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Boomers need to account for the burgeoning federal budget deficit as they save for retirement, college tuition or homes. Uncle Sam's borrowing binge could set off a surge in inflation and push down the dollar, both of which would erode the value of savings. It could also push interest rates higher, hammering the value of the more than $1 trillion in Treasury bonds owned by households directly or through mutual funds. Income taxes, already set to rise, might have to climb further to help close the government's budget gap.
Is the U.S. approaching a tipping point with investors?
For every dollar in debt that Americans have paid off since they started cleansing their balance sheets in mid-2008, the U.S. government has borrowed more than $7. President Barack Obama recently released a federal budget that envisions big deficits out to 2020, adding to the government's already enormous pile of liabilities. With total federal debt projected to equal the size of America's annual gross domestic product (GDP) by fiscal 2011 or 2012, many economists worry that investors could suddenly lose confidence in the U.S., demanding higher interest rates to reward them for the risk they're taking.
In a paper published last month called "Growth in a Time of Debt," economists Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland say that historically, advanced economies have slowed noticeably when their debt-to-GDP ratio has exceeded 90%. According to the Obama Administration's Office of Management & Budget, the total debt-to-GDP ratio was 83% in fiscal 2009 and is on track to hit 94% this year, 99% in 2011, and 101% in 2012.
Coping with Higher Taxes
Taxpayers can fight back by cutting their future income and by extension the amount of money taxed at the higher rates. Essentially this means going against the long-standing advice of never paying a tax bill that can legally be put off into the future.
There are three main strategies for this. First, consider starting a Roth IRA or converting a traditional IRA into a Roth. Contributions to Roth IRAs are made with after-tax dollars, but the gains on the account are tax-free. Taking the tax hit now can pay off handsomely in the future.
The second strategy is to take advantage of low capital-gains rates and sell highly appreciated assets. And the third strategy of the prospect of higher taxes makes the tax-free income of municipal bonds worth a look, although states are also facing their own fiscal pressures. When buying tax-free municipal bonds, avoid long maturities and focus on issues with secure revenue.
Sources: BLOOMBERG BUSINESSWEEK, Feb. 15, 2010 and The Wall Street Journal, February 6, 2010
