Less than two years ago, in spite of all the political tensions that existed even before the 2020 election season and the year and half that has been COVID, Congress agreed on something. They agreed to a series of reforms to the rules of how retirement distributions work, revising decades of policy in a quiet end-of-year maneuver, passing easily through both chambers and being signed into law prior to the end of the year.
These changes included some large revisions involving estate planning as well as a seemingly innocuous shift in the age for required minimum distributions, or RMD’s. RMD’s are an IRS-required distribution of assets from a taxpayer’s qualified retirement accounts that have had taxes deferred – your 401(k) and Traditional IRA are good examples. Originally, the rule required a person who turns 70 and 1/2 years of age to begin receiving distributions, which start effectively at 2.55%, and increase in percentage each year. The new law increased that age threshold to 72 years of age, allowing more time for funds to build before the government begins taking its cut. They also removed the age limit on making contributions, requiring employers to comply in making contributions to employee plans. All of this looks good on its surface.
But the kicker in particular with raising the age limit on RMD’s is that by doing so, it actually decreases the value of what a Roth IRA offers – tax-free distributions throughout retirement. With tax-deferral having a longer runway, this effectively shrinks this advantage, because for each year that you add to the runway of the tax-deferred vehicle, a percentage of the population who could have benefitted from the tax-free treatment will have passed away, thereby receiving no tax benefit from paying the taxes on the wages that went into contributing into the vehicle to begin with. Meanwhile, those with funds in tax-deferred vehicles can either take distributions to cover their expenses and pay the taxes, or perform what is called a Roth conversion – moving the assets from the tax-deductible traditional account to the non-deductible Roth IRA – and have control over when the taxes are paid, without being subject to payroll taxes. And in case you are wondering what that number was for the shift from 70 1/2 to 72, the percentage of the total population that dies in that range is 1.66%, or 2% of the remaining population still alive at that time in that age range.
The concern I had when this legislation came out is not so much the substance of what was being agreed to, but the willingness and the spirit of cooperation on both sides of the aisle to make these sweeping decisions. That there was such willingness, with such little resistance to make these adjustments, signaled to me that we could very easily see more adjustments more rapidly in future years. I could not see any way around it, and that behavior is a risk that must be considered both in asset management and potential future taxation policies.
It is my thesis that over the next 10-15 years, the United States will likely face a generational crisis where the current Baby Boomer generation will by and large be broke. According to the Federal Reserve in September 2020, the median household net worth for ages 65-74 is just $266,400. Given that population will diminish from the workforce in the next decade and with living expenses including health care costs rising in excess of 4%, it will then fall squarely on the children of these then elderly parents and the Medicaid system to absorb the shock of their needs, a population that dwarfs in size to the generation that follows it. There are well-documented issues in Japan, in Britain and in other parts of Europe, as well as beginning evidence in the United States of troubles brewing. It is a social and financial tsunami that is approaching, seemingly miles and miles away, but with an exponentially increasing magnitude each passing year.
CNBC’s reporting included a schedule of increasing the age once more on RMD’s from the current value of 72 to 75 years old by 2032. I did expect for this number to eventually reach 75 years of age, but I expected that to happen over the next 30 years or so – not in a ten-year window. This acceleration of the curve is scary from the vantage point that if this is the adjustment they are looking to make now, what could future adjustments look like down the line?
The consequences of this shift are large. The first generation of people affected are those currently aged 64, who according to the Uniform Life Expectancy Table from the IRS are expected to live to an age of 87.6 years. This change in policy shortens the window of effectiveness for the Roth IRA from 15.6 to 12.6 years, a decrease of 19.2%. During these years, another 4.13% of the overall population or 5% of the remaining population alive during that time will pass away, culling them from receiving any effective tax benefit from their post-tax contributions.
For younger savers, there is an expected life expectancy of 90.25 years, which on first blush makes this policy change look like an actuarial adjustment. However, what also needs to be discussed at the same time are discussions also being had by the IRS and the Congressional Budget Office (CBO) with position papers supporting a continued rise in the full retirement age or FRA – this is the age at which a taxpayer receives their entire Social Security benefit. In 2022, the final age currently slated is a top end of 67 years of age to reach FRA, but the position papers suggest this number needing to climb as high as 70 to decrease costs of the program – an alternative both political parties are happy to embrace as opposed to strictly raising taxes. If they were to enact such a policy right away, younger baby boomers would be the first to be impacted, so it is my prediction that they will kick the can for themselves, initiating new policy starting around 2030 so their generation is mostly unaffected, but everyone after them is. They’ll justify this by pointing to the previous policy of a 2-month increase annually as a “tradition” with respect to FRA.
Moreover, this policy change would be quite regressive. It is well-documented that people who work manual labor jobs suffer more breakdowns in physical condition that force retirement earlier as a result. Moreover, it is also very well-documented that people who are in the lowest income quintile live 10-14 years less than their upper quintile counterparts. These two populations have a severe overlap, with a disproportionate number of minorities, namely Blacks and Hispanics. According to the BLS, if you were black and born prior to 2000, your life expectancy is actually lower than the 70 years of age they are considering raising the FRA to. Allow me to restate this: If you are black and currently age 21 or older, on average you will not live long enough to receive any Social Security benefit if this policy is enacted. Raising the FRA will likely cause a disproportionate amount of the Black and Hispanic populations to lose the financial benefit from the system they are paying into, thereby falling further behind in wealth generation compared to their white and Asian-American counterparts.
But wait, there’s more!
CNBC also reported that starting next year, all catch-up contributions (additional contributions allowed for workers aged 50 and older) for retirement will be considered Roth contributions, with the limit increased to $10,000 a year from its current level of $6,500 for employer-sponsored plans. This means that you will be required to pay the taxes on your wages first before being allowed to contribute to your retirement account, but those wages will be tax-free on withdrawal.
People love the notion of tax-free – until they see just how much it costs them. Under the current system, you are allowed to choose whether the contribution is considered a tax-deferred or post-tax contribution, depending on your financial situation. Since the age band of 50-66 is where the median income is highest, it is likely that for most people, they will be in the highest tax bracket and be subject to the highest amount of taxes during this period of time than any other time in their life – including retirement. The current system allows those people to avoid paying federal income tax, employment taxes, and state and local income taxes on those retirement contributions, which given a median income of $60,000 a year and a median state and local income tax rate means that 40.38% in total taxes on those wages is deferred right now. When that person goes to retire, it is likely they will pay either 22% or 12% in federal income tax depending on what they are earning with respect to Social Security, pay no employment taxes on the distributions, with many states not taxing or offering significant tax incentives on retirement wages.
Under the new proposal, you pay all of those taxes upfront. All of them. Suppose you make the maximum contribution to your retirement account AND you make the full $10,000 catch-up contribution. After you pay 22% Federal, 7.65% employment and a median state and local income tax (SALT) of 10.73%, to actually contribute that amount you would need to earn $16,772. Yes, $6,772 of that amount goes to pay taxes. Depending on what state and locality you live in, you will pay a net difference of 7.65%-18.38% in additional taxes; this is a tax hike of 19%-45% over the current policy.
This contribution and taxation scheme will not affect the poorest Americans, because they do not earn enough to make this level of contribution. It will also not affect the wealthiest Americans, where this type of contribution is just another wrinkle in the tax system they can take advantage of. But for middle class and middle-upper class working Americans who may consider fighting hard to make these types of contributions, the difference in returns as a result of this tax scheme could result in a net loss in value of over $100,000 over a 30-year period of time, assuming a 7% growth rate. This change in policy literally kneecaps the ability for middle-income earners to save more during the later part of their career, thereby placing more pressure on both the individual taxpayer and adding potential increased risk and increased cost to the social safety nets that would need to work should that person go bust.
But when you retire, they are considered Roth contributions so you get that sweet tax-free treatment . . . yes, the same tax-free treatment that they bastardized by raising the age for required minimum distributions.
And meanwhile, as you struggle to claw and climb and build a nest egg to be able to retire on, variables such as increasing inflation, Social Security payments notoriously not keeping up with increases in health care costs and other costs of living are also a potential future threat. If you are age 30 and your annual budget is $50,000, by the time you reach the proposed FRA of 70 years old, your standard of living will cost $110,400 in 2061 dollars, assuming just a 2% inflation rate. If the long-term inflation rate were to creep up just 0.5%, you would need to earn $134,253 in 2061 dollars to match what you are earning now, and with a life expectancy of over 90 you’re staring down a future lifestyle cost of nearly $200,000 a year, not to mention other unforeseen expenses along the way.
This is why avoiding credit card and high interest debt, building an emergency savings, and saving early and aggressively for retirement are vital. Because right now, particularly if you’re younger but even if you aren’t, there’s a tsunami making its way for the shore of the United States, a social policy and financial force gaining velocity and volume rivaling Poseidon himself. If there is anything I hope you garner from reading this exposition, is that you must be prepared and you must own your preparation in these matters.
The fact is, the petulance and hubris of our elected officials over the last forty years has culminated in a financial Doomsday scenario that I believe will have severe, long-lasting consequences. These consequences will bear down not just on our economy, but the overall quality of living of most Americans. What I hope I have also demonstrated is a willingness on the part of both parties to exploit and collude against you as they attempt to use the qualified retirement account vehicles to perform a con job akin to the student loan programs of the 1990’s and 2000’s that culminated in over a trillion dollars worth of debt on young Americans and their families. What they are working on is a scam with the intent to manipulate the tax system in an effort to cover up their own malfeasance.
To that end, I will continue to work to follow up on what ends up being enacted in real policy and adjusting our strategies accordingly with our clients. I strongly urge you to contact your local elected officials, particularly at the state and federal levels, and urge them to reconsider this gross manipulation of the taxation system which will greatly hurt the ability of many middle-class Americans to save for their own future, thereby forcing an increased reliance on the Federal government for aid. We do not become a stronger or wealthier nation by impoverishing a greater portion of our population through financial strip mining of the working class. We do need policies that take care of all people, and I do believe there are methods of taxation and means-testing aspects of our social safety net that would satisfy that need. But I also feel strongly that this approach in manipulating the retirement contribution system, a bipartisan approach that is owned by Republicans and Democrats alike, is a fundamentally dishonest and unsustainable approach to accomplishing that aim.
American Medical Association. (2019, August 13). Trends in health care spending. https://www.ama-assn.org/about/research/trends-health-care-spending#:%7E:text=Health%20spending%20in%20the%20U.S.,as%202016%20(4.6%20percent)
Board of Governors of the Federal Reserve System. (2020, September). https://www.federalreserve.gov/publications/files/scf20.pdf (Vol. 106, No. 5). https://www.federalreserve.gov/publications/files/scf20.pdf
Congressional Budget Office. (2018, December 13). Raise the Full Retirement Age for Social Security | Congressional Budget Office. https://www.cbo.gov/budget-options/54745
O’Brien, S. (2021, June 9). Congress wants to make more changes to the U.S. retirement system. Here’s what’s in play. CNBC. https://www.cnbc.com/2021/06/09/congress-wants-to-make-more-changes-to-the-us-retirement-system.html
Kiernan, J. (2021, March 9). States with the Highest & Lowest Tax Rates. WalletHub. https://wallethub.com/edu/best-worst-states-to-be-a-taxpayer/2416
Li, Z. (2021, January). The Social Security Retirement Age (No. R44670). Congressional Research Service. https://fas.org/sgp/crs/misc/R44670.pdf
U.S. Bureau of Labor and Statistics. (2021, April 16). Table 3. Median usual weekly earnings of full-time wage and salary workers by age, race, Hispanic or Latino ethnicity, and sex, first quarter 2021 averages, not seasonally adjusted. https://www.bls.gov/news.release/wkyeng.t03.htm
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