Tax Rates - Going Up

Over the next year or two it is very likely that tax rates on income, capital gains, and dividends are likely to go up. That is an unfortunate but likely reality especially for those people whom the politicians consider "rich" like most of the people who receive this newsletter. Rising tax rates are a virtual certainty and a promise if leading presidential candidate Barak Obama wins the election this fall (he is currently ahead in the polls). Longer term over the next 10-20 years it is also very likely that we will have higher tax rates due to the current budget deficit and the looming Social Security/Medicare financial shortfalls. Those social programs face severe financial shortfalls over the next 20+ years and taxes will have to be increased, or benefits substantially reduced, or both to keep those programs alive. Fixing the Alternative Minimum Tax will not be cheap either.

Part of the problem is that we have just been spoiled and lucky over the past 20 years by lower than usual tax rates on income and investments relative to US history. The government has kept tax rates low, allowed government spending to grow too fast, run budget deficits, and deferred facing reality by delaying fixing the long term Social Security/Medicare financial problem.

The current top federal marginal tax rate on income of 35% is well below the average in US history and is near the lowest it has been since the 1930's. The top rate was as high as 90% in the 1940's and 1950's, dropped to around 70% in the 1960's and 1970's, and dropped to around 50% in the early 1980's. We have been lucky to have had a top tax rate on income of between 30% and 40% since the late 1980's. There is lots of room for that top tax rate to go up, looking at history.

The current 15% tax rate on capital gains and dividends is also very low relative to history, and is probably the lowest we will see for several decades. This low 15% rate on capital gains is the lowest since the 1930's in the US. Typical capital gains tax rates in US history since the 1940's have been in the 20%-40% range. If nothing happens the Bush tax cuts will expire over the next year or two and then capital gains and dividend tax rates will jump back up automatically.

Presidential Candidates McCain and Obama on Future Taxes
Barack Obama is calling for higher taxes (ordinary income tax, capital gains tax, dividend tax, and social security taxes) on families earning more than $250,000 per year. Obama wants to raise the top ordinary income tax rate from 35% to 39.6%. He says he will not raise your taxes if your income is under $250,000 and "chances are you will get a cut". He wants to raise the tax rates on capital gains and dividends for "rich" people from the current 15% rate to somewhere in the 20%-28% range. On estate taxes Obama is proposing a $3.5 million exclusion for 2010-2011 and beyond and a top estate tax rate of 45% (the same as the current federal estate tax rate).

John McCain wants to make permanent the current federal income tax rates (top rate of 35%), and cut corporate tax rates from 35% to 25%. He opposes the Obama plan to lift the earnings cap on the social security payroll tax. McCain wants to keep the current 15% tax rate on long-term capital gains and dividends. With a likely democratically controlled Congress he may have to compromise and these capital gain/dividend tax rates may go up anyway to the 20% level. On estate taxes McCain proposes raising the exclusion to $5 million for 2010-2011 and beyond and cutting the estate tax rate to only 15%. Of course all political campaign promises and tax plans from both sides should be taken with a huge grain of salt.

What smart things can you do about rising tax rates?

1. Sell some assets you own that have a big capital gain now while the rates are low. If you have an asset with a large long-term gain that you were thinking about selling anyway in the next couple of years you may want to consider selling it now before the capital gains tax rates go up. This may be especially true if you have other reasons to sell the asset as well (concentrated stock/option position in one stock, concentrated family business holding, large real estate holding, a big holding that has had a huge run up recently, etc.). For investments that you may want to hold for a long time it may be better to just continue to hold on to them and let the tax-deferral continue for many years.

2. Use Roth IRA and/or Roth 401K accounts if you can. Roth accounts are taxed now (with current low tax rates) and are tax-free later when you start withdrawing the assets (and when income tax rates are likely higher). Therefore if tax rates go up in the future you will not care (as much) because assets withdrawn from Roth accounts are not taxed. Many people have incomes that are too high to be eligible for Roth IRA accounts (modified adjusted gross income must be below $116K single or $169K for a couple). Under current law (which may be changed) investors of all income levels will be allowed to rollover their current IRA's (of any size) into Roth IRA's in 2010. This could be a smart thing to do in 2010 if future income tax rates turn out to be significantly higher than they are in 2010. Of course if Obama wins the election income tax rates may already be higher in 2010.

3. Continue to give assets with large capital gains to charities. You get the full value of the asset as a deduction regardless if the capital gains tax rate is 15% or 25%. If income tax rates go up your charitable deduction is actually worth more against your income taxes.

4. Factor in higher tax rates in your long-term financial planning. The bottom line is you will need to save more, spend less, work longer, or invest smarter to make up for the higher future tax rates. This is especially true if most of your net worth is in tax-deferred IRA's and 401K's which are taxed at the full ordinary tax rates when withdrawn in retirement. Your tax rate in retirement could be as high (or higher) than your current tax rate.

5. Buy tax-exempt municipal bonds. These bonds typically benefit when ordinary income tax rates rise. Don't buy these in your tax-deferred 401K or IRA accounts.