Before I explain why, it’s worth noting that if I’m right, this is a shattering fact. The wisdom of deferral is one of the bedrock principles of American financial life. It’s the basis for the entire retirement products industry. The ability to shelter income in a tax-free retirement account, in which the money can be invested and grow tax-free until it is drawn down in retirement, is among the largest subsidies in our tax code.
Like all such subsidies, this one disproportionately benefits those who have more money to shelter. But an underlying premise of deferral is that the tax rate incurred when you draw down the money at an older age will be lower than the tax rate you face today.
Or, to put the matter more precisely, deferral makes sense when the after-tax cash you end up with after drawing down your deferred money years hence and paying ordinary income tax rates on those sums exceeds the amount you’d end up with if you paid ordinary income tax rates on the income today and then invested the after-tax money for the same period, and paid capital gains rates when you want to sell your holdings and spend the money in retirement.
This is a bit oversimplified, because lots of variables affect how one might invest and draw down the money, but the key point is this: The wisdom of deferral depends critically on assumptions about the ordinary income and capital gains tax rates one will face in the future.
It’s always been a pretty safe assumption that deferring money in your high-earning years is smart because you’ll be in a lower tax bracket in retirement when you draw the money down. Saving on taxes today and letting the money grow tax-free has thus been a no-brainer.
But now we live in an era of endless trillion-dollar deficits that will have to be snuffed out somehow. Our Chinese overlords will demand nothing less. Meanwhile, a phalanx of graying baby boomers must have their Social Security and Medicare financed. Only small children and Republicans pretend that taxes will not rise as part of America’s inevitable fiscal adjustment. What’s more, it seems entirely plausible that for at least a portion of America’s affluent, tax rates will rise not only to what they were under Bill Clinton, but higher.
At some point — a point that will depend on exactly whose ox gets gored when, and to what extent — this means a swath of Americans will be better off paying taxes now and investing the after-tax income instead of deferring. In one example I penciled out, the break-even between the deferral and non-deferral scenarios 20 years hence comes if the top ordinary income tax rate is 50 percent in the future, and capital gains rates then are 25 percent. If the ordinary rate is higher down the road, or the capital gains rate lower, you’d be better off not deferring.