Lawmakers in Washington, particularly those aligned with the Republican Party, like to talk about tax cuts. Which is why you might be hearing more birds and crickets chirping than usual around Capitol Hill. Because, with all this federal debt piling up, it’ll be a long time before another bill like the Tax Cuts and Jobs Act of 2017 comes around.
While that was, generally speaking, a boon to taxpayers, many heads of household were underwhelmed. People who got a refund every year were suddenly writing checks to the IRS. While the real issue had to do with out-of-step withholding allowances rather than the actual tax rate, there was some unexpected pain.
But the question remains, if a tax cut can catch you flatfooted, what could a tax increase do?
1. The Roth Route
Roth IRAs and Roth 401(k)s are great for creating the kind of diversification that comes in handy when taxes are expected to go up – particularly if income might be going down in the future.
Roth 401(k)s allow you to defer up to $19,500 a year, plus another $6,500 if you’re 50 or older. That’s income you would be paying taxes on at this year’s rate rather than at a future, presumably higher, rate.
But you need to be careful. What if an extra $19,500 of income puts you in a higher tax bracket? Then contributing to a Roth might be counterproductive. The trick is to figure out how much warning track you have left in your applicable income tax bracket, and then be careful not to let any additional income into that next, higher tax bracket. To add another layer of complexity to the calculus, realize that your tax bracket is likely to change along with your tax rate in the future. It’s best to connect with a financial professional who stays on top of these developments as they wind their way through Washington.
Under the right circumstances, a “backdoor” Roth strategy creates no additional tax, and you effectively bypass the income phase-out for a normal Roth IRA contribution. If your earnings are too high, you might no longer be eligible to contribute to a Roth due to income limits, also known as “phase-outs.” Still, you might be able to make a non-deductible IRA contribution, and then convert the money in that IRA over into a Roth. This “backdoor” approach to establishing a Roth account isn’t advisable for everyone, though. A poorly designed backdoor Roth strategy can create taxes, if done incorrectly. Again, best to talk with a trusted advisor.
2. Embrace the pain
You’ve probably heard of Marie Kondo by now. She’s the “organizing consultant” who has a worldwide audience for her message of decluttering. Kondo is famous for urging people to throw out anything that doesn’t delight them.
“The best way to choose what to keep and what to throw away is to take each item in one’s hands and ask: ‘Does this spark joy?’” she writes in her seminal book, The Life-Changing Magic of Tidying Up. “If it does, keep it. If not, dispose of it.”
While that’s sound personal advice, it might be the opposite of what you should be doing from a tax perspective.
If you believe that your 2021 taxes will be higher than your 2020 taxes, now might be the time to acquire things. These could be investments, but not necessarily. You might want to move into a new home or buy some art or collectibles jus’ cuz’, or it might be part of a financial strategy. Just remember that when you’re trading in non-fungible objects rather than securities, there are generally higher transaction and carrying costs.
3. Doing more with less
Ultimately, the goal is to pay for everything you can with pretax income, so you have less income to tax. Funding college and health care expenses pre-tax will become more and more important.
And perhaps this is a time to discuss early retirement. If you’ve been on the fence about that, consider if your after-tax income from working all year would be all that much higher than the passive income you get while golfing.
There is no one single solution. A lot of this depends on your particular situation. Kids in college or soon to be? Good health or not? Side hustles or other sources of income? But that’s the knowable stuff. The future of taxation in America is yet to be written. Best to chat with someone whose job it is to read it.