Congress has a mountainous struggle ahead with debt. We’re already borrowing 40 cents for every dollar of federal outlays. Structural and demographic issues hardwired into the Social Security program since the baby boomers were born are about to make themselves felt – overwhelming payroll tax receipts. And Medicare is in even worse shape. Meanwhile, Congress stripped 500 million from Medicare over the next 8 years to fund ObamaCare, which we now know will cost about $800 billion more than advertised over the next ten years.
One way or another, taxes are going to go up.
What we don’t know is how. Will Congress raise taxes on Social Security income, as the Clinton Administration did in 1993? Will they raise the retirement age to 70 and beyond to balance Social Security cash flows? Will they get out of the Medicaid business and leave it in the hands of the states? Will they move to nationalize 401(k) and other pension assets, or tax their growth? Will they make Roth IRA income taxable? Take away the homeowners mortgage interest tax deduction? Raise income tax rates or lower exemptions? Tax life insurance cash value accumulation and/or death benefits? Raise the estate tax or slash the current exemption of $5 million?
We don’t know.
You’ve heard of investment risk and inflation risk. In the bond world, you have default risk. Well, all investors in America must also deal with the presence of legislative risk: The possibility that Congress will pass laws that substantially change the present or future value of your assets, and present changes to the set of assumptions that guide your investment and savings decisions.
That’s why it’s important to spread your legislative risk among many different types of assets: Tax deferred retirement accounts, pensions, home equity, savings in taxable accounts, municipal bonds, dividend paying stocks, cash value life insurance – all have an important role to play in building a tax-diversified retirement portfolio.
We believe it’s important to divide assets among at least three “buckets,” the taxable bucket, the tax-deferred bucket, and the tax-free bucket
These are assets that don’t present an income tax bill after the year in which you receive them – at least, under the current set of laws. Instead, Congress levies capital gain taxes on any profits you make – though they may charge income tax of some kind on dividend income these sources generate.
The main benefit here is the favorable rate accorded to long-term capital gains – that is, profits on assets you held more than a year.
You can also mitigate your tax liability through techniques such as tax loss harvesting – that is, selling some losers to generate capital losses, to offset your gains (and up to $3,000 of income in any given year).
Examples of assets in the taxable bucket include most things you hold outside of retirement accounts, including rental real estate, your own home (you do get a $250,000 or $500,000 capital gains exemption on your personal residence, depending on whether or not you are married, though Congress can modify this at any time as well). CDs, bank accounts, money market accounts, bonds, mutual funds, stocks, and investment property, including collectibles, tends to fall in this category unless you put it in a retirement fund.
Tax deferred assets include things like deferred annuities, 401(k)s, SEP IRAs, SIMPLE IRAs, 403(b)s, and traditional IRAs. These assets are most vulnerable to an increase in income tax rates in future years. Congress could also begin charging for transactions within them, to some extent, though they would have some difficult questions to explain to the public about why they were changing the rules after investors had committed these funds.
Tax Free Assets
Tax free assets include assets you already paid taxes on, which current law allows to grow tax free, and generate tax free income to you. This works for you very well if you front-loaded your income taxes when rates were comparatively low – as they likely were during the Bush Tax Cut era. Congress is quite likely to repeal the Bush cuts at some point – perhaps after the economy has recovered somewhat and the Democrats retake control of the House.
Examples of assets currently inhabiting this bucket include Roth IRAs, designated accounts in 401(k)s, and cash value life insurance (funded under modified endowment contract limits).
By dividing your assets among each of these tax buckets, you can go a long way towards avoiding a severe shock to your retirement income or plans to pass on assets to the next generation.
Part of our process is looking beyond your assets and asset classes to help ensure you are diversified against acts of Congress as well as acts of God and acts of neurotic stock market players and bond players.