Crimson Tide: Obama’s New Budget is a Tsunami of Red Ink |

Crimson Tide: Obama’s New Budget is a Tsunami of Red Ink

Posted February 14, 2012 by thomas

One of my favorite comedies ever made is “The Jerk,” starring Steve Martin and the beautiful Bernadette Peters. In one scene, Steve Martin, playing the character of Navin R. Johnson, sees a new phone book being delivered to the service station where he works. “The new phone book’s here! The new phone book’s here!” he leaps and shouts. He opens it up, and finds his name in print. “Look! Johnson! Navin, R.! Things. Are going. To start happening to me. Now.”

Whereupon all hell breaks loose.

Well, the Obama Administration’s new budget is here. Things are going to start happening – and all Hell is breaking loose in what promises to be a hard-fought campaign season. Let’s take a look at some of the highlights and what they mean.

Wealthy people are targets. That’s right; you’ve got a bulls-eye on your back and people gunning for you – just like Rob Reiner’s character was targeting Johnson, Navin R., whom he had picked at random out of the phone book as his next shooting victim. Obama aims to raise taxes on the rich – rescinding the Bush tax cuts, and increasing the top marginal income tax rate from 35 percent to 39.6 percent. This equates to more than a 10 percent increase, but it will be collected from a vanishingly small number of people.
Obama proposes enacting the “Buffett Rule.” That means that the scope and reach of the Alternative Minimum Tax is increased to ensure that families with earnings of over $1 million per year pay a minimum tax rate of 30 percent.
Stimulus! Obama knows he’s got an uphill battle unless unemployment goes down dramatically. Hence, he’s proposing spending at least $30 billion in federal funds on modernizing schools, and another $30 billion on hiring teachers. So if you’re in a construction worker’s union or teachers’ union, or you want to join one, you should be pretty happy. If you’ve built a successful business? Not so much. Unless you want to renovate schools.
An expansion of tax subsidies to encourage people to buy the Chevy Volt. When the government is a major shareholder of your company, they’ll take care of you.
The budget claims about $850 billion in “savings” from pulling out of Afghanistan and Iraq - but we knew that already.
The payroll tax cut – a 2 percentage point reduction in payroll taxes taken out of workers’ paychecks, is extended under the Obama budget. This keeps the OASDI tax on employees down to 4.2 percent of payroll, rather than 6 percent. Since Social Security is running a deficit, now, the additional money comes out of the general fund.

So what’s not in the budget? Not to put too fine a point on it, but the budget does nothing whatsoever to meaningfully reform entitlements. But unless we take some significant steps now, the combined deficits projected by the Social Security program, Medicare, Medicaid, The Patient Protection and Affordable Care Act, and interest payments on the cumulative debt will force Congress into some very ugly choices.

What’s on the table? Continuing to raise taxes. Printing money, thereby inflating the currency to pay off Chinese bondholders with cheaper dollars. Seizure or nationalization of pension plan assets, to raise immediate revenue for the Treasury (unlikely, in our view. But an increase in estate taxes would have similar consequences), or default – which is practically the same as inflating the currency, anyway.

How can you protect yourself? One concept we work with all the time is called “tax diversification.”

Just as you should diversify your investments among a variety of stocks, bonds, mutual funds, real estate, and other asset classes, you should also look at diversifying your assets among several kinds of tax regimens:

Tax deferred assets. Examples include IRAs, 401(k)s, 403(b)s, SEP IRAs and Simple IRAs. You can usually get a tax deduction on contributions, and taxes on income and capital gains are deferred. The catch: Withdrawals in retirement are taxed at ordinary income tax rates.

Tax-free assets. Examples include Roth IRAs. Designated Roth accounts within 401(k)s. The cash value in permanent life insurance. You don’t get a tax deduction on contributions. But growth is generally tax-free, if you leave the money in the account long enough.

Taxable accounts. You don’t get a tax deduction, and you don’t get to defer taxes on growth or income from the portfolio. You do, however, get the benefit of much lower tax rates on long-term capital gains – provided the money has stayed in the account at least five years.

Any of the tax advantages are subject to changes. Future Congresses are in no way bound by current laws. If Congress increases income tax rates, people who own IRAs and 401ks will get hurt. By the same token, Congress could increase long-term capital gains rates – which hurts people who hold assets in taxable accounts. Or Congress could simply decide that Roth IRA or life insurance cash values are taxable, after all.

Congress could increase the tax rate on corporate dividends and capital gains on stock sales, hurting everyone who holds assets in stock companies. Or they could continue to debase the dollar, through massive borrowing and quantitative easing at the Federal Reserve. The inflation that results is the same as a tax on everyone, and hurts all savers.

We don’t know in advance what course of action – or combination of actions – Congress will take to stanch the bleeding.

So what to do? First, here’s what not to do. Don’t put all your eggs in one basket! Hold assets in each of these buckets: The tax-deferred bucket, the tax-free bucket, and the fully-taxable investments. That way, you won’t get slammed by any single deficit reduction plan. You will have room to maneuver, and you won’t take too big of a hit.

And have some inflation protection in the portfolio. This means own some TIPS (Treasury Inflation Protected Securities), which are Treasury bonds that are adjusted to keep up with inflation. Own some real estate, commodities, gold and precious metals. And make sure you rebalance periodically, both among your different account types and among your different asset classes. We regularly work with clients on both these topics.

Call to schedule an appointment today. Let’s make sure your portfolio can withstand not just market risks, but legislative risks as well.

Financial Planning | thomas | 5:43 am

2 Comments

By Kent Smith, February 14, 2012 @ 2:40 pm

I appreciated this piece – I’ve not thought nearly enough about the impact of various tax regimes beyond those typically attached to this or that investment class.
By Beating Broke, February 15, 2012 @ 10:21 pm

Our tax system is such a mess. I’m not sure that I’m a proponent of a flat tax, or universal sales tax, or any of the alternative taxes, but we’ve got to do something to straighten the system out so that your average Joe can actually figure some of this stuff out without the need for a whole team of tax attorneys.

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