Diversifying your tax policy may be more timely than ever before, now that we have so many changes happening in Washington DC. So says Dave Stevens, CFP, CPA, PFS, with A&I Financial Services LLC. In last week’s tax chat event, Dave discussed many ways to save a few dollars in taxes. We entered a respectful and friendly debate about whether a person should go Tax Free, or just diversify their tax policy.
There are three basic ways our investments are taxed: taxed-as-earned, tax-deferred, and tax-free. The taxed-as-earned CDs, brokerage accounts, and other investments are (hopefully) held for a long time and taxed at the (almost always lower) long-term capital gains tax rates.
Tax-deferred investments include Traditional (Rollover, Simple and SEP) IRAs, 401ks, annuities and other investments into which a person may contribute pre-tax dollars, or get a tax deduction on the contributions. The money grows without being taxed and then, no later than the year you turn age 70 ½, the Federal government requires you to make a minimum distribution and pay taxes at your (higher than capital gains) income tax rate.
Tax-free investments, as many of you know, are my favorite. You pay the taxes now on the contribution and never again. For young people, and those in a low (particularly temporarily low) income tax bracket, going tax free is an easy financial decision. For those of you who’ve read the book, Go Tax Free, you might recall the three big reasons to consider growing your tax-free bucket:
- Tax-deferred is tax-compounded.
- We tend to lose deductions as we age.
- The government is likely to raise (not lower) income taxes.
Dave takes issue with point #3. And I respect his opinion. Our debate benefits you, our clients. Let’s hear him out.
“The government is not likely to raise taxes overtly. The politicians want to keep their jobs and if they make the tax increases obvious, we are more likely to vote them out. Instead, the government is likely to increase taxes covertly." Dave can foresee a day when the Federal government imposes a VAT, like many countries in Europe and the rest of the world. If the USA imposes a sales (or consumption) tax, then every dollar a person spends from either an IRA or Roth IRA is less valuable because everything we buy is taxed on purchase. The folks with money in a Roth IRA have less spendable money than they thought they would have had.
Furthermore, Dave argues, a VAT might accompany a LOWERING of income taxes so that it appears like we have a lower tax bracket. Dave argues this affects the most wealthy people in the country the most, because they consume the most (disposable luxury items), and so taxpayers might approve.
Well, given the number of proposals for “taxing the rich” going on in Washington DC right now, a VAT seems more likely than ever before. Now is a good time to talk to your wealth manager!