Conventional wisdom holds that it's better to defer taxes as long as possible, but that's not always true. Sometimes you want to pay some taxes now, to avoid paying more later.
Doing that involves a careful calculus: Will your tax rates be higher in the future than they are now? Will paying now save you money later? What about the other uses you could put the money to now?
A classic example are Roth IRAs and Roth 401(k)s. These retirement accounts require you to make your contributions in after-tax dollars, so you're effectively paying now. But later, all of your earnings will be tax free.
The Roth question gets complicated when you qualify for the alternative of putting tax-deductible money into a retirement account.
It seems like it would always be better to get the deduction but it isn't. That's because withdrawals from tax-deductible retirement accounts are taxed as income when they are made. And if you expect to be making your withdrawals in a place and at a time when your effective tax rate is high, you might be better taking a hit now and investing tax free.
Teen workers who establish Roth IRAs make the most of this: Their income might be so low as to be not taxed at all, or to be taxed at a very low rate. By the time they are old enough to use the Roth, their rate could be much higher.
Here's another example, from St. Louis financial adviser Larry Swedroe. He discusses the case of the bond buyer who buys a bond only to see interest rates slide. That's the opposite of what's happening now, but it can't hurt to be ready.
When rates fall, bond prices rise to the point where the resold bond offers the same yield as a new bond. So the bondholder could either sell his bond immediately after rates fall for a capital gain that would be taxed at 15 percent (as long as he'd held it for a year), or hold his bond and reap higher interest every year until his bond matures. That higher interest would be taxed at a normal income tax rate, which could be as high as 35 percent.
Of course there are many other factors involved, and that's the rub.
In the first place, it's not so easy to buy and sell individual bonds, without giving up something in trading costs and yields. In the second place, the taxes paid now would reduce the principal that the hypothetical investor could keep in the market.
Says Swedroe: You'd need a significant fall in rates, a large portfolio and longer durations for it to make sense. The moral of the story? You've gotta do the math.
Here are some tips for deciding when it makes sense to take a tax hit early.
- Make a good guesstimate of what your tax rate will be tomorrow, and compare that with what it is today. You may think that it will be lower if you intend to retire, earn less, or move to a low-tax state; but it could be higher.
Personal income tax rates are low by historical standards and the deficit is at record breaking levels. Sounds like a rate hike, someday. Furthermore, income tax brackets are broader than they used to be, and there are fewer of them. So, even if you earn less in the future, that might not bump you down to a bracket lower than the one you're in already.
- Don't forget the Social Security hit. Once you earn over $25,000 ($32,000 for married, filing jointly), half of your Social Security benefits become subject to income taxes. Once you earn $34,000 ($44,000 for married, filing jointly), as much as 85 percent of your benefit is taxable. If you defer taxable income until you retire, and that income is just enough to push you into having your benefits taxed, that makes your effective marginal tax rate then quite high.
- Consider today's low capital gains tax rate. Income that you take as a gain now can be better than income that you take as taxable income later, as Swedroe pointed out. That may mean that if your 401(k) plan is lousy, you might be better off investing now in tax-managed mutual funds or individual stocks that would allow you to take your tax hit when you choose. This also means that the hard sell you get from the variable annuity salesmen - that it's worth paying fees to defer taxes - may not be true.
- Or, make the most of losses. Furthermore, you can use losses now to offset capital gains, and as much as $3,000 in taxable ordinary income.
If you've got big losses this year (and if you invested in April, you probably do), you can sell your losers, take some income that you would ordinarily defer and essentially destroy the tax hit.
- Plan your Roth conversions carefully. If you make under $100,000 a year, you can convert your tax-deferred IRA into a Roth IRA. We'll crunch the numbers in a future column, but for now, it makes sense to realize that you can convert to Roth gradually, so as to minimize your taxes on the converted amounts and to avoid throwing yourself into tax hell when you retire.
- Look at the risk and opportunities in your portfolio. Don't hold onto an investment that you no longer have faith in, just because you don't want to pay taxes on the money it's made you. You might come out ahead if you bite the bullet and sell, pay taxes now and reinvest the proceeds in something more promising.