The current national debt hovers around $14.3 trillion. This is very troubling, considering the United States’ 2010 GDP came in around $14.7 trillion. That means the national debt is scary close to being 100% of GDP.
Two Options to Reduce National Debt
Although the national debt changes constantly (you can even get updated on the national debt amount on Twitter), major reductions only come when the government spends less than it earns.
As with personal finance, there are two ways to reduce debt: increase income while not increasing spending, or reducing spending. In the federal government hierarchy, spending less isn’t very popular. It doesn’t matter what political stance you prefer. All must admit that government spending has increased dramatically and no end is seen on the horizon. Small cuts in spending will have little impact on the overall debt.
That leaves on major option: increasing income. For the government that means increased taxes. A small increase in corporate or personal income tax rates could result in billions of extra dollars to use toward debt repayment. We mention this because one of the reason’s a Roth IRA is an attractive retirement investment option is you pay taxes today on your investment, and never again. If tax rates double by the time you retire, it won’t impact your nest egg. (The opposite is true of Traditional IRAs. Doubling of tax rates would have a devastating impact on your nest egg.)
Current Taxes on a $1 Million Portfolio
Let’s look at an example portfolio with $1 million invested in a Traditional IRA. You’ve received a tax deferral for those investments when you first invested. Now it is time for retirement. Let’s also assume you withdraw $60,000 per year out of that portfolio and have no other form of income. Based on the 2011 single filer tax brackets, your marginal tax rate would be 25%. You would pay $11,125 in taxes based on that income level and that bracket ($4,750 + 25% of the $25,500 of income in that bracket).
|$0 – $8,500||10% of taxable income|
|$8,500 – $34,500||$850 plus 15% of excess over $8,500|
|$34,500 – $83,600||$4,750 plus 25% of excess over $34,500|
|$83,600 – $174,400||$17,025 plus 28% of excess over $83,600|
|$174,400 – $379,150||$42,449 plus 33% of excess over $174,400|
|$379,150+||$110,016.50 plus 35% of excess over $379,150|
If your tax bracket during your working years had been in the 28% or higher brackets, you just received a nice tax benefit for waiting to pay taxes. But what if the brackets went up?
Theoretical Increased Taxes on a $1 Million Portfolio
Now let’s say Congress is forced into a corner and can’t come up with any spending cuts to fight the large deficit. They, to the chagrin of their constituents, increase all tax rates by 5% across the board:
|Taxable Income||New Theoretical Tax Brackets|
|$0 – $8,500||15% of taxable income|
|$8,500 – $34,500||$1,275 plus 20% of excess over $8,500|
|$34,500 – $83,600||$6,475 plus 30% of excess over $34,500|
|$83,600 – $174,400||$21,205 plus 33% of excess over $83,600|
|$174,400 – $379,150||$51,169 plus 38% of excess over $174,400|
|$379,150+||$128,974 plus 40% of excess over $379,150|
Now that $60,000 annual withdrawal from the Traditional IRA falls into the 30% marginal tax bracket. The tax you owe would jump from $11,125 to $14,125. If your initial tax bracket had been 25% or 28% you would have been better off using a Roth IRA.
What Will Congress Do?
There’s simply no way you can predict what Congress will do now, 10 years from now, or 30 years from now. But we’ll have to deal with rising deficits and debt eventually and the options are limited. Don’t be caught unaware when tax rates go up and your retirement hangs in the balance.