Cliff or no cliff, taxes will rise
In the political negotiations over America's “fiscal cliff,” one thing emerges as a betting certainty. Regardless of whether lawmakers reach a compromise with the White House, taxes likely will go up.
In all probability, taxes will continue to increase until Congress enacts major changes in the nation's tax code and the Medicare/Medicaid and Social Security benefit systems. This will reverse a decades-long trend towards lower taxes. Many corporations and lottery winners see this and are taking preparatory steps. What can ordinary folk do to prepare?
The outlook for increased tax rates prompted many corporations to issue “special dividends” this year so shareholders wouldn't face a bigger tax burden. In most cases, this amounts to advanced payment of dividends that will be taxed at current rates. If the companies wait to pay money to shareholders in future years, the dividends likely will suffer tax at higher rates.
Even Mike Good — the Phoenix man who held one of two winning tickets for a nearly $600 million Powerball prize — elected to take a $192 million cash payout to avoid higher tax rates in the future.
The concept of retirement accounts such as the Individual Retirement Account (IRA) and the 401k, together with their specialized derivatives, was based on the central concept of lower future marginal tax rates.
In theory, when a person retired from regular employment, they would receive a reduced income and therefore be taxed at a lower rate. The falling tax rates of recent decades reinforced this idea.
To encourage people to build for retirement, the government enacted substantial tax incentives. The total growth of the assets, including income and capital gains, was tax-free within an IRA or 401k. All contributions made to these retirement savings plans were tax deductible in the relatively high tax years of contribution.
In short, all assets grew tax-free, with taxation delayed and applied to withdrawals in future years when individual tax rates might be expected to be lower. With the specter of higher tax rates in future years, this attraction becomes lessened.
However, the Bush administration created what became known as the Roth IRA. It differed from conventional tax-deferred retirement vehicles in that it was a savings vehicle for money already taxed. From then on, it was tax-free, even upon withdrawal.
Roth IRAs were so attractive that their creation was restricted to the less well-off and the size of annual contributions limited. However, over time, these limitations have been reduced.
Most importantly, anyone with a Roth can roll the assets of a conventional IRA or 401k into the Roth. However, all taxes must be paid now on the assets rolled over.
This triggering of a taxable event can be a disincentive. But if individuals see taxes rising, possibly to confiscatory rates, it may be better to pay the tax on a rollover at today's lower rate and forget forever taxes on Roth assets.
Unlike conventional retirement accounts, Roths have no mandatory withdrawal requirement for those over 70 1⁄2 years.
The prospect of higher taxes should inspire all individuals to inquire into the wisdom of establishing a Roth and rolling other retirement assets into it.
John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Trib Total Media. Email him at email@example.com.