With the latest Democrat tax proposals, a growing national debt and continued increases in government spending, taxes are going up sooner or later. Despite all the political mutterings, rising taxes seem a certainty. Tax hikes will be rising to finance our high national debt and to pay for long term public obligations (such as medicare and social security).
Here then are various ways on how to deal with the higher taxes. Some of these strategies are plain good practice even in the current investment climate.
Contribute to a Roth
A Roth Individual Retirement Account (IRA) or Roth 401(k) can be a great hedge against higher taxes in the future. You put in after tax dollars, the money grows un-taxed and all withdrawals in retirement are tax free.
In contrast, with a traditional deductible IRA or 401(k), you put pretax dollars in and every dollar you take out in retirement is taxed as ordinary income—at what are likely to be higher rates than today. Note that while a Roth IRA is subject to income limits, a Roth 401K when offered by employers, is not.
Do a Roth conversion
This strategy involves taking money out of a traditional IRA, declaring the taxable income and depositing it in a Roth, where all future growth is tax free.
Another rule that makes a Roth conversion attractive for affluent families: With a pretax IRA you must take money out from age 70-1/2; with the Roth you can let it ride and become a tax-free kitty for your kids. This may become the most tax effective way to leave an inheritance for them.
But be mindful that with a IRA to Roth IRA conversion, you need to factor in current IRA account balances and ability to pay taxes related to the conversion. Both of which can impact whether a conversion makes financial sense.
With rising stock markets, capital gains tax gains are likely to keep on coming. And it is likely that capital gain rates will be rising again in coming years under Democrat plans.
But you can minimize your tax bite by strategically deploying assets among taxable and tax-deferred accounts. Tax-efficient index funds, exchange-traded funds and “tax-managed” funds belong in taxable accounts. Small-cap growth funds, whose managers trade a lot, belong in tax-deferred accounts.
Don’t rush to sell, and thus realize costly gains, but use new money and any asset-reallocation moves to improve the location of holdings. Given the market’s recent volatility, now may also be a good time to harvest losses that can be used to offset gains as you move assets around to strike a tax-efficient balance.
Buy municipal binds
If you’re in a high tax bracket, tax-exempt municipal bonds are a buy, says Robert Gordon, president of Twenty-First Securities. While off their peak of this year, muni yields are still high relative to Treasury’s, even at current tax rates. Avoid private purpose bonds—the kind whose income is taxable in the AMT.