Last Updated 8/9/2021
As a result of our country’s rapidly growing debt, you could be forced to pay higher taxes in the future. In today’s article I will discuss 3 strategies for how you can protect yourself against that TODAY!
At the end of 2020, the U.S. debt stood at around $28 trillion; up from $23 trillion the year before. And as you likely know, Congress is discussing further spending and possibly further stimulus which will only increase the debt.
How Will the Government Pay for This
This leaves one to wonder how the government will pay for this debt. On the one hand, the idea of a stimulus bill is to “stimulate” the economy and increase employment. And as a result, of higher employment, more tax revenue will come in. On the other hand, if that doesn’t pan out, then the government could choose to raise income taxes. It’s likely going to be a combination of the two, but today I want to focus on how you can protect yourself from rising taxes if they come.
3 Strategies to Combat Higher Taxes
Strategy #1: Roth Conversions
A Roth Conversion is where you move money from your IRA account (taxable in the future) to your Roth IRA account (tax-free in the future). Doing so forces you to pay taxes on the amount you move come tax time. So, if you move $50,000 today, you will pay income tax on that amount when you file your tax return.
Why Would You Do That?
If you are in the 12% or under tax bracket (taxable income is less than $40,525 / $81,050 for a single and married person respectively), then you would pay $6,000 in taxes. If in the future your tax bracket is 24%, you would pay $12,000 in taxes. So in essence, you are agreeing to pay $6,000 today to protect against a higher tax in the future.
Who is This Strategy Good For?
Tax brackets today are as low as they’ve been in decades. So, right off the bat, if you are in the 12% or less tax bracket, then you should make Roth Conversions a part of your investment strategy. The next level for tax brackets is 22% (taxable income is between $40,526 to $86,375 for singles or $81,051 to $172,750 married couples). Even if you are are in this bracket or higher, you should give some consideration to Roth Conversions to protect yourself from higher taxes in the future.
One caveat to mention. If you are in a really high tax bracket now, but you are getting ready to retire in a year or two, then you may want to consider holding off on doing a conversion until you retire if you will be in a lower tax bracket then.
Strategy #2: 3-Bucket Strategy
We are big fans of what we call a 3-Bucket Strategy. This is where you have money in 3 different types of accounts – a pre-tax account (i.e. IRA or 401k), a tax-free account (i.e. a Roth IRA), and a taxable account (i.e. an individual, joint, or trust-owned account).
Why Would You Do That?
The benefit of doing this is that you’ll be able to choose which bucket you withdraw from in the future. This gives you flexibility and options no matter what tax environment lies ahead. If taxes are high, then take from the Roth IRA bucket tax-free. If taxes are low, then take from the pre-tax or taxable bucket.
Who is This Strategy Good For?
This strategy is good for anyone; however, it will be dependent upon how much you can actually save today. Not everyone can afford to contribute to all 3 buckets. Ideally, you want to max out your pre-tax and tax-free accounts first because a dollar that is not taxed today is a dollar that stays in your account and grows. And the benefit of this is HUGE! And then once you’re doing that, then also begin contributing to your taxable account.
Strategy #3: Increase Your Tax Deductions
Managing your tax deductions is a foundation of any great financial plan.
Why Would You Do That?
The more tax deductions you have the less you will pay in taxes. So, even though we are in a low tax rate environment today, every dollar that you save in taxes is a dollar that can be applied to the previously mentioned strategies.
Ways to increase your tax deductions include:
(1) Increasing your pre-tax 401k contribution.
(2) Having babies (just kidding, that is actually a tax credit, which is a conversation for a different day).
(3) Increasing your pre-tax IRA contributions. If you don’t have cash flow to do this, then you could take money from a taxable account to make the contribution so you get the deduction.
(4) Bundling itemized deductions in one year and then taking the standard deduction the next. This comes in handy if you make large charitable contributions every year or have large medical expenses. Essentially you push as much deductions into one year as you can (even making next year’s charitable contributions this year or paying next year’s medical bills this year). Done properly, this could save you a tremendous amount in taxes.
(5) Taking advantage of a Qualified Charitable Distribution (QCD). If you are 70 1/2 years of age or older, meaning you’re at the age where you have to take money out of your 401k and IRA, then a QCD would allow you to get a tax deduction for your charitable contributions even if you don’t itemize your deductions.
Who is This Strategy Good For?
This strategy is perfect for someone who has large medical expenses or large charitable contributions but most of the time you take the standard deduction. If you can afford to increase your 401k contributions then you’ll find this strategy very helpful. Lastly, if you are age 70 1/2 or older then you will find tremendous benefit in the QCD strategy.
One Final Point
It is not guaranteed that taxes will be higher in the future. As such, these strategies are not guaranteed to result in you paying less taxes over your lifetime. But what these strategies will do is protect you and build a hedge around your investments in case a higher tax rate environment shows up.
Please comment below and let me know whether or not you’ve found this content helpful. Also, I’d love to hear other strategies you’re using to protect from possibly higher taxes in the future.
Brad Tinnon
CERTIFIED FINANCIAL PLANNER™
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