Many financial strategies are changing, and one of the oldest tax planning strategies should be among them for many of you.
Since the beginning of the income tax, taxpayers have been told to defer taxes whenever possible. Don’t pay a tax today when you can put it off to a future year. The advantages are you have the opportunity to earn a return on the dollars you keep, and the value of the dollars could be diminished by inflation before you pay the taxes. Also, you may find ways to reduce the taxes by the time they are due.
Now, it’s time to consider not deferring taxes. Pay taxes now to avoid paying higher taxes later. This is definitely a good strategy for higher income taxpayers for the next couple of years and could be a good strategy for most taxpayers for the long term.
We’ve already seen several tax increases put on the books for the next few years. The new medical insurance law includes higher Social Security and Medicare taxes on upper-income taxpayers and for the first time imposes those taxes on non-salary income beginning in 2013.
Additional tax hikes likely are on the way. The 2003 income tax cuts are set to expire at the end of 2010, and Congress seems content to let them expire on at least the two highest tax brackets. In addition, the 15% maximum tax on long-term capital gains and on dividends is set to rise. The capital gains tax will increase to 20%, and dividends will be taxed at ordinary income tax rates under the current schedule.
Ways also need to be found to pay for all the stimulus money that was spent the last few years. Entitlement spending also is breaking budgets at all levels of government. I suspect economic growth will be lower than forecasts, and that will mean lower government revenue and larger deficits. That could lead to higher taxes.
These are the reasons you should consider abandoning the notion that tax deferral always is a good idea. Especially perilous is the idea you will be in a lower tax bracket in retirement than you are now. I’ve advised against using this assumption for years. Now it seems even more likely that people will be in the same or higher tax brackets at retirement as they were during their working years.
For years the top retirement and tax planning advice was to maximize contributions to qualified retirement plans such as 401(k)s and traditional IRAs. You received tax breaks for these contributions today. In other words, taxes were deferred. The price you pay for deferral is the distributions are taxed as ordinary income at the rates in effect at the time of the distributions. At least some of these distributions are likely to be of long-term capital gains. In a taxable account they would be taxed at a much lower rate than ordinary income. In addition, there is the risk tax rates will rise. That diminishes the advantage of deferring taxes from today until some future year.
Consider the reducing or eliminating contributions to qualified retirement plans. You could be better off foregoing today’s tax breaks and putting the money in a taxable investment account. You’ll give up a deduction or income exclusion. But in that account you’ll have more control over the timing of taxes and also whether the income will be capital gains or ordinary income. Long-term capital gains will be taxed as long-term capital gains, not as ordinary income.
Converting a traditional IRA or employer plan into a Roth IRA is another consideration. We’ve discussed this in detail over the last year, and those discussions are in the Archive on the web site.
In my book, The New Rules of Retirement, and in past visits I also discussed when it makes sense to empty an IRA early. Pay all the taxes now and put the after-tax proceeds in a taxable account. For some taxpayers that makes sense, and it could make sense for more taxpayers because of future tax hikes.
Perhaps the best strategy at this point is tax diversification. It’s a relatively new idea based on the same philosophy as investment portfolio diversification.
We don’t know what tax rates will be even five years from now, much less 20 or 30 years ahead. You could do a lot of research and thinking, decide the tax law will go in a specific direction, and plan your finances to minimize taxes in that scenario. Unfortunately, you’re likely to be wrong. Plan your finances to maximize the benefit from one tax scenario, and you likely realize significant harm from any other scenario that develops.
A better approach is to spread your finances among different tax strategies.
Have some of your money in tax deferred accounts (IRAs, 401(k)s, annuities), some in Roth IRAs, and some in taxable accounts. You won’t minimize taxes under any scenario. Instead, you’ll have flexibility. You’ll be able to adjust to changes in the tax law. Most importantly, your financial plan won’t blow up if the tax law is completely different from what you anticipated. You won’t pay the maximum taxes under any scenario.
July 2010. RW