By Boyce F. Lowery, CLU, ChFC
Conventional wisdom says that it’s the smart thing to do to defer taxes. “Take advantage of tax-deferred retirement accounts!” we hear all the time. But what does it actually mean to defer taxes? And is it really as smart as everyone says it is?
What Does it Mean to Defer Taxes?
Deferring taxes is like going into a partnership with government for ownership of funds not yet taxed. For example, let’s say you are in the 30% marginal tax bracket for federal and state income taxes combined. Any money that you earn but then defer the taxes on is the same as government being a 30% owner in that sum of money where taxes haven’t yet been paid. You get to keep control of all of the money right now, but in the future, you will have to pay out your partner’s share in taxes, including owing taxes on the gains made on that money.
It gets worse. The difference between the combined governments’ share of your money and a real partnership is that the ownership percentages can change when governments are involved. In a business partnership, your partner can’t unilaterally decide to change their ownership stake. The government, on the other hand, has free reign to change your tax liability up or down, which essentially changes their stake in your money. While today they may only claim 30% by way of example, in future years they may claim 35%, 40% or even more and you have no recourse. In that case, your decision to defer taxes would have been a losing proposition for sure.
The most common way to defer taxes is through retirement savings accounts. Traditional IRAs, 401(k)s, and SIMPLE IRAs are all popular vehicles. These plans allow you to make contributions with pre-tax money and not pay taxes until you withdraw the funds in retirement. That way you have more money to invest up front to multiply your returns – so they say. But remember, you’re really investing your money and the government’s share of your money. You are hoping/betting that your future tax rate will be lower than it is now. Don’t be so sure!
What Is the Current Outlook for Taxes?
Because tax rates change, it is important to consider possible future tax rates when considering deferral. There is no way to know what the future holds for certain, but looking at present rates from a historical perspective can be helpful. Here is a graph that shows the highest and lowest marginal tax rates since 1910:
It can also be helpful to look at the political and economic climate for clues as to how tax rates may change in the future. How do our current presidential candidates view taxation? What about the general population? Consider the impact of the current coronavirus shutdowns on government revenue and how the stimulus measures will affect budget deficits and the nation’s debt burden. Is there anything else that may affect government revenue needs, such as the number of Baby Boomers who are retiring and beginning to receive Social Security and Medicare benefits?
Are There Tax Options Other Than Deferral?
Tax deferral might be an advantage that can provide a boost to wealth building. Still, deferral is not the only tax option available. There are other ways to accumulate money with preferable tax treatment. Roth accounts are one of those ways. With a Roth IRA or Roth 401(k), funds are taxed prior to investment, but all of the investment gains are tax-free. These accounts allow retirement savers to lock in current tax rates and generate tax-free future income.
Life insurance also provides tax advantages without the uncertainty of tax deferral. Most cash value life insurance plans allow you to access the cash value in a tax-advantaged way. The cash value can be withdrawn up to the total premiums paid completely tax-free. Also, loans can be taken against the cash value even above the cost basis on a tax-free basis as well.
Taxes can be a heavy burden, so it is important to be aware of all of the tax-advantaged opportunities available to you. If you would like to learn more about tax-advantaged ways of building wealth, call us at 888-827-0146 for a free and confidential consultation.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.