Our income tax system is what’s known as a “progressive” income tax. Like every developed nation, the US taxes high incomes at a higher rate than lower incomes. Some may debate whether or not a progressive tax structure is fair or effective (although it’s interesting to note that there has never been a nation that can be considered prosperous by modern standards that did NOT use a progressive income tax system), but the fact is a progressive income tax system is here to stay. And in today’s economy, where job security is largely a thing of the past and young people of today can expect a lifetime of fluctuating income, this presents a possible tax trap for some, and a tax saving opportunity for those who plan ahead.
Over the course of a career, nearly all people will fall into multiple tax brackets. Most of us start out in the bottom brackets, many of us move up to the middle brackets at some point, and a few will have years in the top income brackets. Without proper planning, people with modest assets and only a few high earning years may wind up paying taxes at levels equal to, or higher than, the truly affluent. This is because the income tax system only looks at one year at a time. So even one good earnings year can put you in the highest bracket, even though over your career you don’t necessarily earn a lot of money relative to your peers.
Sales people are often a good example of this; real estate agents in particular. When working on commission, a person might make $500k one year, but then earn $20k each year for the next 5 years. This person would pay taxes at the highest rate (currently about 40%) on a significant portion of their income during this period. Meanwhile, somebody in a more stable profession might earn $100k each year for six years, resulting in the same before tax earnings of $600k during the six year period. However, $100k of annual income will probably put this person in no higher than the 25% tax bracket. As a result, the person with steady earnings might pay tens of thousands of dollars less in taxes on the exact same amount of income.
It might not seem fair, but that’s the way it works…and it’s awfully hard to imagine any alternative so that’s probably the way the system will be in the future. But this does present a tax savings opportunity. A savvy individual needs to consider their lifetime earning potential and plan accordingly.
Young people, who are likely still in relatively low tax brackets, should generally fund Roth IRA accounts and other investments that give no tax deduction right now, but offer tax savings in the future. Buying up stock and other assets likely to appreciate over the long run can also be a good move from a tax perspective at this point as well, as we’ll see later.
As individuals move toward middle-age, and their prime earning years, that becomes the time to start reducing their income through the use of tax-deferred savings plans, such as 401k’s and Traditional IRAs. In addition, if this individual was smart enough earlier in life to invest in a diversified group of assets, this person will probably have some assets that have lost value over time. These assets can be sold at losses and used to offset income that would otherwise be taxed at a high rate. Appreciated assets should be held on to, as these items won’t be taxed until they are sold.
Finally, as careers wind down, individuals can start recognizing income that was deferred earlier in their lives. This can be in the form of taking distributions from IRAs and 401k’s, or it can mean selling assets that have been held for many decades and experienced significant appreciation.
In addition to offering overall tax savings over a lifetime, this approach also provides flexibility during the inevitable fluctuations throughout a career. If a person has been setting aside money, then a period of unemployment, for instance, can more easily be navigated. A middle-aged person who becomes unemployed for a long period may choose to withdraw some money from a Roth (which can be done totally tax-free as long as certain criteria are met), as well as other money from a Traditional IRA or 401k (which can conceivably be done with no penalty and very minimal tax through careful planning).
Through careful planning, an individual can easily save tens of thousands of dollars over their lifetime by setting aside money in a way that makes the most sense from a tax perspective. Young people should generally look to assets that offer no current deduction but can grow in value without being taxed. Middle-aged individuals in their prime earning years should seek to maximize the deferral of taxes. And retired individuals should recognize income that has been deferred in a balanced way that will minimize the taxes on this income. Through this approach, individuals can avoid some of the unintended side affects of a progressive tax system.