The Importance of Long-term Tax Planning

When budgeting for retirement expenses, pre-retirees tend to consider health care, housing, food, utilities, and travel, but often overlook taxes. This oversight would be a mistake, as taxes typically rank among the top three expenses during retirement, and for some retirees, taxes can be the single largest item in their retirement budget.

Fortunately, tax is one of several areas where smart planning can make a huge difference. The main goal of long-term tax planning is to minimize total wealth lost to taxes during your lifetime. The focus on lifetime taxes cannot be overemphasized. In our zeal to minimize this year’s tax bill (and maximize our refunds) we can sometimes miss opportunities to save a lot in future taxes by paying a little more in taxes today.

In the United States, we have a highly progressive tax structure. Federal marginal income tax rates increase steeply from 10% to 37%, depending on total taxable income. Because the IRS taxes income and not wealth, a good deal of tax planning involves smoothing out your income stream in order to shield it from the highest marginal rate(s). For example, an individual earning $100,000 in one year, and $0 in each of the next the next three years will pay far more in total federal taxes than someone who earns $25,000 a year for four years.

It is also important to note that, at present, Americans enjoy relatively low rates of total taxation. This phenomenon is especially true for the highest earning citizens, who’ve seen their Federal marginal tax rate decline substantially since WWII. For the twenty-year period 1944-1963, the Federal marginal tax rate on the highest earners oscillated between 82% and 94%. But note the sharp decline in the highest marginal rate in the graph below, from 91% in 1963 to 28% by 1988. The highest marginal rate has risen a bit to 37% today, but this rate is still low when judged by the standard of the last 75 years.

While we can’t predict what tax rates might be in the future, we can make an educated guess. Due in large part to last year’s recession and related Coronavirus relief spending, U.S. budget deficits are very large (>5% of GDP) today, and our total national debt is at the highest proportion to GDP since WWII. Also, without additional Congressional action, the reduced marginal rates in the Tax Cuts and Jobs Act of 2017 are set to expire in 2026. It would not be going too far out on a limb to expect that tax rates are likely to be higher in the future than they are today.

Roth accounts, which are funded with post-tax dollars, can be a very important component of an intelligent retirement savings strategy. There is no immediate tax deduction for Roth contributions, but when certain conditions are met, you can expect to enjoy tax-free withdrawals in the future, regardless of future marginal rates. In lower income years, it can even make sense for some savers to convert a portion of their traditional IRA to a Roth account. While the conversion itself is a taxable event, the rates you pay today on the conversion may be substantially less than on IRA withdrawals in the future. 

Managing income and using Roth accounts are just two of many potential tax savings and planning strategies that exist today. However, not all strategies are appropriate for all savers, and the right tax plan needs to reflect each saver’s unique income stream, employer benefits, spending needs, and investment accounts. Done right, long-term tax planning can take a bite out of one of the largest expenses in retirement and have a positive impact on the lifestyle that retirees can expect. 


Disclosure: The opinions expressed herein are those of Vickery Financial Services (“VFS”) and are subject to change without notice. VFS reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product.  This should not be construed as tax advice. You should always consult with your tax professional with regard to specific tax questions and obligations. VFS is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about VFS, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.