contributed by Nathan Gehring, CFP® (US)
A frequent struggle when working with clients and their tax preparers on tax matters is helping them balance current tax savings with potential future tax costs. As a financial planner, I am often looking at a client’s tax picture over many years and decades, whereas the client and tax preparer often are focused on the past year, current year and occasionally the next year. These two different focus-points can lead to very different recommendations and strategies.
The short-term focus often results in recommendations that reduce total taxes paid in the present year, but at the cost of higher taxation in future years. This makes sense, since people generally want to pay as little tax this year as possible. However, this focus can be harmful to an individual’s overall financial picture when looked at over many years.
A long-term focus considers a client’s total tax picture over many years and looks to be as tax efficient as possible over that duration, sometimes giving up current tax savings in order to target larger tax savings over the long-term.
“Permanent Marginal” Tax Rate
One of the most powerful concepts when looking at the long-term tax picture is the “permanent marginal” tax rate. This is the lowest marginal tax rate an individual is expected to pay throughout their lives, or at least over a very long time frame measured in decades. This “permanent marginal” tax rate is an individual’s tax floor.
The conventional definition of “marginal tax rate” is the rate of tax that would be paid on the next dollar of income in any particular year. The “permanent marginal” tax rate is quite different. It is a rate that could be much lower than the marginal tax rate in any particular year.
This “permanent marginal” tax rate is critical, however, because it is the rate a client is certain to pay in any year. When viewing tax recommendations long-term, this “permanent marginal” tax rate becomes the rate that can be counted on and played with to be tax efficient.
For example, once I know that a client has a “permanent marginal” tax rate of 15%, I also know that it generally makes sense to recommend a client take as much income as possible year in and year out as the 15% rate allows. Why? Because I can predict with a reasonable amount of certainty (barring major legislative action) that they will never have a lower tax rate. However, that same client might have a higher rate in the future! So, by recommending a client take as much income as possible every year at the 15% rate, I’m also reducing the likelihood they will have extra income in years where they may be in a higher tax rate.
It May Cost You More Now
What’s difficult about this concept for many people is that it can frequently result in paying more tax this year than is absolutely necessary. In fact, this concept can result in more taxes being paid for several years. However, this is done in anticipation of a rate in excess of the “permanent marginal” tax rate in the future.
This is often the case when working with retirees who have a large IRA. The basic rule of thumb is to defer taxes as long as possible on an account. Money in an IRA is only taxed when it is withdrawn, so people generally don’t take any distributions unless they need to. On the surface, this makes sense. Why pay tax this year if you don’t need money out of the account?
But what if for the next four years you expect to have a marginal tax rate (the rate the next dollar will be taxed at) of 15%, which is also your “permanent marginal” tax rate. And five years from now, when you’re going to need money out of the IRA, you will be in a higher tax bracket…say 25%. Wouldn’t you rather take money out of your IRA during some or all of these four years at the 15% rate, put the money aside in account for when you need it, and save 10% in taxes instead of waiting until five years from now to take the money out?
Not Quite This Simple
Making tax planning recommendations are never quite as simple as the above example suggests. There are many other issues to consider including potential exposure to the Alternative Minimum Tax, the potential for tax law changes, uncertainty in a client’s life and a host of other issues.
However, knowing a person’s “permanent marginal” tax rate is an important and powerful concept. This “permanent marginal” tax rate is critical to consider whenever reviewing your tax situation. Any tax strategy that doesn’t consider the “permanent marginal” tax rate has the potential to result in increased tax costs over the long-term, even while saving some money today.