When Should You Stop Deferring Taxes

Conventional investment advice has been turned on its head by changes in the fundamentals of the economy and markets. Next, fundamental changes in the government, demographics, and the economy will force changes in tax policy and tax planning advice.

The age-old advice to defer taxes whenever possible could become a thing of the past, at least for a few years. Over the years, we pointed out a few exceptions to this strategy discovered in our research. Soon, the rule for many people could be to pay income taxes as early as possible, because rates will be higher later.

The structural changes leading to this conclusion are significant:

? We have a new President and Congress. They explicitly campaigned on promises to raise taxes, at least on the wealthiest Americans. “Wealthy” tends to be defined downward after an election, and that is likely to be the case.

?  Social Security and Medicare cannot be sustained under current tax and spending policies. Either benefits must be reduced or taxes raised or both.

?  The response to the financial crisis was for the federal government to bailout, subsidize, insure, and otherwise commit to spending a lot of money. There is a chance some money will be recovered from the government’s “investments,” but most likely the government will have net negative cash flow.

?  The new government leaders plan to spend a lot more money, especially on medical care. The details are not clear at this point, but higher medical spending by the government clearly is part of the plan.

?  Environmental policy is likely to include significant tax increases.

?  A result of the current crisis likely will be less leverage in the economy, leading to lower economic growth. Lower growth means less tax revenue from the current tax structure.

The specific tax increases won’t be known for at least months, but we have a lot of clues and can begin to plan.

Higher income individuals are likely to face higher income taxes. During the campaign the income cut off for higher taxes initially was $250,000. But at times lower numbers were used, and Congress traditionally defines “high income” much lower than $250,000. The current plan is to let the 2003 tax cuts expire after 2010, which will affect many taxpayers.

All Americans are likely to be hit with indirect and non-income taxes. These include gasoline taxes, other carbon and energy taxes, and various fees and charges.

Means-testing is another likely form of tax increase. Already upper income people receive a lower return on their Social Security taxes and pay higher Medicare premiums. Benefits from Social Security and Medicare likely will be reduced above some income level. Expect similar actions in other government programs.

Tax benefit reductions also are likely in lieu of tax rate increases. Itemized deductions and personal and dependency exemptions now are reduced at higher incomes, effectively increasing tax rates. Congress likely will search for other tax breaks to phase out as income rises. Related changes will be “closing loopholes” by eliminating deductions and income exemptions.

A long shot in the short term is imposition of a value added tax or some kind of a national sales tax. This tax can be hidden in the cost of goods and services, raised easily, and will generate a lot of money for the government.

Taxes on long-term capital gains are likely to rise above their current 15% level. A rise to 20% seems almost certain after 2010, and an increase to 28% is possible. Taxes on dividends also will rise. The question is whether they will be taxed the same as long-term capital gains or will return to being taxed as ordinary income.

The bottom line is reduced benefits, higher taxes, and fewer opportunities. Most people should plan to spend less, save more, and work longer.

A good guess is that most over age 55 won’t have to deal with lower benefits from Social Security and Medicare, except those with higher incomes. Those farther from retirement likely will face changes.

What should you do?

The good news is the economic crisis prevents the imposition of higher taxes for a year or more. That gives you time to plan.

IRAs and retirement accounts likely will be hurt by future tax increases. All distributions are ordinary income, and you cannot spend the money without taking a distribution.

In the past we pointed out when it makes sense to pay taxes early on an IRA by either emptying it early or converting to a Roth IRA (if your adjusted gross income is $100,000 or less). These strategies will be profitable for more people if income tax rates rise. In 2010 and later years under current law anyone will be able to convert a traditional IRA to a Roth IRA.

More people should give serious thought to emptying their IRAs early or converting to Roth IRAs. Details are in the web site Archive and in my book The New Rules of Retirement.

It is too soon to sell capital assets to avoid higher taxes. A retroactive capital gains tax increase is unlikely. The government wants to tell investors in advance the tax will increase, because that will trigger asset sales by people seeking to benefit from the lower rate, boosting government revenue. Plan what you will sell in a year or two to avoid higher capital gains taxes, and expect lower after-tax returns from capital assets after that.

The same advice applies to dividends. There won’t be much you can do to avoid the eventual increase. Factor lower after-tax income from dividends in your plans.

Reconsider plans to defer future income. Your income tax rate in the future is likely to be higher than today. You could have more money in the long-term by paying taxes today and investing the after-tax amount.

Review IRA and 401(k) contributions and deferred compensation arrangements. Those earning $50,000 or less probably won’t be hit with higher income tax rates and can safely continue tax deferrals. But the higher your income is above $50,000, the greater your risk of paying higher rates in the future. Income tax rate increases might very well be retroactive, even to Jan. 1, 2009.

Forget the notion you will be in a lower tax bracket in retirement. Many of us will be in higher tax brackets, especially when all types of taxes are included.

Retirement spending plans should be revised to reflect higher costs. If you are not already retired, consider working longer and saving more. As the tax proposals become more specific and are closer to enactment, investment plans will need to be revised. We might shift strategies or simply accept lower after-tax returns from certain assets.