Executive Summary
With years of ongoing Federal budget deficits and a large and growing national debt, there is a common perception that "at some point" tax burdens must rise to address the issue. While the timing is not certain, the belief that higher tax rates may be inevitable has become a strong driver for many advisors and clients to do whatever they can to manage that future tax exposure. And one of the most popular strategies: take the tax exposure off the table altogether, by contributing to Roth accounts and doing Roth conversions, with the goal of paying taxes now when rates are lower and not in the future when they may be higher.
A closer look at paths to tax reform that can address Federal deficits though, reveal that while tax burdens in the aggregate may be higher in the future, marginal tax rates will not necessarily be higher. In fact, most tax reform proposals, from the bipartisan Simpson-Bowles to the recent proposals from Representative Camp, actually pair together a widening of the tax base and an elimination of many deductions with a lowering of the tax brackets! In addition, proposals to shore up Social Security and Medicare often involve simply raising the associated payroll taxes that currently fund them... tax increases that would result in a higher tax burden on workers, but no increase in the taxation of future IRA withdrawals. And the US remains one of the only countries that does not have a Value-Added Tax (VAT), which could also increase the national tax burden without raising marginal tax rates.
In the end, the simple reality is that there are many paths to higher tax burdens in the future that don't necessarily involve higher marginal tax rates on IRA withdrawals. Which means ultimately, advisors should be very cautious about doing Roth conversions - especially conversions at rates that are 33% or higher - and the best possible thing to do with a pre-tax IRA may simply be to continue to hold it, and wait for tax burdens to increase... because when paired with a compression of tax brackets that leads to lower marginal tax rates, not converting to a Roth could actually be one of the best long-run tax savings strategies around!
Roth Conversions And Marginal Tax Rates
When evaluating a prospective Roth conversion (or contribution to a Roth, versus a traditional account), the basic principle for maximizing long-term wealth is relatively straightforward: you should pay your taxes when the rate will be lowest. If your tax rates are higher now and will be lower in the future, keep the pre-tax account and wait and withdraw at those lower future rates. If your tax rates are lower now and will be higher down the road, convert/contribute to the Roth and pay the tax bill now at the more favorable rates.
The caveat to applying this approach, though, is that it’s crucial to understand what tax rates are being compared in the first place. Because a Roth conversion (or a future traditional IRA distribution) happens at the margin – on top of whatever income and deductions the person already has or is projected to have – it’s crucial to look at the true marginal tax rate, now and in the future. And that means more than just looking at an individual’s tax bracket, as phaseouts of tax credits and deductions based on income can cause marginal tax rates far higher than just the tax bracket alone.
At the same time, it’s also important to recognize that a marginal tax rate is just that – a tax rate, at the margin, on the last dollar of income. It does not necessarily speak to a person’s total tax liability, or the overall share of their income being consumed by taxes each year. That's measured by the effective tax rate.
Example. A married couple that earns $350,000 of ordinary income faces a marginal Federal tax rate as high as 39.8% (including a 33% tax bracket, a 2% impact for the phaseout of personal exemptions, a 1% impact for the phaseout of itemized deductions, and a 3.8% Medicare surtax on net investment income). However, their actual tax liability due would be only $85,231 (assuming 2 personal exemptions and $15,000 of itemized deductions, both partially phased out), which on a $350,000 income is equivalent to a 24.4% effective tax rate. In other words, while the couple may be adding income at the margin at almost 40%, their overall tax liability on the income already earned is not nearly that high. And if their (itemized) deductions were greater, their tax burden would be reduced and the effective tax rate would have been even lower for the couple, despite their marginal rate still being pegged at almost 40%!
Impact Of Tax Reform On Marginal Tax Rates
The reason this distinction between marginal and effective rates is so important is not merely that it’s crucial to use marginal (and not effective) tax rates to properly do the analysis in the first place. It’s that with a growing buzz for “tax reform” and resolving the ongoing Federal deficits, many clients (and their advisors) are increasingly concerned about the “risk” that tax legislation cause tax rates to be higher in the future. Yet here, again, it’s crucial to make the distinction regarding the impact of tax reform on marginal versus effective tax rates.
At a broad level, there are three fundamental levers that tax reform can adjust, if the goal is to generate more total taxes in the future:
- Expand the tax base by taxing more types of income/taxpayers/etc
- Keep marginal tax rates but reduce deductions
- Increase marginal tax rates
Notably, the first option may change the individual’s effective tax rate indirectly by potentially including more income in the formula for taxes in the first place, but it doesn’t change the marginal tax rate at all. In other words, taking more types of income or making more people subject to the income tax system in the first place can generate more taxes in total, without necessarily increasing their tax rates.
In the second option, the individual’s effective tax rates will rise, but there still isn’t necessarily any impact on the marginal tax rate, as the whole point of eliminating deductions is that it raises the tax burden on existing income, not the rate on the next new dollars income. For instance, if in the prior example we changed the law to limit deductions and it reduced the couple’s available deductions by $10,000, their tax liability would rise to $88,531 and their effective tax rate would be 25.3%, but their marginal tax rate would still be the same! Higher effective rates and a greater tax liability don't necessarily mean higher marginal tax rates.
Ultimately, it is only the third option – to outright increase marginal tax rates, such as by increasing the tax brackets – that actually results in a true increase in future marginal tax rates.
These distinctions are crucial, because the reality of tax reform is that it most often relies on the first and second options to increase taxes, and not necessarily the third. For instance, in the Tax Reform Act of 1986, a significant number of tax preferences and deductions were eliminated, the types of income being taxed were expanded (by eliminating a lot of real estate and other “tax shelters”), and the tax base was so widened that the top marginal tax rate fell from 50% in 1986 to only 28% by 1988 (and because the lower marginal rates were offset by fewer deductions and a wider tax base, individual income taxes as a percentage of GDP remained relatively flat at 7.7% in 1986 and 7.8% in 1988).
And notably, this 1986-style tax reform – where the tax base is widened and/or deductions are eliminated to the point that we don’t need to raise marginal tax rates and in fact can lower them – is the same approach that has been advocated in recent years as well. For instance, the bi-partisan Simpson-Bowles proposal from President Obama’s Deficit Commission suggested reform that would eliminate most tax deductions, expand ordinary income treatment to capital gains and dividends, but reduce the tax brackets down to a simple three-bracket system with rates of 9%, 15%, and 24% (with a top rate possibly as high as 27% if some deductions are kept), resulting in a dramatic decrease in marginal tax rates for most taxpayers. Similarly, the more recent proposal from Republican Ways and Means Committee Chairman Dave Camp would also limit most itemized deductions, and reduce down to three tax brackets (10%, 25%, and a top 35% rate that applies for married couples over $450,000 of income), which would reduce marginal tax rates by less than Simpson-Bowles but still to a material extent.
In addition, to the extent that tax reform even does touch the marginal tax rates and increase them, it doesn’t necessarily impact everyone. While it is often noted that the top tax bracket was as high as 94% in the aftermath of World War II, the reality is that tax rate hardly applied to anyone or any income, due both to the incredibly high bracket threshold (it would have taken almost $2.5M in today’s dollars to have been subject to that rate) and also because the structure of deductions and exemptions were very different back then (something we ultimately sought to stamp out by creating the Alternative Minimum Tax 20 years later). For instance, the chart below (based on data from the National Bureau of Economic Research and the Journal of Business) shows the top marginal tax bracket going back to World War II, along with the average marginal rate that was actually paid when weighted by the distribution of AGI; as the chart reveals, while the top marginal rate has varied significantly, the income-weighted typical marginal rate has actually been quite stable for most taxpayers.
Other Non-Income-Tax Remedies For Federal Deficits
As both the history of tax reform and the recent proposals show, the assumption that the total tax burden and effective tax rates “must” rise in the future still doesn't necessarily mean that marginal tax rates will be higher in the future. In fact, almost 70 years of tax reform since World War II has persistently shown that our path to higher taxation typically involves widening the tax base and constraining deductions and even lowering the top marginal rates in the process – an approach that is being signaled by most recent tax reform proposals as well.
In addition, the potential for tax reform that results in higher effective but lower marginal tax rates also ignores all the other ways that additional tax revenue can be generated in the future without adjusting the income tax system! For instance, we are one of the few developed nations that does not have some form of Value-Added Tax {VAT} or other national sales/consumption tax (a VAT is similar to a sales tax, but is applied to manufacturers when the product is made, rather than at the cash register when it is sold). If a VAT were to be introduced in the US in the future, the total tax burden that applies to consumers would rise, but (marginal) income tax rates would not; in fact, the introduction of a VAT could even be paired with reform to our corporate or individual income tax system that lowers income tax rates in exchange for the introduction of a VAT. The end result – once again, a greater future tax burden in total doesn’t necessarily mean higher income tax rates on IRAs.
Similarly, the reality is that some of the greatest drivers to our projected future deficits are attributable to Social Security and Medicare, which at this point are primarily funded via payroll taxes that apply to wages but not to IRA distributions. Accordingly, we could “solve” our Social Security shortfall by increasing the payroll tax by 2.72% of taxable wages (effectively taking the Social Security tax rate from 12.4% to approximately 15.1%) and similarly resolve the Medicare shortfall by levying another 1.11% tax on taxable payroll; while these tax increases would have a significant economic impact, and would result in a higher tax burden for some, they would again not lead to higher income tax rates on future IRA withdrawals (as those taxes apply only to employment income).
Dangers Of Converting To A Roth To Avoid Higher Taxes In The Future
As discussed earlier, the fundamental benefit of a Roth conversion (or contribution) is the opportunity to pay taxes now – presuming rates are lower – rather than deferring the tax liability to the future when rates may be higher. In light of this dynamic, it is quite logical to convert/contribute now to avoid tax rates that may be higher in the future due to changes in tax law… except the reality is that marginal tax rates really might not be higher in the future even if tax burdens increase.
In fact, most current scenarios and proposals - whether it’s the implementation of a VAT, raising Social Security and Medicare taxes, or simply implementing tax reform that pairs together a widening of the tax base and a reduction in tax preferences and deductions without raising tax brackets - are actually paths to lower marginal tax rates in the future, even with a higher total tax burden. And if such a scenario were to happen, individuals could actually find that doing Roth conversions and contributions today may actually turn out to have been wealth destructive. Instead, with reform proposals that could lead to higher tax burdens but lower marginal taxes, it may well be that the best possible outcome could be leaving money in tax-deferred accounts, making new contributions to those accounts, and simply waiting and taking the distributions in the future when marginal tax rates are lower!
Realistically, it’s worth noting that tax reform doesn’t seem very probable in the immediate future. Representative Camp’s proposal was essentially marked “dead on arrival” in Congress as soon as it was put forth, and the Simpson-Bowles plan has seen little movement since the report was released in late 2010. At this point, there may be no progress on tax reform until after the next Presidential election, when we see whether one party or another takes the White House and enough of Congress to push through their version of reform (notably, both parties largely agree on the general structure of reform; the primary debate is simply whether the net result should be revenue-neutral, or a revenue raiser).
Nonetheless, it seems likely that at some point, tax reform will come, and whether in the reform itself or as a part of changes to Social Security, Medicare, and/or the introduction of a VAT, there is a strong likelihood that it will involve a greater future tax burden. But it’s crucial to remember that a higher future tax burden does not necessarily mean higher marginal tax rates in the future… and for those who do seek out conversions, at the least be very cautious about doing Roth conversions in the upper 33%+ tax brackets when most tax reform proposals today have a top rate no higher than 27%! But in the end, the best course of action for most IRA accounts may actually be to wait for the tax “increases” to happen, and do the withdrawals or Roth conversions then, when the marginal rate may be lower!
