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Today's Market WrapUp 12.10.2007 Mon Tue Wed Thu Fri Allison Archive The Taxman Cometh All the major investment houses are now marketing heavily to the recent or soon-to-be retiree. Their pitches are many and varied, but they all stress income and security. That is what retirees are interested in; investments that will fund their retirements and offer peace of mind. My concern is that many of these investment products do not address two looming issues that may seriously affect retiring Baby Boomers; higher taxes and higher inflation. The future is impossible to predict with certainty, but the economic fundamentals are ominous, and without obvious solutions. With a Total US Debt load (over $48 trillion) now measuring 3.5 times America’s GDP, and growing like crabgrass, our ability to repay what has been borrowed becomes virtually impossible. Federal government debt alone is now over $9 trillion. (For some perspective, the 1980 Federal debt burden was $750 billion, less than 10% of today’s level). Debt Tax The amount required to pay interest on the existing national debt is referred to as the “debt tax.” This tax pays nothing toward the principal, only the debt service. In 2002 the debt tax was eighteen cents out of every federal tax dollar. Today it is approximately 20 cents out of every federal tax dollar. In other words, 20% of every dollar taxpayers send the government goes to pay our federal debt service. If interest rates rise significantly due to increasing inflation, the debt tax problem will logically get much worse. Meanwhile, as a result of existing debt, the United States has less money to spend on education, infrastructure and technology; improvements needed for the country to remain competitive in the global market. Trillions in unfunded Government Mandates Higher inflation looks more and more attractive to a debt-burdened government. The Roman Empire was not able to overcome this dilemma. We have the electronic printing press and reserve currency status on our side. Will that be enough ammunition? The way programs such as Social Security, Medicaid and Medicare are structured, the federal government will incur an additional debt of (at least) $50 trillion during the next 20 years, according to government GAO figures. This will limit our alternatives. US Comptroller General David Walker is on a personal mission to warn the public. "We are talking about an unprecedented change in the demographic landscape of America," Walker said in a CNN interview last spring. "And we are not prepared for this oncoming wave." The $50 trillion total amounts to about $440,000 per American household, Walker said. "It's going to take us probably 20 years to do all the things that need to be done,” said Walker. "But we need to get started now because the clock is ticking and time is working against us." Unfortunately, this modern day Paul Revere’s message is seldom heard above the daily white noise of political expediency. Without historic, society-disrupting change, the debt-service bills will continue to spiral upward, the manufacturing base will continue shrinking, and government spending will just keep growing. At some point the piper must be paid. The government will ultimately face the stark reality of raising taxes, cutting spending and inflating the currency (even faster) to decrease the impact of the debt load. Spending cuts unlikely Politicians will talk a good game about cutting spending, but don’t hold your breath. With the demographically powerful Baby Boomers starting to retire in large numbers, and politicians desirous of staying in office, it is unlikely that significant spending cuts will occur. Patriotic Taxes Tax increases are likely to be initiated on multiple fronts in the future. They may take the form of higher income tax brackets “to make the rich pay their fair share,” higher payroll taxes, higher gas taxes, higher property taxes, hotel occupancy taxes, airport taxes, user fees, etc. etc. It may even be sold as a patriotic movement such as “help pay down the debt and get America moving again!” Many future taxes will be nearly invisible, and the most troubling tax of all will be totally invisible; inflation. The demographics do not look favorable either, with too many Americans in line for entitlements and too few working to pay for them. And the Federal Reserve must continue furiously printing money to make up the difference. Retirement Strategies Once in awhile it’s important to remove your nose from the grindstone of the here and now and seriously consider the world at the time of your retirement. For most people that time may be years, if not decades from now. However, the actions you take now may have a significant impact on your retirement plans. The Big Money will always have its tax shelters, tax attorneys and off-shore accounts. As always, the increasing tax burden will fall on the average American. The average Joe or Josephine must protect themselves as the taxman becomes a more pervasive part of their lives. The Roth IRADespite the economic storm clouds and general gnashing of teeth, there are ways to prepare and protect one’s golden nest egg. Which brings us to the Roth IRA. Of all the retirement vehicles, it is the only one that allows all savings and investment earnings to be withdrawn (after age 59 ½) totally tax-free. No income tax. No capital gains. Zippo. That may not seem like a big deal today, when you can get a tax write-off with a regular IRA, but it could be a huge deal in 10 or 20 years from today. If present trends continue, or worsen, those retirement dollars will emerge in a world with considerably higher tax rates. The retiree with a conventional IRA or a 401-k may end up paying more tax on his/her withdrawals than on income during the working years. If inflation worsens, as I believe it will over the next decade, then the retiree will need to take increasing amounts out of his 401-k or IRA to retain his standard of living. Unfortunately, these increasing amounts may place the retiree in a higher tax bracket, so the retiree’s standard of living may fall even as a larger percentage of the nest egg is spent each year. 401-k Concerns The 401-k may prove to be a major concern for Baby Boomers looking out 10-20 years. The forced savings aspect of the 401-k is a positive, especially if the employer matches contributions. However, for most 410-k owners, their savings can only be invested in a very limited spectrum of choices, usually plain vanilla stock and bond funds and company stock. In an environment of rising rates and inflation, bond funds will get battered. In an IRA, one can own an individual bond and ride it out to maturity, or buy shorter-term maturity bonds or CD’s. 401-k’s don’t offer this flexibility. This lack of choice leaves most 401-k holders without the ability to direct their savings into sectors that can weather inflation and retain purchasing power. Growing inflation, brought on by government spending and printing excesses will likely ravage the value of bond funds and hurt the performance of broad-based stock funds. At retirement, the 401-k, the vehicle of so many hopes and dreams, may yield bitter fruit. For instance, in ten years the typical million dollar 401-k portfolio will have lost significant purchasing power through years of inflation, only to face potentially high tax rates when the money is withdrawn. Millions of Baby Boomers may suffer this fate, and indeed millions more will likely be unable to retire at all without drastic changes in quality of life. Investment Flexibility and no TaxmanThe Roth IRA is not a magic wand, but it can make a significant difference over time as investment dollars compound tax free. Higher income people are unable to qualify for the Roth (your MAGI must be at or below $156,000 for married joint filers and $99,000 for individuals to qualify for the full contribution) but those who can contribute should not hesitate. The Roth contribution limit is $4,000 in 2007, with an additional $1,000 “catch-up” provision for those over 50 years old. In 2008, the limit will rise to $5,000, with the same $1,000 “catch up” provision. Another excellent aspect of the Roth is that you can withdraw your contribution amount any time, at any age, without penalty or taxes due. Only the earnings must be left in a minimum 5 years and not withdrawn before age 59 ½. There are also no mandatory distributions after age 70 ½ in the Roth IRA, unlike the regular IRA. While miracles can happen (and are gratefully received) the future appears to be inexorably moving toward an environment of higher inflation, higher interest rates and ultimately higher tax rates. Any retirement vehicle that allows for both investment flexibility and no tax consequences is a unique safe-haven, especially in a high-tax environment. Investors who save and compound their growth tax-free over time will ultimately reap the benefits of this delayed gratification strategy. Congress could renege on the Roth IRA No strategy is without risk however. There are those who believe that the U.S. government will unceremoniously pull the rug out and renege on the Roth’s tax-free withdrawal status at some point down the road. That threat is viable and will continue to exist, but consider the alternative of the 401-k. Would you rather have the flexibility to invest in the Central Fund of Canada (gold and silver bullion) or be stuck in stock and bond mutual funds if our “manageable” inflation rate suddenly accelerates into hyperspace and beyond? The Roth IRA is not the complete answer and is not without risks, but its obvious benefits make it an important investment tool in a very uncertain world. Dividends Most retirees have been trained to think in terms of safety once in retirement, and to many that means a high percentage of their nest egg in bonds or bond funds. If you believe that we face a future of rising inflation, then bonds may not be the ideal retirement vehicle. Many seniors today are living on a “fixed income” from bonds or annuities that pays them a flat stream of depreciating dollars. Now that retirees are living much longer than previous generations, it’s important to have a nest egg that can keep pace with inflation. Dividend-paying stocks, particularly large-cap international companies with a long history of paying rising dividends, should be part of the solution. No Risk-less Retirement One can only hope that our leaders in Washington DC will one day realize that printing money in ever-increasing amounts will not solve our country’s ills. Ultimately, it leads to the debasement of the currency and tremendous pain and upheaval for the struggling Middle Class. There is no risk-less retirement. I am working to help my clients understand and be prepared for the issues ahead. By taking thoughtful action years before retirement you can help mitigate some of the risks and give yourself more options once you choose to retire. You may also feel more in control of your future, which certainly helps to make your current frame of mind a lot more pleasant. Today’s Markets U.S. stock indexes rose Monday, marking the fourth consecutive day of gains, amid cheer ahead of Tuesday's expected interest-rate cut by the Federal Reserve and financial shares getting a lift from a hefty investment in Swiss banking giant UBS AG. The Dow Jones Industrial Average was up 101.45 to close at 13,727.03. The S&P 500 Index rose 11.30 to close at 1,515.96. The Nasdaq also closed higher, ending at 2,718.95, up 12.79. Gold futures rallied nearly 2% on Monday, boosted by dollar weakness and expectations that the Federal Reserve will cut interest rates on Tuesday. Gold for February delivery surged $13.30 to end at $813.50 an ounce on the New York Mercantile Exchange. Wishing you a good evening, Tony Allison Copyright © 2007 All rights reserved.
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