The market has been abuzz lately with chatter about various tax initiatives as we head toward the 2020 general election. Given the large federal deficit and rising income inequality, some new ideas have surfaced—including Rep. Alexandria Ocasio-Cortez’s proposal for a 70% top marginal income tax rate. Putting politics aside, we decided to investigate how a much higher marginal tax rate might impact decisions investors make today. In particular, we wondered, “Should investors continue to defer income if they might be deferring into a higher tax environment?”
Does Deferral Hold Up?
Let’s assume for simplicity’s sake that a 40-year-old investor expects to retire at age 65 and live until age 90. We’ll also assume that our investor has the ability to make a $10k pre-tax contribution into her portfolio each year—either as the after-tax equivalent into a taxable account or the full $10,000 into a tax-deferred account (like an IRA or 401k). For our analysis, we’ll compare two different levels for the top income tax rate: (1) our current environment using a 50% rate, and (2) a higher 70% threshold.
In all scenarios (Display), we have assumed that the investor is not spending down the assets, and that required minimum distributions are reinvested in the taxable account. To ensure that we are comparing the tax deferral to taxable savings on a “spendable dollar” basis, we further assume that both portfolios are liquidated and taxed at age 90.
Our base case attempts to mirror the current lower tax environment—a 50% top rate on income. While higher than the current federal rate, it’s intended to account for a high state income tax. To isolate the effects of a changing environment, we consider four separate scenarios:
- consistently low rates (Consistently Low)
- a switch from low to high rates in retirement (Increasing)
- a switch from high to low rates (Decreasing)
- a consistently high rate throughout (Consistently High)
In all cases, we assume a 30% rate on capital gains.
Tax Deferral Overcomes Higher Taxes
Not surprisingly, we see that the current low tax rate environment provides the greatest overall opportunity for wealth creation in tax-deferred accounts. Over the 50-year period, our investor would have amassed $594,000—a figure that eclipses all other scenarios.
But our findings also show that even in the most extreme environment for tax deferral (deferring from a low rate into a high rate), the advantage of tax-deferred portfolio growth outpaces simply saving into a taxable account over the given time horizon. All else being equal, under our “Increasing” scenario, our investor would end up with $365,000 in the tax-deferred account versus $299,000 if she saved in a taxable account.
These observations offer an important insight. While higher tax rates will reduce the growth of both taxable and tax-deferred assets, changes in rates over time impact the value of tax deferral most. This should not discourage investors, though. Even in these extreme scenarios, they come out ahead when deferring taxes.
In short, is it still worth deferring income if taxes go up? Without a doubt.
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- Pavan W. Auman
- Director—Wealth Strategies
- Tara Thompson Popernik
- Director—Wealth Strategies Research