As we have written about previously, there is a 2026 tax cliff on the horizon. Absent another act of Congress, many provisions in the Tax Cuts and Jobs Act of 2017 will expire January 2026, automatically reverting the tax code to the higher tax burden we had six years ago. If Congress does act, it is anyone’s guess what the tax code will end up becoming. Many representatives campaigned in 2022 on promises to revamp, extend, or revert the tax law, and ideas for the new tax code will likely continue to be major talking points in the 2024 elections.

Tax uncertainty like this makes tax planning decisions more difficult, but we have a plan to help clients. To combat the uncertainty, we are effectively creating two tax plans as a part of our Tax Planning service this year: one assuming that the current tax code is made permanent and a second assuming that the Tax Cuts and Jobs Act expires in January 2026. While this adds complexity to an already complicated analysis, it will allow clients to determine what risks they are willing to take and what assumptions they wish to make.

However, many clients have asked us what we assume will happen. Should they assume the tax cuts will remain or the brackets will change? For me personally, I suspect that taxes will go up in the future. When I polled my colleagues, the majority also thought this was the most likely outcome.

As I write this in April and May of 2023, the political news is full of debt limit negotiations. Republicans gained majority in the House in January , while Democrats have kept their Senate majority and the Presidency. The United States hit its current $31.4 trillion borrowing limit on January 19 and is now approaching the so-called X-Date. The latest news is that there is a deal to suspend the debt ceiling for two years working its way through Congress.

Rising interest rates over these past years have been a new experience for many Americans. After nearly two decades of low interest rates, it was hard to imagine that a 1983 mortgage had a 11.5% interest rate. Now, we are wondering if we will see that interest rate again. Interest rates affect more than just American borrowers and investors though. They also affect the largest borrower of all: the federal government.

In their 2019 article, “Each American Is $240,000 in Debt Because of Excessive Government Spending ,” Rachel Greszler and Benjamin Paris write for The Heritage Foundation about the three layers of government debt. The two that everyone frequently reports on are the current deficit (overspending from this year) and the current national debt (overspending from prior years). However, there is a third category of indebtedness the federal government has and that is unfunded obligations. Greszler and Paris define this as “money the government doesn’t have, but nonetheless promised to spend.” Using 2019 numbers, they explain:

Unfunded obligations are often considered problems for future citizens, but with Medicare and Social Security both running cash flow deficits and running out of money in 2026 and 2035, respectively, these future obligations have become a current burden.

Social Security’s unfunded obligations alone amount to $13.9 trillion. This means that, over the next 75 years, the government has promised to pay out $13.9 trillion more than it expects to collect in payroll taxes.

…If Social Security’s shortfall wasn’t bad enough, it pales in comparison to Medicare’s $42.3 trillion in unfunded obligations. At $128,500 per person—a whopping $514,000 for a family of four—America’s runaway Great Society program, lauded by socialists as a model for the future of health care, is already breaking America’s bank.

All combined, each American effectively owns $240,000 worth of U.S. debt and unfunded obligations—an amount equal to the average home price in the U.S. Just imagine having to pay two mortgages instead of one just to cover past government excesses.

Over the past four years since that article was written, Congress has simply ignored the problem. As of August 2022, Social Security is still projected by the Social Security Administration to be insolvent in 2035. Knowing how Congress likes to procrastinate, they might wake up to this problem during a December 2025 tax bracket discussion. Although, they may still find a way to wait until 2034 to address it.

Regarding the U.S. deficit, David Ditch at The Heritage Foundation writes:

It has been incredibly reckless for Washington insiders to assume low interest rates would be around forever. With interest rates rising, the country is faced with the prospect of dedicating more than $1 trillion dollars per year to interest payments by the end of the decade, and trillions more per year not too long after that.

Servicing the federal debt will soon be an anchor dragging on the economy, steadily eroding the growth and prosperity that we take for granted. Any attempt to artificially push interest rates down would threaten to make inflation worse, squeezing families from both sides.

Federal spending is projected to grow much faster than the economy. Of that incredible growth, a full 79% would arise from net interest payments, Social Security, and Medicare.

Accompanying this commentary, Ditch offers three charts to show the gravity of the situation. One chart uses a median family earning $70,784 per year as an analogy to show that if the federal government were this family, they would be $447,142 in debt while still charging $19,879 to the credit card in 2022. Another shows the projected devastating effect of compound net interest on the deficit. A third shows how government provided health insurance and retirement income represent 57% of the increased spending with the net interest making up another 21% on top of that.

As the Tax Foundation summarizes in its article “Fast Approaching Debt Limit Deadline and Growing Debt Demand Action “:

Lawmakers must act swiftly to lift the debt limit and make good on our obligations. Whether attached to the debt limit, they should adopt the same sense of urgency in the effort to rein in our deficits and debt, paying mind to international experiences on successful fiscal consolidations.

With debt upon debt, the federal government needs to either increase revenue or decrease spending. What a convenient scapegoat they have in the expiring Tax Cuts and Jobs Act. Inaction can result in increased revenue while action which increases revenue slightly less than inaction can be praised as a tax cut victory (even though it will be a tax hike).

For these reasons, I would err on the side of assuming higher taxation after 2026. It is possible our current brackets will remain or perhaps even more favorable tax brackets will be created, but these outcomes seem less likely.

I have difficultly imagining a likely outcome where I would regret a Roth conversion. Assuming higher taxation in 2026 suggests that taxpayers should do larger Roth conversions now than if our current brackets were permanent.

Photo by Dynamic Wang on Unsplash. Image has been cropped.