Why your tax rate is going up

Taxes are likely to head higher. And a return to historical levels could derail your retirement savings - unless you protect yourself now.

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By Janice Revell, Money Magazine senior writer

NEW YORK (Money) -- Last week, the federal government began sending out more than $100 billion in "tax rebates" to millions of Americans in an effort to stimulate the sluggish economy.

If you're among the 130 million people who qualify for the rebate, that's great. But you should savor the feeling. Regardless of what happens over the next few months, your taxes have nowhere to go but up in the long-term future.

And if you didn't qualify for the tax rebate because you make too much money (it phased out at an adjusted gross income of $75,000 for singles or $150,000 for married couples) you're even more vulnerable.

A little trip down memory lane can help explain why. You might not remember it - perhaps you blocked it out - but as recently as 1980, the top federal income tax bracket was a mind-numbing 70%, or double today's rate. Even if you were in the middle class, earning $100,000 in today's dollars, you fell in the 49% marginal bracket. Today, if you earn $100,000, you're in the 28% bracket.

That is a monumental cut in taxes over a relatively short period of time. And the same story holds true for taxes on investment income: the maximum rate on long-term capital gains has plunged, from 28% in 1980 to 15% today.

Today's low rates can't last. The tax cuts of the past decades were supposed to lift economic growth (which they did) and hike tax receipts faster than federal spending (which they did not). Not even close. The resulting tsunami of federal debt is one reason to expect your taxes to rise over the next quarter-century.

And then there's the looming retirement of 77 million Baby Boomers. The oldest Boomers have already become eligible for Social Security, and they'll become entitled to Medicare in three years. According to research by the National Center for Policy Analysis, if today's low tax rates remain in place, a staggering 76% of all federal income tax revenue in 2050 will be soaked up by those two programs alone - before a penny is spent on defense, national parks, health care for the poor or haircuts for congressmen.

Clearly, something has to give; it will undoubtedly include today's historically low tax rates. And that has major implications for your retirement savings strategy.

Now, some of you Boomers may be thinking that your income will go down in retirement, so you have no reason to worry about higher taxes. But that's not the case.

Let's say, for instance, that you make $70,000 today, an income that puts you in the 25% marginal tax bracket. Once you're retired, though, you figure you can get by comfortably on 80% of that income, or about $55,000 a year. But if we return to historic tax rates, it won't matter if you're making less - your tax rate in retirement could still go up.

If we return to 1980 rates, for example, your $55,000 income will put you in the 34% marginal tax bracket, or 9 percentage points higher than today. (And that's assuming that a portion of the $55,000 is in the form of Social Security payments, some of which are not taxed.)

All of this means that when you're saving for tomorrow, you must factor in the very real possibility that you'll be in a higher marginal tax bracket when you retire.

That means that you should be saving in vehicles that allow you to pay taxes today, instead of putting them off until tomorrow. The Roth IRA and the new Roth 401(k) are two examples.

In traditional IRA s and 401(k)s, you postpone income taxes on your contributions until you withdraw the money at retirement. With the Roth versions, you pay taxes on the money you put in - now, at today's low tax rates - but pay no taxes on that money (or earnings on that money) in the future when rates will likely be higher.

You can contribute up to $5,000 to a Roth IRA ($6,000 if you're age 50 or older) in 2008. To be eligible, your modified adjusted gross income must be less than $116,000, or $169,000 as a couple filing jointly.

A Roth 401(k), on the other hand, has no income caps - no matter how much you make, if your employer offers it, you can contribute to it. You can contribute up to $15,500 to a Roth 401(k) ($20,500 if you're 50 or older) in 2008. You can also divvy up your 401(k) contributions between the traditional and Roth versions, as long as your total contributions don't exceed the annual limit.

Sure, it's conceivable that tax rates won't go up in the future. But why take that chance? By diversifying and putting some of your savings into Roths, and other money into accounts that let you pay tax up front, you'll at least be hedging your bets.

Questions or comments about retirement? Send e-mails to jrevell@moneymail.com.  To top of page

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