If Income Tax Rates May Increase, Change Your Retirement Savings Plan

One would need to be foolish to think that income tax rates will not increase over the next three years. With the government outspending its income by over $1 trillion a year, the obvious way to close the budget gap is to collect more taxes from the population. So you should fully expect that whatever income tax rate you pay today, it will be five percentage points higher in the not-too-distant future. For example, if your marginal tax bracket is now 25% it could very well be 30% in the foreseeable future and if you live in a state that collects state income taxes, expect the state income tax rates to rise in a similar fashion.

When income tax rates are rising, traditional IRAs and 401(k)s become much less valuable and possibly detrimental to your wealth. Here's why. Let's say today your marginal income tax rate is 25%. So you put money into a traditional IRA or 401(k) and you get a tax deduction. The tax deduction is at today's rate 25%. But in a few years, if your income tax rate rises to 30% and you start taking money out of your IRA, you would have foolishly saved 25% per dollar invested only to pay 30% per dollar invested when you distribute the money from your retirement plan. Does this mean you should not save for retirement in the face of rising income tax rates?

Certainly you should save for retirement but you should be using either the Roth IRA or Roth 401(k). Using those tools you get no tax deduction today, but when you take the money out, the distributions are tax-free. So in the case of Roth accounts, you have given up a 25% tax break when you place the money into the account but when it comes time to harvest the money, you avoid a 30% tax rate. The guys on Wall Street call this arbitrage with income tax rates and it's a smart way to help your retirement nest egg.

Rising Income Tax Rates Help Municipal Bond Investors

Taking the same concept one step further, you can see why during a period of rising income tax rates, investing in tax-free bonds could be more attractive than most people see at first glance. It's great to invest in an instrument that gives you interest that is tax-free. At a 25% tax bracket you are saving taxes at the 25% rate but if you own municipal bonds today and three years from now everybody else like you is being charged 30% for taxes, your municipal bond portfolio becomes even that more much more attractive likely increasing the value of those bonds the marketplace. This author urges you to consider that income tax rates will increase and to plan and invest accordingly.