Tax Reform Part II - Roth IRA's and Tax Exempt Municipal Bonds

This is our second message discussing the concept of tax reform.  There is a lot of talk about a fairer, flatter tax system which we understand to mean lower tax rates, coupled with a broader tax base (meaning fewer deductions and credits) similar to the tax revisions passed in 1986.  However, passage isn’t likely until 2013 or later, since neither party has a specific plan yet. I want to reiterate that this discussion does NOT relate to any changes proposed for 2011 or 2012.

In our last message, we discussed capital gains & qualified dividend tax rates.  Today, we are going to review Roth IRA conversions and tax free municipal bonds (along with a few other items). 

You may want to rethink the wisdom of doing a Roth conversion. The general rule is that it pays to convert to a Roth and pay the tax bill on the conversion up front if you expect your tax rate when you pull out the funds will be the same or higher than the tax rate on the conversion. Since major tax overhaul will reduce tax rates, your future tax rate may end up being lower than they are now.

Roth's have other advantages, such as tax-free payouts for heirs, that still may favor making a switch. One thing that Congress won’t do in tax reform is to renege and subject Roth payouts to tax.

Lower federal tax rates affect the decision whether to buy tax-free bonds. The after-tax yield on taxable bonds rises as tax rates decline, so investing in them may provide more bang for the buck than exempts.

Another aspect of tax overhaul is that municipalities may have to pay higher rates on their bonds to get investors to bite. That hikes their borrowing costs...bad news for state and local governments with tight budgets. The good news is that tax reform won’t nix tax-exempt bonds.

Businesses must factor in tax reform as they plan equipment purchases now. Tax overhaul is likely to stretch out depreciation periods compared to current law, as a way to pay for reducing the top corporate tax rate from its current 35% level.  Businesses may end up better off if they place assets in use before reform takes effect.

Remember, that many assets put in service in 2011 receive 100% bonus depreciation. It falls to 50% for those placed in service in 2012. It is unlikely that these incentives will be extended beyond 2012.

Finally, there was a Senate hearing yesterday in which executives from 5 of the largest oil companies were asked to defend their industry's $2 Billion federal subsidy.  In no way am I defending big oil and while we think that it makes sense for ALL federal spending to be scrutinized, we don't believe that singling out one business or industry is the way to address our fiscal problems.

$2 Billion is A LOT of money, but let's put this into perspective: Federal spending is expected to reach $3.6 trillion in the current year, tax revenues are projected to be $2.1 trillion and the budget deficit is $1.5 trillion.  After this subsidy is eliminated from the budget the DEFICIT would still be $1,498,000,000,000.  To put it another way, it would take 750 similar spending cuts to eliminate the deficit.  And to put it another way, under the current spending plan it takes the federal government less than 5 hours to spend $2 Billion.  Our political leaders need to put the gamesmanship aside (on both sides of the aisle) and get serious about controlling federal spending.