Tax Deferral- Pay The Tax Now or Pay The Tax Later

Millions of American’s contribute to tax deferred accounts every month and every year. In fact, thanks to the Pension Protection Act, you are now automatically enrolled in a 401k when you start a new job. I wanted to share a few thoughts on these types of accounts and how it should affect your overall tax planning.

Now I’m the first one to want to save money on my tax bill come April, but at what expense? If in reality I am saving money today that costs me more tomorrow, are the savings worth it?

When you defer taxes its important to keep in mind that you are deferring the tax and the calculation of that tax. If I defer my taxes to a later day, and my tax rates increase, I will pay additional taxes that I would not have paid today had I rid myself of those taxes.

Have you ever seen this chart?

Tax History

It illustrates historical tax brackets. Just by glancing at it, you’ll notice something very interesting… we are in some of the lowest tax brackets our country has every seen! What are the chances of them going down? When these type of accounts originated over 30 years ago, tax brackets were high. You could pay up to 70% in taxes (Tax Brackets 1950-1980). To retire at a lower tax bracket was already planned, most worked for one company, and had an idea of what their pension would be at retirement. We do not live in the same economic environment as we did 30 years ago.

Now consider a few other items:

1. Our Nations Need For Revenues

usdebtclock.org/ has our total US debt at 56.9 Trillion as of today (Jun 11, 2012). They suggest that each household would have to pay $685,072 each to pay off their share of the debt. Rumor is that only about 50% of the American households pay taxes. So for us taxpayers, we would each owe around 1.37 million dollars. These are substantial figures, almost impossible to visualize (what a trillion dollars looks like). I’m almost certain of one thing… taxes cannot go down.

2. Your Personal Finances

Apart from our national issues, have you thought much about the changes that will occur in your personal finances? Chances are that by the time you retire, you will naturally be in a higher tax bracket. For one, simple inflation alone will put your income at higher tax rates. Now take into account your mortgage being paid off, your children leaving the home, and potentially higher income. It seems highly unlikely that you will ever find yourself in a lower tax bracket. Your future has less exemptions and less deductions. It will is far too natural to naturally progress into higher tax brackets.

I have always avoided postponing taxes, and even though there are many reasons not to, the real reason for me, personally, is simple. I plan on making more and more money every year I live. I don’t plan on a day where I will earn less, and I certainly don’t want to be motivated to earn less, just to minimize my taxes. I believe that the best thing you can do is get rid of your taxes today, and shelter them in the future.

Jake

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Jake

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