How to deal with higher taxes

With our growing national debt and continued increase in government (bailout) spending, taxes are going up sooner or later. Despite the presidential candidate’s political mutterings, the only way to finance our high national debt and afford to pay for long term public obligations (such as medicare and social security) will be to increase taxes or remove existing tax breaks. Forbes recently ran a detailed article on this topic, providing various ways on how to deal with the higher taxes. Some of these strategies are plain good practice even in the current investment climate. Here are some highlights with my comments:

1) Contribute to a Roth. A Roth Individual Retirement Account or Roth 401(k) can be a great hedge against higher rates. You put in after tax dollars, the money grows untaxed 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 now. With the Roth IRA, couples with adjusted gross income up to $159,000, and singles earning up to $101,000, can this year contribute $5,000 each ($6,000 for those 50 or older). Regardless of income, anyone whose employer offers it can use the newer Roth 401(k) option. For 2008 you can contribute up to $15,500 in after tax salary ($20,500 if you’re 50 or older). This was an item I was planning to do as part of my single step personal challenge, and as soon as the markets stabilize I will be opening one up.

2) 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. Only taxpayers with gross income below $100,000 are eligible, but that limit will end in 2010—unless Congress reneges. Another rule that makes a conversion attractive for affluent families: With a pretax IRA you must take money out from age seventy and a half; 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.

3) Relocate assets. Investors may have been lulled into complacency over capital gains taxes in the three years through 2005 as their mutual funds used losses booked over the previous couple of years to offset gains. The holiday’s over. Last year funds distributed $393 billion in long- and short-term gains to taxable shareholders, up 270% from 2005, estimates Thomas Roseen, a senior analyst at Lipper.

With the capital gains likely to keep on coming, 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.

4) Buy munis. 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. Vanguard, which offers some of the lowest-cost funds around, eliminated most of these bonds from its muni funds last year.