Donald Trump and the Republicans will soon unveil their long-awaited tax proposal. It’s expected that they will introduce cuts to business and individual income taxes, simplify the number of tax brackets, and reduce the number of itemized deductions.
The tax code is ever-changing, and the way we think about taxes, retirement, and personal finance could be significantly altered if the Republicans can close ranks and pass a tax bill.
So should we plan our retirements, which may be 20, 30, or even 40 years in the future, based on the tax structure of today, even though tax laws will likely be very different in 2040 or 2050?
Taxes and Retirement Were Very Different 40 Years Ago
The modern system of how we pay taxes, save for retirement, and make personal finance decisions hasn’t been around forever. The way our generation will save for retirement is different from how previous generations saved for retirement, and our children and grandchildren will probably save for retirement very differently from us.
Our grandparents lived in a generation where you worked for a company for 40 years, and the company would take care of you in retirement by offering a generous pension plan. This pension, combined with Social Security payments, usually was enough to meet your retirement needs.
Today, pension plans are all but gone for new employees, and companies are quick to cut staff if it will help their bottom line. Medicine has more job stability than other professions, but doctors still do hop around from hospital to hospital. I anticipate that the current generation of residents will be switching jobs more frequently than the previous generation of doctors, now that hospital employment is the norm rather than the exception.
A Whole New Alphabet Soup of Retirement Accounts
Think about all of the savings vehicles and tax changes that have been enacted in the last 40 years:
- 1978: 401(k)s are first introduced
- 1981: Individual Retirement Accounts are popularized with the 1981 Reagan tax cuts. The top tax rate is cut from 70% to 50%.
- 1986: The home mortgage interest deduction is increased, making home ownership very attractive, especially to upper-middle class Americans. The top tax rate is cut from 50% to 28% over two years.
- 1990: George H.W. Bush raises taxes, including the top marginal tax rate from 28% to 31%.
- 1993: Bill Clinton is inaugurated, and passes tax increases, raising the top tax bracket to 39.6%.
- 1997: Roth IRAs are introduced, as are 529 accounts.
- 2001: George W. Bush makes 529 distributions tax-free instead of tax-deferred when spent for college expenses
- 2003: Health Savings Accounts are created with the 2003 Bush tax cuts. The top tax bracket is cut from 39.6% to 35%.
- 2009: The Affordable Care Act is passed.
- 2012: Barack Obama signs the American Taxpayer Relief Act of 2012, which raises the marginal tax bracket back to 39.6%.
- 2017: Donald Trump unveils his tax plan…
A new intern who started residency in 1977 and recently retired would have witnessed the introduction of 401(k)s, IRAs, Roth IRAs, 529s, and HSAs during her career. None of the major vehicles today’s physicians use for saving money on healthcare, retirement, and college existed when she started residency.
Predicting Tax Law Is Harder Than Predicting The Stock Market
Some people try to plan their savings strategies based on their views of future government or tax policy. For example, they might avoid traditional IRAs in favor of Roth IRAs because they believe that tax rates will increase in the future. Many people don’t even include Social Security in their retirement plans, because they assume it will be insolvent by the time they retire.
Unfortunately, predicting tax law is an incredibly tricky proposition. It’s hard enough to predict politics one election cycle in advance, much less 15-20 years in advance. Who would have predicted that Donald Trump would become President of the United States? Even the great political prognosticator Nate Silver of FiveThirtyEight put Donald Trump’s chances of becoming the Republican nominee at 2% in August 2015 (even though he was leading the polls at the time).
Optimize Your Finances Based On Current Law…
Ultimately, us ordinary investors have little control over tax policy. Sure, we can elect leaders that conform with our political views, but when planning our finances, we can only work with the system we are given and take advantage of the current rules of the game.
If they take away the home interest deduction, then it would swing the pendulum more towards renting than buying a home. If they cut the pre-tax 401(k) contribution limits while increasing the post-tax (Roth) contribution limits, then you’ll be contributing more money into Roth accounts. If they cut Social Security benefits or increase the retirement age, then save more money when you’re young so that you can self-fund your retirement.
…But Remember That The Only Thing Certain About Future Tax Law Is Uncertainty
One approach to deal with future tax law uncertainty is to hold a diverse set of retirement and investment accounts. This gives you flexibility when it is time to withdraw your money in retirement, and reduces the effects of future tax law changes. This means having a mix of pre-tax (traditional 401(k), IRA, HSA) and post-tax (Roth IRA, taxable) accounts for retirement savings. Use a mix of 529 plans and taxable accounts for college savings. Consider it tax diversification, so you don’t put all your retirement eggs into a single tax basket that might get plundered by Uncle Sam in the future.
Read and React, Don’t Whine Or Prognosticate
It’s important to optimize your financial situation based on the rules of the game, not gripe about how the new tax law didn’t personally benefit you. Don’t prognosticate that the bill will be repealed when the Democrats take control of Congress and the White House. Republicans have been promising to repeal the Affordable Care Act since it was passed in 2009, and it hasn’t happened even though they control all chambers of government.
There are always winners and losers in any tax legislation. If you end up being on the losing side, then make changes to minimize your losses. If you’re on the winning side, make the appropriate moves to maximize your advantage.
What do you think? How do you feel about the Trump tax plan? How is your retirement money diversified between taxable, pre-tax, and Roth accounts?
Great article, WSP! Predicting future tax policy is a lose-lose proposition in my opinion. Like you mentioned, one way to kind of hedge yourself is to have good tax diversification. My plan is to try and have a 1/3 pretax, 1/3 after- tax, and 1/3 tax-free. There’s no science behind those numbers, though. It’s just an arbitrary starting point that I picked out for myself. Thoughts?
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