Is there really any doubt that income taxes will be going up at some point in the future? Deficits are growing ($590 Billion for 2016 alone) and there is no interest in Washington in reducing expenditures. Given the magnitude of Federal spending, even if a balanced budget were possible, the reduction in cash flow would crush the economy and send unemployment through the roof. We’re addicted to our spending.
Politicians have realized that even the faintest hint of “raising taxes” would be career suicide. This means that increasing marginal tax rates (except on those making over $250,000) is impossible. But raising tax revenue by “closing loopholes for the rich” is considered a heroic undertaking. There are a lot of proposals out there right now to increase tax revenue, and you don’t have to be Bill Gates or Warren Buffet to be impacted.
Many of these “loopholes for the rich” benefit middle class professionals. Chances are that if you are reading this, you’re going to be paying higher taxes in the years ahead. Even if your marginal tax bracket remains the same, your effective tax rate – the total amount of taxes you pay – could rise with these proposals:
- Eliminate the Stretch IRA for beneficiaries who inherit an IRA.
- Close the Roth conversion process which allows the “back-door Roth IRA”.
- Create Required Minimum Distributions for Roth IRAs.
- Cut the estate tax exemption from $5.45 million to $3.5 million and increase the rate from 40% to a range of 45% to 65%.
- Eliminate the step-up in cost basis on inherited assets.
- Add a 4% surtax on income over $5 million.
- Cap itemized deductions to 28% of your income.
- Create a capital gains schedule that requires an asset be held for 6 years to qualify for the lowest long-term capital gains rate of 20%. Increase capital gains taxes on assets held less than 6 years.
- Increase the Social Security payroll tax from 12.4% to 15.2%.
- Increase the payroll tax ceiling from $118,500 (2016) to $250,000. Or eliminate the cap altogether.
- Apply the payroll tax to passive income, so business owners are taxed the same on distributions and dividends as they would be on salary.
- A proposal in July from Ohio congressman James Renacci would lower the corporate income tax and add a consumption tax, or European-style VAT.
- Limit the mortgage interest deduction, which disproportionately benefits wealthier home owners because it requires itemized deductions. One proposal is to replace the deduction with a smaller tax credit.
- Place a cap on tax-deferred accounts. For example a 62-year old with $3.2 million in tax-deferred accounts would be ineligible to make further contributions. Other proposals suggest caps as low as $500,000.
Although this is an election year, I do not view this as a political issue. Whoever is elected to the Presidency and to Congress will have to deal with reducing deficits. While some candidates propose to cut taxes, this would dramatically increase the debt, which already stands at $19 Trillion. When interest rates eventually rise, a significant portion of our annual tax revenue could be needed solely for paying interest on our debt. So, I view tax cuts as not only unrealistic, but dangerously inflating a problem our children will ultimately have to bear.
If effective tax rates are going higher, what can you do to keep more of your investment return?
1) Tax efficiency will be more valuable. Using low-turnover ETFs, asset location, and tax loss harvesting can lower your tax liability. Reduce tax drag and keep gross income under $250,000, if possible. See: 6 Steps to Save on Investment Taxes.
2) Tax-free may be more preferable than tax-deferred. If you think your tax rate in retirement will be the same or higher than today, there is less benefit to investing in a Traditional 401(k) or IRA. Preference goes to the Roth 401(k) or Roth IRA. See: To Roth or Not to Roth.
3) Tax-free municipal bonds will be even more attractive when compared to taxable bonds.
4) Rather than allowing capital gains to accumulate for years and become an enormous tax bill in the future, it may be wise to harvest gains in years when you are in a lower tax bracket, up to the threshold of your current tax rate.
5) Don’t negate reduced tax rates for qualified dividends and long-term capital gains by placing those investments into an IRA or Annuity where the distributions will be taxed as ordinary income.
