Is tax deferral dead?
The Washington Post, March 30, 2011
I hate to toss a grenade into anyone's tax return preparationsand goodness knows the Lower Upper Class has enough to worry about, what with SAT prep getting insanely expensive for the kids, and exclusive resorts refusing to cut prices despite the sluggish economybut tax deferral might be dead.
What I mean is that the presumption that it is always better to shelter a dollar of income from taxes today, in favor of paying taxes on that dollar some years down the road, is, for the first time in memory, open to question.
Before I explain why, it's worth noting that if I'm right, this is a shattering fact. The wisdom of deferral is one of the bedrock principles of American financial life. It's the basis for the entire retirement products industry. The ability to shelter income in a tax-free retirement account, in which the money can be invested and grow tax-free until it is drawn down in retirement, is among the largest subsidies in our tax code.
Like all such subsidies, this one disproportionately benefits those who have more money to shelter. But an underlying premise of deferral is that the tax rate incurred when you draw down the money at an older age will be lower than the tax rate you face today.
Or, to put the matter more precisely, deferral makes sense when the after-tax cash you end up with after drawing down your deferred money years hence and paying ordinary income tax rates on those sums exceeds the amount you'd end up with if you paid ordinary income tax rates on the income today and then invested the after-tax money for the same period, and paid capital gains rates when you want to sell your holdings and spend the money in retirement.
This is a bit oversimplified, because lots of variables affect how one might invest and draw down the money, but the key point is this: The wisdom of deferral depends critically on assumptions about the ordinary income and capital gains tax rates one will face in the future.
It's always been a pretty safe assumption that deferring money in your high-earning years is smart because you'll be in a lower tax bracket in retirement when you draw the money down. Saving on taxes today and letting the money grow tax-free has thus been a no-brainer.
But now we live in an era of endless trillion-dollar deficits that will have to be snuffed out somehow. Our Chinese overlords will demand nothing less. Meanwhile, a phalanx of graying baby boomers must have their Social Security and Medicare financed. Only small children and Republicans pretend that taxes will not rise as part of America's inevitable fiscal adjustment. What's more, it seems entirely plausible that for at least a portion of America's affluent, tax rates will rise not only to what they were under Bill Clinton, but higher.
At some pointa point that will depend on exactly whose ox gets gored when, and to what extentthis means a swath of Americans will be better off paying taxes now and investing the after-tax income instead of deferring. In one example I penciled out, the break-even between the deferral and non-deferral scenarios 20 years hence comes if the top ordinary income tax rate is 50 percent in the future, and capital gains rates then are 25 percent. If the ordinary rate is higher down the road, or the capital gains rate lower, you'd be better off not deferring.
Is that unimaginable for a chunk of the best-off Americans? I think not. It depends on how the tax side of America's fiscal adjustment is apportioned between broad-based taxes (such as value-added or carbon taxes), and changes in income and capital gains rates. (Note that if this conversation seems to bear little relation to current debate in Washington, that's because current debate in Washington bears little relation to reality).
Now, let's pause to acknowledge that, for those affected, this is (as Bill Clinton would say) a high-class problem to have. But, as I've argued before, the Lower Upper Classcomposed of doctors, accountants, engineers and lawyers, etc.is a politically influential group. My own guess is that dawning awareness of the potential loss of deferral advantages will hasten a Lower Upper Class push for a serious new billionaire's tax bracket. Get the dough from those who can really afford it, Lower Uppers will reason. Not from those struggling with multiple private school tuitions, please.
The interesting thing is that, as best I can tell, few people have been thinking about this. There was a flurry of analysis on this theme to help folks think about Roth IRAs, but little about the broader trend toward higher taxes. One financially savvy friend I asked said he always deferred as much income as he could, and had never given the matter a second thought (though now he will). Another affluent friend has looked at the question closely and knows that if his ordinary income rate jumps 4 to 5 percentage points, he's better off paying the taxes today. My own accountant looked at me a little cross-eyed when I asked, which I took to be proof that my question was either dumbor smart.
Since The Post
's readership is chock-full of finance and tax gurus, I'd like to crowdsource an answer. To defer, or not to defer? That is the question. What's the right way to think about it? I'll showcase any particularly illuminating or amusing replies posted in comments here (or e-mailed to me) on the PostPartisan blog well in advance of April 15.
After all, the political system may be in denial about the inevitability of higher taxes as America ages. But tax planners, and millions of taxpayers, can't afford to be.