There is talk about rising tax rates. While most of it has focused on people earning more than $400,000, it’s important to know how to prepare for rising tax rates in case it ever affects you.
There are many ways to prepare for rising tax rates: selecting which retirement accounts to make contributions to, contributing to an HSA, carefully selecting which assets to put in each account, and strategically increasing or decreasing your income.
First, let’s look at how tax rates today compare to historical tax rates and why it is reasonable to assume tax rates will go up at some point in the future.
Unlike others, I am not of the position that “tax rates must go up to pay for our debt.” Rather, I am of the position that it’s normal for tax rates to change over time. It’s reasonable to assume that they go up and down over a lifetime. Planning for that is important.
I don’t remember where I heard it, but someone once said, “You should pay all the tax you are legally obligated to pay, but don’t leave them a tip.”
Failing to plan for higher or lower taxes is leaving the IRS a tip. Let’s explore ways to prepare for rising tax rates.
Planning for Rising Tax Rates – Today vs. Historical Tax Rates
We are in a historically low tax rate environment. Look at the chart below.
You can see how our top marginal tax rate, which is the rate someone would pay on additional income in the highest bracket, is close to the lowest it has been.
Also, the tax brackets are fairly wide, meaning people can recognize a fair amount of income in each bracket at a low rate. In comparison, tax rates in 2017, which are slated to come back in 2026 if no tax legislation is passed before, were higher and narrower. People could recognize less income within each bracket, and it was taxed at a higher rate.
Look at the charts below. For example, a married couple filing jointly with a taxable income of $160,000 would fall in the 22% marginal tax bracket today. In 2017, they would have been in the 28% marginal tax bracket.
2021 Taxable Income Brackets
|Rate||Single||Married Filing Jointly|
|10%||Up to $9,950||Up to $19,900|
|12%||$9,951 to $40,525||$19,901 to $81,050|
|22%||$40,526 to $86,375||$81,051 to $172,750|
|24%||$86,376 to $164,925||$172,751 to $329,850|
|32%||$164,926 to $209,425||$329,851 to $418,850|
|35%||$209,426 to $523,600||$418,851 to $628,300|
|37%||$523,601 or more||$628,301 or more|
2017 Taxable Income Brackets
|Rate||Single||Married Filing Jointly|
|10%||Up to $9,325||Up to $18,650|
|15%||$9,325 to $37,950||$18,650 to $75,900|
|25%||$37,950 to $91,900||$75,900 to $153,100|
|28%||$91,900 to $191,650||$153,100 to $233,350|
|33%||$191,650 to $416,700||$233,350 to $416,700|
|35%||$416,700 to $418,400||$416,700 to $470,700|
|39.6%||$418,400 or more||$470,700 or more|
The 2017 tax brackets would be adjusted for inflation in 2026, meaning the taxable income amounts above would be higher, but let’s assume they are not for simplicity to illustrate the point.
In other words, if the 2017 tax brackets come back in 2026, someone with $160,000 of taxable income today would pay six percentage points more in taxes for each additional dollar of income earned up to $233,130. On the other hand, using today’s tax bracket, they would pay 22% until $172,750 and then 24% until $329,850.
We are in a low tax rate environment compared to where we could be in 2026.
How do you take advantage of today’s low tax rate environment?
Roth 401(k) vs. Traditional 401(k)
The first step you can take is choosing your retirement account wisely. If you have access to a 401(k) with both a Roth and Traditional option, you can select whether you want to be taxed today or in the future.
With the Roth 401(k), you are voluntarily paying taxes at today’s rate in return for tax-free growth and tax free distributions in the future. With the traditional 401(k), you are voluntarily deferring taxes at today’s rate in return for tax-deferred growth and taxable distributions in the future.
Continuing the example from above, do you want to reduce your income and save 22% in taxes for each dollar you contribute to a Traditional 401(k) or do you want to give up the 22% savings in return for tax-free growth and distributions?
The question is not an easy decision. It’s not just a matter of comparing your tax bracket in 2026. You need to compare it to what it could be when you retire and start to take money from your 401(k). For some people, retirement brings a lower tax bracket. For others, Social Security, Required Minimum Distributions, and other income can push them in a higher tax bracket.
Knowing you are in a lower bracket today, and at least in 2026, taxes may be higher, you may be okay volunteering to pay 22% in taxes today and contribute to the Roth 401(k) to possibly avoid higher taxes later. This is a way to hedge against higher taxes in the future. You can start to build a tax-free retirement account, and then if you wanted to contribute to the Traditional 401(k), you could do that in the future when tax rates are higher and the tax savings are correspondingly higher.
Please keep in mind this assumes you make similar levels of income in the future. It’s possible your income goes down. It’s possible tax rates will go down. It’s possible your marital status changes and your significant other’s income changes the entire picture.
I am giving you the tools to think about it in your own situation and make the best informed decision possible.
If you already have money in a Traditional 401(k) or Traditional IRA, another option is to convert a portion of those assets to a Roth IRA. You could allow the tax-deferred assets to continue to grow, or you could make an active decision to purposefully convert those assets to a Roth IRA and voluntarily pay the tax today.
This isn’t the best decision for everybody, but if you think you will be in a lower tax bracket today than you will be when you need to withdraw the funds in the future, a Roth conversion can make sense, even while working.
For example, if you are in the 22% tax bracket today given the wider tax brackets and you feel you will be in the 25% tax bracket in the future, it makes sense to do a Roth conversion.
A common question is, ”What about the opportunity cost of the taxes paid and the growth on it?” It doesn’t matter. Only the marginal tax bracket matters.
For example, if you have $100 invested in a traditional IRA, convert it to a Roth IRA and pay 25%, your Roth IRA will be $75. Let’s say it grows 10%. After a year, it will be worth $82.50.
Instead, if you left the $100 invested in a traditional IRA, it grows 10% to $110 and then you distribute the entire account and pay 25%, your after-tax amount is $82.5 – the same as the Roth IRA.
This means you only need to compare your marginal tax bracket today to your marginal tax bracket in the future. If you anticipate your marginal tax bracket rising in the future, it likely makes sense to recognize income today by contributing to a Roth 401(k) or doing a Roth conversion.
Another option is to contribute to an HSA. Unlike retirement accounts, an HSA combines the best features of both a Roth 401(k) and a Traditional 401(k).
Contributions are tax deductible. Growth is tax-deferred. Withdrawals for qualified medical expenses are tax-free. It’s triple tax advantaged!
With this account, you do not need to estimate your tax bracket today and tax bracket in the future because it’s triple tax-advantaged. Assuming you have the available funds and are on a qualified health insurance plan that allows you to make HSA contributions, contributing to an HSA is a great deal.
I’ve previously written in-depth on HSAs, so I encourage you to read it. I would not select a health insurance plan solely because it allows you to reduce your taxes and make HSA contributions. First, you need to decide which health insurance plan makes the most sense for you and your family given costs, out-of-pocket maximums, and other factors.
Pick the Right Account for Assets
Another often overlooked strategy is asset location or asset placement, which is a fancy way of saying, put assets in their most tax-favored accounts.
For example, once you decide on an overall investment mix, you want to pick the right account for each investment. If you wanted to be 80% stocks and 20% bonds, you likely don’t want to be 80% stocks in your Roth IRA, Traditional IRA, and Brokerage account.
Instead, you want assets with the highest expected returns in the Roth IRA because the account grows tax-free and withdrawals are tax-free. Instead of Uncle Sam investing alongside you, you get to keep 100% of the return. If the Roth IRA goes up 20% in a year, the full 20% is yours.
Conversely, the assets with the lowest expected returns should likely go in a Traditional IRA because future distributions are taxable. If your Traditional IRA goes up 20%, Uncle Sam will get a future cut of it. For example, if you anticipate being in the 25% tax bracket in the future, your return is only 15% after taxes. Uncle Sam has a future claim to 25% of the return, or 5%.
This is why it generally makes sense to put most of the bonds in a Traditional IRA, most of the stocks in the Roth IRA, and let the brokerage account balance things out with the remaining assets.
I say “in general” because each situation is unique. If you are saving for a down payment on a home in five years, you may not want the brokerage account to be aggressively invested in stocks. Given the relatively short time frame, you may want it more conservative.
Income and Deductions
Lastly, to the extent you are able, you may want to pull income into the current year and push deductions into the next year.
For example, if you are expecting a bonus within the next year and your employer is open to giving it to you in the lower tax year, you could push for a bonus now.
The same can be done for your portfolio. For instance, if you have a $10,000 capital gain in your brokerage account and you are in the 15% capital gains bracket this year and could be in the 20% capital gains bracket next year, you may want to sell the asset this year.
Although it’s only five percentage points difference, there is talk about capital gains going from 23.8% to ordinary income rates as high as 39.6% for people earning over $1M per year. In their case, when they recognize capital gains is even more important.
Whether your capital gains rate is doubling or only going up by a little, small, proactive steps will help you pay the tax you are legally obligated to pay, but not tip the IRS.
Lastly, you can adjust your deductions in certain circumstances. The one that comes to mind for most people is charitable giving. If you were planning on giving a large amount to charity this year, you may want to consider giving it next year if you plan to be in a higher bracket. If you are itemizing and in the 22% tax bracket today, but anticipate being in the 25% tax bracket next year, it likely makes sense to defer the gift.
For example, if you planned to give $5,000 and could itemize, at 22%, the deduction equates to about $1,100. At 25%, the deduction is $1,250, a difference of $150.
Although it may seem small, the combination of everything can add up significantly, particularly over many decades.
Summary – Final Thoughts
Regardless of your views on whether tax rates will rise or not, it’s important to understand what steps you can take if tax rates do rise. We are in a historically low tax rate environment and taking advantage of it is important.
When it comes to retirement accounts, don’t blindly defer money in a tax-deferred account because that’s what you have been told. Carefully think about what your marginal tax bracket is today and make an active choice if you want to defer your taxes now or pay more today for tax-free growth.
When it comes to your investments, consider the taxability and expected return of each investment. Except in a few rare circumstances, your most aggressive assets should likely go in your Roth IRA for the tax free growth.
Lastly, to the extent possible, bring income into the current year and put off deductions, such as charitable contributions, into a higher tax year if you anticipate tax rates rising.
Enjoy the tax savings!