taxes go up but tax rates don’t? By broadening the tax base, which means having the tax rates apply to more income.
Right now the government collects tax only on a portion of one’s income. Through numerous exemptions and deductions, the taxable income ends up being only a subset of one’s total income. Through tax credits, the actual tax is further reduced from the number you would normally calculate by applying the tax bracket percentages against the taxable income.
If we get rid of or limit the exemptions, deductions, and tax credits, the actual tax bracket percentages can be lowered and the government would still collect more taxes.
Exhibit A would be the recently circulated Gang of Six deficit reduction plan. Prior to the recent breakdown, the plan has received favorable opinions from both Democrats and Republicans. Some said it can get the crucial 60 votes in the Senate. The Gang of Six plan, which borrows ideas from the Fiscal Commission report, raises taxes and lowers the marginal tax brackets.
Taxes will go up does not mean tax rates will have to go up.
Would you rather have a lot of deductions and higher tax rates or fewer deductions and lower tax rates? I would much prefer the latter because it’s much less prone to gaming. You probably heard about GE paid zero federal income tax despite having reported a large profit. How? Through exemptions, deductions, and credits.
Although the Wall Street Journal would scare the public with sensational headlines like Preparing For D-Day: When Congress Takes Your Deductions, one should realize that the exemptions, deductions, and credits largely benefit the rich. If we replace those exemptions, deductions, and credits with lower tax rates, the net effect to a typical middle class family can be very small. For most people, there’s nothing to fear about losing tax deductions.
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Don says
This is a fine argument, but not connected to reality. The current view of the Tea Party is that removing any credit or exemption is a tax increase and not to be voted for. It would seem that until at least the next election, there is no real chance at tax reform as you describe.
KD says
I wish I was more learned about political theory. What is voting for a government that is anti-government called? What is wanting to preserve all entitlement programs but also wanting no taxes called? What is writing a tax-code that exempts half of the working population from paying any and the richest having a lower marginal rate (hedge fund managers) than middle-class called? Illiterate? Unreasonable? Suicidal?
This will end badly. The American capitalist success was just that. Success due to presence of capital. With capital now being available to emerging economies, this will be less true. One day truth will hit home.
Sorry for the rant. Delete if needed.
Money Beagle says
“If we get rid of or limit the exemptions, deductions, and tax credits, the actual tax bracket percentages can be lowered and the government would still collect more taxes.”
Practically every year, I do a simple estimation of my tax return. Every year, my actual return comes back with a bigger refund than my estimation had given. Am I complaining? No. But why does it happen that way? Because of all the refunds and credits.
You could cut tax rates for every income level and eliminate some of the credits and deductions, and solve the whole problem. But that would make sense, so it’ll never get done.
serbeer says
You are quite right TFB, but I think that undermines your original argument in favor of traditional 401K rather than supports it. You based your analysis on the fact that in retirement your 401K dollars “fill in from the bottom.” The very bottom is tax free you explained and further up has low tax rate as well.
Well, if deductions and exemptions are eliminated, it is no longer the case. And ability to convert to Roth may be undermined as well even if retires early, before SS and without pension.
nick says
The Tea Party has proven itself so extreme that not only will they lose their campaign contributions from businesses, but they will be actively opposed by the business community.
For all the trouble they cause, at least they will be 1-termers.
Harry Sit says
@serbeer – The case against Roth 401k does not depend on the 0% bracket created by the exemptions and deductions. If we still have progressive brackets and the tax rates will be lower, the average tax rate on withdrawals in the future will still be lower than the top bracket today.
schmoe says
“lot of deductions and higher tax rates” or “fewer deductions and lower tax rates”
Congress is systemically motivated towards the former because it allows them to curry favor with their supporters with special deductions and credits. It also allows Congress to favor the wealthy in stealthy ways while appearing to be tough on them.
Steve says
The only thing I am certain of, is that I don’t know what’s going to happen with tax rates in the future. I’ve lost faith that our political system will find a fair, competent solution. Generally I split between Roth IRA/401K and traditional 401K and contributions to a brokerage which have no tax advantages. That way I won’t get slammed with whatever nonsense Congress decides.
Rod Flash says
“lot of deductions and higher tax rates” or “fewer deductions and lower tax rates”
Personally, I suspect that what we’ll see is fewer deductions and equal or higher tax rates. This still leads to the Roth being a decent choice, epecially if you are currently retired (as I am) and able to convert at 15%. I can’t see there being a future time when I’m in a lower tax bracket, even if your scenario comes to pass. If politicians would stop spending far in excess of the ~18% of GNP that they traditionally get as tax revenues, then maybe. I won’t be holding my breath.