Predicting Income Tax Rates

Can anyone predict the future of our income tax rates? David raised that issue in a comment to April 27’s post. I guess the correct answer is, yes you can predict future income tax rates; just not accurately.

In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.

My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.

A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.

An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.

The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.