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Are We Entering A Higher Tax Environment?

If the current political rumblings and future projections are an indicator, better hang onto your wallet because we could be facing higher federal taxes.

With the Presidential candidacy heating up, there may very well be Democrat in the Oval Office in 2009 and they are all advocating higher taxes. Whether it is just letting the 2001 and 2003 tax cuts “sunset,” increasing taxes or repealing legislation for the purpose of tax fairness (the latest buzzword these days), I wouldn’t plan on the tax burden getting any lighter.

Then there are the long term issues. According to a recent brief titled "Medicare Costs and Retirement Security" from the Center for Retirement Research at Boston College, our ongoing entitlement program expenditures in the form of Social Security, Medicare and Medicaid spending will nearly double as a percentage of our GDP by 2040. The Medicare system will fall under the heaviest increase due to an aging population, increased longevity and skyrocketing health care costs. Projected rising out of pocket costs will make up over fifty percent of the average Social Security benefit and it would take an 18.5% increase in income taxes to pay for these costs. Whether it’s higher taxes or a cut in benefits, something will give.

Concerned about future taxes implications and want to strategize? Here are some ideas to consider:

Take Some Capital Gains Now: With long-term capital gains at historically low rates (and better in 2008), it may be a good idea to incur capital gains now rather than later. Say for example you are retired and have the option of drawing from a taxable account, tax-deferred account (IRA, 401(k), etc.) or tax free (Roth). It may be a good idea to take advantage of the lower rates now and liquidate a holding that incurs a long-term capital gain. Also, what if you have a large concentrated holding? It may be a more cost effective time to liquidate that holding now to diversify more appropriately. In the future, these advantageous tax rates may not be around.

Roth’s and Roth Conversions: Roth’s (401(k)’s 403(b)’s and IRA’s) aren’t as popular because they don’t create an immediate tax deduction as compared to a tax-deferred account. This could be a mistake. Qualified withdrawals of Roth’s are tax-free and after many years of compounding, this can be a powerful weapon in your retirement arsenal. Also if eligible, the Roth conversion may make a lot of sense. If not repealed, in 2010 the income restrictions currently in place for converting a Roth will be lifted. You definitely would want to determine if the Roth conversion makes sense, but it certainly would put you in control of your tax situation by paying the tax now, a known rather than pay an undetermined tax amount in the future (and more as the value of the underlying investments compound). Also a problem comes with paying the tax on the conversion, but you may work two strategies I’ve suggested into one. If you have holdings subject to capital gains, this now may be an opportune time to sell at a lower capital gains rate to pay the taxes from the conversion. With this, just be sure that you stay within the income limits. In the end, I’m a big believer of clients having taxable, tax-deferred and tax free accounts in their retirement strategy if their circumstances allow for this. By having each, you are essentially diversifying by account/tax implications and can manage the benefits of each type of account to your advantage in your retirement distribution strategy.

Health Savings Accounts: If eligible and if it makes sense for you, this can help offset some of those higher predicted health care costs. The beauty of this account is that you get a tax deduction up front, and if you use if for qualified health care costs, the distribution is totally tax-free. I believe the key here isn’t paying out of pocket medical costs on a year to year basis out of the HSA. If you really want to get the biggest bang for the buck from this account and offset the dire health care cost projections, I would hold the HSA funds as long as possible for retirement health care needs and place these in high growth assets. That is where you are going to get the greatest power out of this type of account by getting both the tax deduction/tax free benefit while the investment keeps up with the cost of healthcare.

Save Often & Early: In geology, the two biggest influences are time and pressure. In investing, it’s how much you can save and how early you start saving. This may seem simple, but it has a much bigger impact than any of the strategies mentioned above.

A final word of caution, don’t let the tax tail wag the dog. Purely avoiding taxes because you don’t want to pay taxes alone is nonsense. For example, many people hold large proportions of their net wealth in an individual stock, only to see it crash. The reason why they held? They didn’t want to pay taxes although it ultimately ruined their long-term plans. So before doing any strategy to be more tax efficient, just do your homework to make sure how feasible the strategy is, and if it will get you closer to achieving your goals.

Safe Investing Seminar for Seniors

The State of Maine Office of Securities will be hosting a “Wise and Safe Investing Conference” on Tuesday, October 9th at the Sable Oaks Marriott in South Portland from 9:30 AM to Noon.

The event is an educational forum geared towards senior investors/consumers with practical advice on investment scams and investing safely and is free and open to all who wish to attend. If you are interested in attending, please call toll free at 1-877-926-8300 to register. If you have any questions, feel free to contact the Office of Securities education manager Alyson Cummings at 207.624.8560.