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The Roth IRA and the future of taxes
A few years ago, I wrote an article looking at the differences between a Roth IRA and a 401(k) with regards to how taxes will change in the future. If taxes go up, then a Roth IRA, or Roth 401(k), is better. If taxes go down, then a 401(k) is better.
When I'm offering financial advice for the future, I usually operate under the general assumption that income taxes are going to go up over the next 30 years. This has nothing to do with my personal political beliefs, but it has everything to do with numbers.
Again, I'm not arguing one way or another whether it's right for taxes to be lower or higher. That's not the point. Instead, I'm interested in trying to predict what will happen. I don't have any political motivation one way or another when it comes to trying to figure out what moves I should make that are best for my retirement — and what moves you should make that are best for your retirement.
Here are five reasons why I believe tax rates will go up over the next 30 years, thus making a Roth IRA a good investment choice.
Income tax rates haven't been this low in almost a century
Take a look at this tool, which shows the history of income taxes in the United States from 1913 to 2012. Depending on what tax bracket you look at, recent tax rates are lower than they've been for everyone since the 1930s or 1940s.
With all the complaints about income taxes out there, the truth is that the government has actually been trimming taxes significantly over the last two decades, leading to a point today where almost everyone is paying a lower tax percentage than they would have paid 20, 30, 40, 50 or 60 years ago.
Play around with the tool. You might be able to find a narrow exception or two at a few specific income points, but the trend for almost every income over the last 30 or 40 years is downward.
Debt is going up
Imagine that your parents made $20,000 a year in 1970, and they had debt equal to 20% of their income. That would be $4,000 in debt.
Today, that same couple is probably making $60,000 a year thanks to inflation. That same 20% debt would add up to $12,000 a year, but in truth, their debt percentage has gone up — way up. They're now in 60% debt, which is $36,000 a year.
That $4,000 to $36,000 a year jump looks scary, but it's scary for two separate reasons. One is inflation, which isn't a big deal. The part that's actually scary is the percentage growth of inflation.
That's what is happening to the United States. Not only is our debt growing thanks to inflation, it's also growing as a percentage of our income (the most common way to measure a nation's total income is called Gross Domestic Product, or GDP).
Since the mid-1970s, the national debt has been going steadily upward. The growth in actual dollars has been astounding, but it's also been growing as a percentage of GDP.
Our population is aging
In 2010, 13% of the U.S. population was 65 or older. That grew by more than a third during the past decade. By 2050, it's predicted that 20% of the population will be that old.
What does that mean? It means that a larger portion of the population will be in retirement than ever before, which also means that a smaller portion of the population will be in the workforce than ever before.
Thus, a larger percentage of the population will be using Medicare and Social Security benefits.
Those programs are paid for out of our tax dollars. With more people going into that system than ever before, it's simply not realistic to imagine those taxes going down.
Without major changes to these programs, far beyond what anyone is realistically suggesting in Washington, these programs are going to be demanding money in the future. Either major cuts will have to occur, or there will be some sort of tax impact on working Americans. With more Americans in retirement, which side of that equation will have a louder voice in Washington?
A smaller percentage of the population will be in the workforce
It's reasonable to assume that the vast majority of Americans earn far more when they're working than when they're retired.
If that's true, the future will see a smaller percentage of Americans earning that relatively "big" paycheck from working, while a larger percentage of Americans are in some form of retirement, paying a smaller tax bill.
That means, on average, the amount that people pay in will be smaller. Fewer people are paying the larger tax bill that comes from working and more people are paying a smaller tax bill in retirement, so there's less coming in per person than before.
In order to keep paying the bills, there's either going to be a much bigger tax squeeze on the percentage of people who are still in the workplace or a somewhat smaller tax squeeze on everyone.
This all adds up to either higher taxes or major governmental changes
Given all of these factors, the numbers clearly point to a decline in the total amount of taxes paid in the United States. The only way to make that change work is to either raise taxes or drastically cut spending. Given that historically, we've had much higher tax rates, I think an increase in income tax rates is a pretty good possibility.
Again, I'm not stating what I think is the best political outcome for the situation. I'm simply stating that I think, given what we know right now, there's at least a significant chance that tax rates will go up from here — a chance that's much higher than the chance that tax rates will go down from here.
Because of that, with all else being equal, I recommend paying taxes on your retirement savings now rather than later, because it looks to me like rates are going up. With all else being equal, investing in a Roth IRA trumps investing in a normal 401(k).
Of course, that's not a perfect rule for all situations. If you're earning a much higher income now than you will in retirement, then a 401(k) or a traditional IRA makes a lot of sense. Also, if an employer is offering matching contributions, that trumps almost anything that could be said about taxes; get those matching funds.
One final note: There are obviously political solutions that could fix these problems. I think all of us are aware that there are different political stances that might address these issues in different ways, but that's not the point. The point is that regardless of what we each might feel is the best political way to handle these issues, we all must make money decisions based on what is most likely to happen.
People should take action accordingly to protect their own financial future.
[This article originally appeared on the Simple Dollar in September, 2019. It was updated in November, 2021.]