Taxes May Have Nowhere to Go But Up

By Katherine Reynolds Lewis
c.2008 Newhouse News Service

If you're grumbling about the size of your tax bill this year, brace yourself.

Many financial advisers predict that tax rates are going to rise to cover the escalating burden of an aging population and the federal debt.

"In all the discussions I have with contemporaries, we do expect rates to go up at some point in the future," said Ira Herman, a partner at J.H. Cohn, an accounting firm in Roseland, N.J.

Each American's share of the federal government's unfunded obligations amounts to $175,000 comparable to a home mortgage with no collateral, said Stuart Butler, a vice president at the Heritage Foundation.

To cover the gap between expected revenue and the cost of Medicare, Medicaid and Social Security benefits through 2050, income tax rates would have to almost double, according to a July 2007 analysis by the Congressional Budget Office.

Of course, the government probably would reduce promised benefits and increase payroll taxes rather than solely boosting the income tax. Still, it seems likely many Americans eventually will refer to the current income tax structure as "the good old days."

And who exactly would pay higher taxes?

There aren't enough wealthy people to cover the huge, looming burden, Herman said, so it will have to be shared with the middle class.

"Everyone agrees that, in order to fulfill the promises we've made to people who are going to be retiring, Social Security, but even more, Medicare taxes would have to go up very, very much," said Joel Slemrod, director of the office of tax policy research at the University of Michigan. "My guess is there will be a combination of tax increases and non-trivial cutbacks in these promises."

A combination of near-term factors also points to tax increases, Slemrod said: A Democrat could become president in 2009, and the Baby Boomers are beginning to retire.

What's more, if Congress allows the Bush tax cuts to expire in 2010, capital gains will be taxed at higher rates, marriage tax relief will end, and the 10 percent tax bracket will go away.

Since 1975, combined local, state and federal tax revenue has hovered around 27 percent of gross domestic product. That's lower than most other developed countries. Tax revenue averaged 36 percent of GDP for the members of the Organization for Economic Cooperation and Development in 2005.

What should you do to guard against the possibility that U.S. tax rates will creep closer to other developed countries'?

"It's very difficult to plan for taxes, other than the fact that you know we're going to have to pay them," said Tom Papanikolaou, chief operating officer of Pension Builders and Consultants in Cleveland.

Still, some basic principles do apply.

Take a long-term approach and save aggressively.

"People need to set aside as much as they can," Papanikolaou said. "You're going to get your best return by investing in equities."

Contribute the maximum to your 401(k) or other tax-deferred retirement plan, said Kevin Mahn, chief investment officer for Hennion and Walsh in Parsippany, N.J.

Keep your options open.

"The old boring rules continue to make sense ... : stay diversified, stay nimble, you can't lock in to certain positions," said Barbara Weltman, a contributing editor to tax guides published by Hoboken, N.J.-based John Wiley and Sons. "Different philosophies on taxation come and go."

If you're eligible, open a Roth IRA or Roth 401(k) account. You'll pay taxes on contributions now. But your investment earnings will be tax-free when you withdraw them in retirement.

Consider converting a traditional IRA to a Roth IRA. After 2009, even people who earn too much to contribute to a Roth will be able to make conversions, Herman said.

"Make sure your financial adviser runs the numbers for you," he said. "Even if I'm in retirement, if I have enough money, I'm going to be in a potentially higher bracket."

For David Strong, a certified public accountant at Crowe Chizek in Grand Rapids, Mich., the decision hinges on how long you have until retirement. If you have decades to go, you will be able to accumulate more earnings that you can then withdraw tax-free. If you are on the cusp of retiring, conversion might not make as much sense.

"You'd really have to analyze how long do I have to have those funds grow, and does it make sense to pay a tax bill now that I could certainly defer," Strong said.

Don't reject good investments solely because of taxes.

Even if tax rates rise, a well-managed mutual fund with low fees could outperform a tax-free annuity that is mismanaged and loaded with expenses.

Similarly, municipal bonds are exempt from federal and some state taxes, but you need to compare the overall yield with what you'd get on a taxable investment, said John Pridnia, a CPA in Muskegon, Mich.

"Just because you're paying income tax doesn't mean it's always a negative situation," Pridnia said.

Moreover, some financial advisers don't believe taxes will inevitably rise.

"Everything can change based on who's in the Senate and what party is in office," Mahn said. "I believe in our country and the capitalistic system and I believe we can always find a solution."

Raising taxes doesn't guarantee increased revenue, said Alan Reynolds, an economist at the Cato Institute in Washington.

If capital gains and dividends taxes increase, people will sell those investments or put them in a tax-protected retirement account. And if payroll taxes climb, employers will find other ways to compensate high performers, such as company cars, Reynolds said.

In the end, taxes are only one part of the picture for financial planning, said Leo Bruette, a tax partner with BDO Seidman in Bethesda, Md.

"You can't ignore it, but there are so many breaks for retired folks that it's not as significant a factor as you might think," Bruette said.

To cover the gap between expected revenue and the cost of Medicare, Medicaid and Social Security, according to estimates that assume health care costs grow 1 percent faster than GDP, income tax rates would have to rise:

from 10 percent in 2005 to 17 percent in 2050, for the lowest bracket

from 25 percent in 2005 to 43 percent in 2050, for the middle bracket

from 35 percent in 2005 to 60 percent in 2050, for the highest bracket

from 35 percent in 2005 to 60 percent in 2050, for corporations

Source: Heritage Foundation, Congressional Budget Office

This article was originally published on Thursday, February 28, 2008, by Newhouse News Service.