How to Deal With Higher Taxes

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With our growing national debt, fiscal cliff(s) and continued increase in government (bailout) spending, taxes are going up sooner or later. Despite all the political mutterings, one thing is for sure. Taxes will be rising to finance our high national debt and to pay for long term public obligations (such as medicare and social security). Here then are various ways on how to deal with the higher taxes. Some of these strategies are plain good practice even in the current investment climate. 

1) Contribute to a Roth. A Roth Individual Retirement Account (IRA) or Roth 401(k) can be a great hedge against higher rates. You put in after tax dollars, the money grows un-taxed 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. Regardless of income, anyone whose employer offers it can use the newer Roth 401(k) option.

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 ended in 2010. Another rule that makes a conversion attractive for affluent families: With a pretax IRA you must take money out from age 70-1/2; 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.

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