THE BLOG
06/20/2013 01:05 pm ET | Updated Aug 18, 2013

Government Money Promises: Think Twice

What happens if the United States government doesn't keep its promises? That's not an idle question if you're planning for retirement.

The United States has a pretty dismal record of breaking its promises -- not to foreign investors, but to its own citizens -- when it comes to money.

After all, in 1933 by executive order the government confiscated all gold bullion coins, bars and paper gold certificates from its citizens under threat of imprisonment. Gold was integral to our currency, with those certificates freely interchangeable for the metal -- until the government decided to create new rules.

If you're a young worker, contributing to a tax-free Roth IRA because you believe the government will keep its promise to allow you to withdraw both contributions and investment gains without paying taxes, you might want to think twice.

If you're a middle-aged worker, thinking ahead toward retirement and saving as much as you can in your 40l(k), you might want to think twice.

And if you're in your sixties, and thinking about waiting until the last possible year to take your Social Security benefits in order to maximize your check, you might want to think twice.

It is not unprecedented for the government -- our elected representatives -- to renege on promises made and acted upon in good faith. Here are just a few examples:

Taxing Social Security Benefits

When Social Security was first enacted, the benefits were explicitly made free from Federal taxation. Treasury department tax rulings in 1938 and 1941 made it clear that these benefits were a return of "contributions." (Remember, FICA stands for Federal Insurance Contributions Act) But that changed with the passage of the 1983 Amendments to the Social Security Act. Starting in 1984, a portion of your Social Security check became taxable, depending upon your other income. That taxation was expanded in 1993, with the result that as much as 85 percent of your Social Security benefit may be subject to taxation, depending on your other income.

The actual reasoning for making Social Security benefits tax-free is so tortuous, that you might want to read about it under "agency history" at the Social Security website. Basically, the 1979 commission to study the issue of Social Security funding decided that since the employer gets to deduct its portion of your Social Security "contribution," then at least a portion of your benefit should be taxable. So, Congress voted to make Social Security taxable, after nearly 50 years of precedent to the contrary.

The change was a shock to many Americans. If, in its current search for money, the Congress decides that people above a certain level of assets should get a smaller, or perhaps not any Social Security benefit, despite having contributed over a lifetime of work, the shock will be even greater!

Taxing "tax-free" Municipal Bond Interest

Municipal bonds are IOUs issued by states, cities and other municipal taxing authorities. They are free from Federal income tax, and may also be free from state taxes to bond purchasers who are residents of that state. Muni bonds pay a lower rate of interest as a result of being able to offer this benefit, lowering costs for the issuers who use the proceeds for public works.

This tax break makes muni bonds especially attractive to taxpayers in higher brackets. For example, a taxpayer in the 35 percent bracket would need a taxable bond yield of 6.15 percent just to break even with a 4 percent muni yield on an after-tax basis. If the muni bond is also free of state taxes, even those in the 15 percent tax bracket might find them an attractive investment on a yield basis in many states.

But the IRS decided that municipal bond interest is part of your "modified adjusted gross income" for determining how much of your Social Security benefits, if any, are taxable. For a married couple filing jointly, if half of your Social Security benefits plus other income, including tax-exempt muni bond interest, is more than $32,000 ($25,000 for single filers), up to 85 percent of your Social Security benefits are taxable. So much for the promise of "tax-free" municipal bond interest. (Calculating the alternative minimum tax may also mean muni bond interest becomes taxable.)

For those who bought these muni bonds, expecting to receive tax-free income in their retirement years, the revisions came as a shock. If the government decides at some point in the future to make Roth IRA withdrawals taxable in part or in full, there will be a similar shock. But it wouldn't be unprecedented.

What's Next?

As I've written recently, several proposals have surfaced as part of the Federal budget negotiations -- proposals that would change existing rules, and give the government another grab at your money. One such proposal wants to limit the amount you could save in a retirement account to a level the government deems "sufficient" to fund your retirement!

Another proposal would change the tax treatment given to IRA beneficiaries, who are not a spouse of the decedent. Instead of being allowed to stretch out the growth of the IRA over the lifetime of a young beneficiary, the proposal would require all money in the inherited IRA to be withdrawn (and taxed!) over a period of five years.

We are now entering the fifth year in which the Congress has not passed a budget, instead funding the government with "continuing resolutions." When they do get around to seriously dealing with our annual budget deficits, you can be sure they will go after money that is currently tax-deferred, or un-taxed.

Promises, promises. They won't mean much when the government decides it wants your money. That's the lesson of history. And that's The Savage Truth.