Imagine you’re standing on the bank of a river. The bank you’re standing on represents your current financial status, and the opposite bank is the amount of wealth you need for retirement. The river itself is the difference between how much wealth you currently have and what must be accumulated to reach your retirement goals.
When we look at bridging this wealth gap, it’s important to factor in anything that could get in the way of reaching our goals. That’s why taxes are so important. You can’t have an accurate calculation without understanding how taxes impact your wealth gap. You see, taxation plays a significant role in our ability to accumulate wealth. If you went through your whole life without utilizing any of the tax breaks available to you, you would have built substantially less wealth than someone who understood the Internal Revenue Code (IRC) and took advantage of its many tax-saving benefits.
In fact, one of my colleagues often calls the Internal Revenue Code “the greatest wealth creation tool in the United States.” He’s not wrong. The IRC is a tool for wealth creation. As such, it can be the difference in whether taxes impact your wealth gap in a negative way. You see, much of the IRC is pages and pages of information on how you can legally minimize taxes.
Let me be absolutely clear, I am not offering tax advice. Nor am I advocating for illegal or unethical means of avoiding the payment of taxes. You should always consult a professional before employing any of the strategies found within the IRC to ensure that you are compliant with the law.
By the Numbers
The top marginal income tax rate of 37% affects taxpayers with a taxable income of $539,900 or more for single filers. Likewise, it impacts married couples filing jointly, with a taxable income of $647,850 and above. But what does that mean for you? Will taxes increase? Will tax brackets expand, or decrease? The only way to truly opine the answers to these questions is to look back at historical tax brackets.
In 1984, the lowest bracket was up to $3,400 for married couples. The highest tax bracket began at $162,400 (the 1984 values are the base upon which inflation indexing began). However, the brackets began to spread in the 1990s. In fact, the highest bracket floor in 1994 rose to $250,000 while the lowest bracket ceiling remained around $38,000. So, there began to be a “spread” between the tax rates of high-income earners and those with less income. That spread has become an albatross in the modern era.
Historical tax data
To better put into context how taxes impact your wealth gap, let’s look at some of these numbers through a tax rate calculator. Using this calculator, if you were making $50,000 (in today’s dollars) in 1913 you would have paid around 1% in taxes. However, that same $50,000 earnings in 1942 would have landed you in a 20% tax bracket. So, what happened? Well, that would have been about the time that the government needed to fund the war effort for WWII. Since that time, there hasn’t really been a whole lot of movement. If you’re a single filer earning $50K today, you’re going to be taxed at about 22%.
However, most of the clients I work with earn much more taxable income than $50K. So, let’s go with a more realistic figure. We will enter $500K into the calculator. Keep in mind, the effective tax rate made a considerable change between 1937 and 1942. In 1944, a person earning $500K (in today’s dollars) would be taxed at the bracket rate of 51%. That number rose to as high as 58.9% in the early 1980s.
What History Tells Us
Famed historian and co-documentarian of the PBS series prohibition, Lynn Novick attributes the creation of the federal income tax to Prohibition in the United States. Novick states, “I had no idea how important liquor was to the federal government. It started in the Civil War with the levy on beer and whiskey to help fund the war, and it never really went away. Some 30% to 40% of the government’s income came from the tax on alcohol. So, Prohibitionists realized that the only way they’re going to have a ban was through income tax, which was a progressive cause and was really supposed to distribute wealth and to make things equitable during the robber baron era, where the wealth was being accumulated in a very small segment of the population.”
In 1913, the top tax bracket was 7% on any income over $500,000 ($11 million in today’s dollars). The lowest tax bracket was 1%. But so much has happened since then. We’ve experienced WWI, WWII, the Great Depression and so much more. Each of these events has played a major role in how we are taxed. For instance, the New Deal carried an inflation-adjusted price tag of $856.1 billion in 1933. Then from 1943 to 1982, the average tax bracket for the taxpayer earning $500,000 jumped from 14% to an average of 50% +/-.
Similarly, the Great Recession saw an economic stimulus that totaled $1.8 trillion. As a result, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 maintained the 35% tax rate through 2012. And recently, we saw the largest stimulus package in our nation’s history, with the CARES Act, which checked in at a staggering $3.6 trillion. As we have seen in the past, we could reasonably anticipate another increase in federal income taxes because of this.
Putting It All Together: How Taxes Impact Your Wealth Gap
According to the old adage, there are two certainties in this life: death and taxes. With that in mind, I wanted to get you thinking about how taxes will likely impact your wealth gap. I want you to be confident in your personal plans and direction. You know what you want out of retirement and how long you have to build the wealth that will fund it. Don’t let something like taxes throw off your calculation.
To ensure that you’re not overpaying on taxes, you should have a CPA helping with your annual tax filings. But that’s not all. You should also be meeting with your CPA and CFP® about proactive strategies to mitigate your tax burden. The less you pay in taxes, the more you can save for retirement. Both will help you to close your retirement wealth gap sooner than later.
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