Every decade or so – a new virus emerges that fear mongers hype as “the one” that will wipe out the human race. It never turns out to be quite as bad as projected of course – but it does make for sensational conversation.
Well there is a virus of sorts that’s on the horizon and while this one may not wipe us our physically – it certainly will take its toll financially. It’s “tax rate risk” – and it is incurable – at least for the next generation or two.
Tax rate risk is the exposure of our money to taxation at rates that we won’t know until some point in the future. And I’m not just talking about that 401k you’ve been funding?
We have taxable equity building in our homes that may become more heavily taxed in the future. In addition, more Americans than ever have equity locked up in businesses. When those are liquidated the gains are taxable. More social security benefits than ever before are taxed already; and Medicare parts A, B, and D – are themselves taxes that can go up at the drop of a hat (and have in the last 2 years).
Add up the IRA, the 401k, the house, your business, and trends in social security and Medicare and chances are – nearly 100% of your income will come from sources that are completely exposed to significant tax rate risk.
Assume you’re drawing $80,000 a year in retirement from a combination of investment income, Social Security, and an IRA. The entire $80,000 is taxable at the prevailing rate each year. At an effective tax rate of 25%, you end up with lifestyle income of $60,000. But if tax rates increase to 40%, net income shrinks to $48,000.
Now $1,000/month less may not put you in the poor house, but if most of your living expenses are fixed (mortgage, property taxes, insurance, etc.), that $1,000 comes completely out of discretionary income – meaning lifestyle compromises.
What’s more, tax rate risk can’t be mitigated. You’ve already agreed – years ago – to pay taxes as you receive the money. You’ve make your deal – Uncle Sam has held up his end – and now you’re stuck.
I believe it is a financial imperative that we pay attention – and take steps to minimize our tax-rate risk right now – while there’s still time. This often means making the tough decision to pay taxes on some things now – even when deferring them may be an option.
Taxes are “on sale” in a way they may never be again in our lifetime – or those of our kids and grand kids. By shifting into tax-free vehicles now – we’ll be laughing at the polo grounds while others are lamenting their fate at the shuffleboard court.