Rising Income Tax Rates

There is a lot of talk about an upcoming "fiscal cliff" in the U.S. where current policy has a lot of tax increases and spending cuts going into effect in the beginning of 2013.  If a different solution cannot be agreed upon by both parties, it is said that the economy will go off this "fiscal cliff" into another recession and have the U.S. face a similar crisis in Europe.  It seems like higher taxes will be a certainty in the future; it is only to what extent.  A lot of it will also depend on the results of this year's election as well.

Looking at income taxes, the government has essentially been on sale with borrowed money because of lower than historical tax rates and higher government spending.  We are getting much more in government services as government spending has ballooned over the past few decades, with a lot of funding going toward defense and helping the elderly, poor, and disabled.  However, this borrowed money will have to be paid back somehow.  Because the federal tax burden has been falling at every income tax level, taxes are sure to rise.  There is a lot of debate going on in Washington, and although it has been thrown around that we have to raise taxes on the rich, I doubt tax reform would be effective with taxes rising for everyone.  This discount we are getting on the government nowadays is not free; someone at some point in time will have to pay for it.

Will income taxes rise back to historical levels?  It seems unlikely but however much taxes don't increase will have to be compensated by spending cuts.  There may be other taxes to make up for the resistance in raising income taxes, but these increases definitely make the Roth IRA and Roth 401(k) very attractive accounts to fund.  It gives you the certainty of how much you'll be paying for taxes since you fund them with after-tax income and leaves out the uncertain future tax rate in retirement.  It may be better to bite the tax bullet now and pay income taxes at these lower rates than at whatever future rate it is bound to rise to.  Unless you are going to be in a very different tax bracket when you retire, the Roth seems to trump the normal IRA and 401(k).

This year's presidential election will be extremely important for how taxes will be reformed.  On one hand, Obama's campaign seems to focus more on raising taxes for higher income individuals and closing many loopholes that millionaires take advantage of every year.  The two highest income tax brackets would be raised from the current 33% and 35% to 36% and 39.6% respectively.  Capital gains would be taxed at 20% for high earners as well and dividends would be taxed at ordinary income levels for individuals with income above $200k.  The alternative minimum tax would also be replaced with the "Buffett rule" which would require people making more than $1 million each year to pay at least 30% of investment income in taxes.

On the other hand, Romney's plan focuses reducing income tax rates while holding taxes on dividends and capital gains where they currently are.  He would reduce each tax bracket's income tax rate by 20%.  Investment income taxes for people making less than $200k would be cut altogether while all other tax payers keep the same 15% tax rate.  The alternative minimum tax would be repealed altogether as well.

As you can quickly see, the tax environment will look very different depending on who wins this year's election, and while you should not solely decide on your vote on their tax proposals, it should be a major consideration.  Also, even though Romney's plan does decrease income taxes, taxes in general should rise in the long-run.  As long as taxes do remain close to current levels, it would be beneficial to try to pay taxes upfront with Roth accounts to avoid taxes in the future