| Largely lost in the rush to allocate hundreds of billions of dollars to rescue the U.S. economy is another pressing reality. Paying for Medicare and Social Security as the baby boom generation moves into retirement will require trillions in new spending, and unless something is done to curb the growth of those “entitlement” programs, taxes may have to rise dramatically. According to a recent analysis by the Congressional Budget Office, tax rates would have to increase by 90% to pay for projected spending in Medicare and Social Security through 2050.
As the population ages, the study says, the lowest tax rate on individual income will need to jump from 10% to 19%, the tax rate on incomes in the current 25% bracket will have to soar to 47%, and the highest rate could jump from 35% to 66%. To meet the accelerating cost of entitlements, the top corporate income tax rate also will likely need to increase from 35% to 66%.
The study was released in May 2008, before the current financial crisis threw the nation into a tailspin. Deficit spending to stimulate the lagging economy could mean additional pressure on future tax rates. And the CBO is not alone in its predictions. David Walker, former comptroller general of the United States, warned in March 2007 that the federal government’s promises have outrun its likely revenue by such a margin that there will be no choice but to raise taxes. Ben Bernanke, chairman of the Federal Reserve Board, has made the same point.
What can you do to prepare for the likelihood of much higher taxes in the years ahead?
Get your finances in order. To improve your financial picture in advance of higher tax rates, consider locking in a low mortgage rate, putting aside a cash reserve of six months’ living expenses, and ramping up your personal savings rate.
Open a Roth IRA. With a Roth you pay income taxes on contributions, but withdrawals during retirement are tax-free. That’s a great formula if you expect future tax rates to rise sharply. Also consider converting a traditional IRA to a Roth. The current $100,000 income ceiling for conversions is due to disappear in 2010.
Contribute to your company’s Roth 401(k) plan. Very similar to a Roth IRA, the 401(k) version offered by many employers also taxes current contributions rather than later payouts, when tax rates could be much higher. Also consider non-retirement investment accounts over tax-deferred plans for the same rationale. Consider selling successful investments. Stocks will eventually recover from their current slump and taking investment profits sooner rather than later could be wise. The current 15% tax rate on capital gains is likely to increase during the next few years.
Consider other types of investments. If tax rates rise 90%, the high expenses associated with variable annuities will appear much lower. Tax-free municipal bonds will also become more important to a tax-efficient portfolio.
Ask for our help. We can work with you to make sure your financial plan prepares you for higher tax rates or other changes in the years to come. | 
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