So far, unemployment is still hovering around 10%, with pockets of America experiencing jobless numbers that are much higher.  A recent article written by Shawn Tully at Fortune.com helps explain the fundamental problems with the current administration’s economic policies.  Tully interviewed Allan Metzer, a person he describes as “one of the most influential monetarists of the past 50 years.”

When it comes to understanding why the stimulus hasn’t delivered all that our politicians promised last year, it turns out that it all comes down to human nature.  And the study of economics is, essentially, nothing more than the study of human nature.  When asked to comment on why the temporary tax cuts included in the current stimulus plan haven’t resulted in an increase in spending and consumption by the American public, Metzer explains, ”The temporary reductions (tax cuts) under Carter, George W. Bush and Obama were all failures, since people spend more only when they’re confident their take home pay will rise permanently.”  It makes sense, doesn’t it?  It’s just human nature to save the “extra” money from a temporary tax cut or use it pay down some of your personal debt whenever you know that the money is not a permanent increase to your take-home pay.

When asked to comment on whether or not President Obama’s stimulus plan was a good idea, Metzer says, “It’s unbelievable that a man whose main theme was to smooth investment comes to be the proponent of redistributing income away from the people and companies who do the investing.  My advice on the stimulus plan was, don’t do it. Let’s look at the plan. First, a lot of the money was used to reduce the deficits of state and local governments by increasing the federal debt. It was simply money transferred from the federal government. The economic multiplier effect was zero. Second, the temporary tax cuts went to paying off credit cards and other debts, not spending that would have increased economic growth.”

Again, it makes sense, doesn’t it?  I guess it just makes too much sense for Washington.

The most obvious implication is higher taxes.  One of the primary sources of income for the government is taxing American’s personal income.  Debt pressures in Washington are likely to produce tax increases once the economy begins to rebound.  But don’t be fooled into thinking that the recent discussions about raising taxes on what Washington considers the “rich” – those earning more than $250,000/year – is the cure for what ails us.  The additional revenue that increasing taxes on these wealthy taxpayers will only put a small dent in the pile of debt our government has accumulated.  I believe tax increases for all income levels are inevitable over the next decade.  But even those measures are likely not enough to bring our nation’s debt addiction under control. 

Look for other “creative” revenue solutions like a “Value Added Tax” (VAT) to begin to gain traction in Washington soon.  Common in Europe and other parts of the world, a VAT is basically a tax that is levied at each level of production for almost all goods and services.  This tax results in a significant increase in the cost of things bought and sold.  It is considered a “hidden” tax because, other than the higher price, most consumers aren’t aware that they are paying for it when making purchases.  Never underestimate how creative a government can be when looking for ways to increase its revenue streams.

Given all this, The Wall Street Journal’s Brent Arends has a good article on how to protect yourself (somewhat) from the burdens of America’s debt.  Arends provides easy-to-understand, practical advice; however, I find it odd that he leaves out any suggestions to utilize Roth accounts to protect yourself from future tax increases.

You have one of those old, traditional IRA’s lying around somewhere, don’t you? You haven’t paid much attention to it. There’s probably a year’s worth of unopened account statements sitting on your desk under a pile of other unimportant mail, right? Sure, the balance of the account is nothing to brag about, but your sins likely include an inappropriate asset allocation as well.  Highly conservative money market fund, anyone?

Your poor neglected IRA needs some new life. It could use some old-time religion. Heck, your IRA may actually be in need of a good old-fashioned conversion. A Roth conversion, hallelujah!

Believe it or not, the IRS will allow you to transform your traditional IRA by converting it to a Roth IRA.  There are restrictions in place (in 2009) that keep most people who make more than $100,000 from taking advantage of the Roth IRA conversion, but in 2010, these restrictions are lifted and all are welcome to convert.

If you are unsure whether or not a Roth IRA is right for you, check out this related post.

Stated simply, the primary benefit of converting to a Roth is that you will never pay tax on the contributions or earnings when you withdraw funds from the Roth account.  This assumes that the distribution is deemed “qualified” by the IRS.  To learn more about what the IRS considers a qualified distribution from a Roth account, check out this related post.

There is a word of warning, however, that puts a damper on all of this good news regarding Roth IRA conversions.  You will be taxed on the entire amount you decide to convert to the Roth IRA. The IRS will treat the conversion as if you received the amount as income in the year of the conversion. It’s as if your employer handed you an extra paycheck for the total converted amount, but you don’t get to spend any of the paycheck today. Yes, it is a bummer, but try to keep a long-term perspective and remember how much you will enjoy receiving all of that money and its earnings (hopefully there will be earnings!) tax-free during retirement when your income tax rate may be higher. 

It is important to note here that you do not have to convert the entire amount in your traditional IRA to a Roth IRA all at once.  In fact, if you think a conversion might push you into a higher tax bracket, consider employing a number of smaller conversions over several years.

Although I am not a proponent of market timing when it comes to investments, there is a timing strategy you may consider with a Roth IRA conversion.  It is usually better to convert after your investments in the traditional IRA have taken a beating. The reason for this should be obvious. The lower your account balance at conversion, the less you will have to pay in taxes on the conversion itself.

The IRS also allows you a “do-over” on a Roth IRA conversion.  If you perform the conversion and then later realize, for whatever reason, you miss your old traditional IRA, the IRS allows you “recharacterize” the Roth conversion.  It’s as if it never took place.  The deadline for recharacterizing your Roth conversion is your normal income tax deadline – April 15 of the year following the year the conversion took place.

So now you know the truth about Roth IRA conversions.  And the truth will set you free (from taxes in the future).

With the recent government stimulus programs and bailouts, however, the country’s debt load is expected to increase by more than $9 trillion over the next decade according to a recent article by Jeanne Sahadi, senior writer for cnnmoney.com. More than half of the $9 trillion increase in debt that the U.S. government is projected to take on over the next decade will be interest owed on the debt. $4.8 trillion, to be exact.

I had trouble getting my head around what our country’s current debt of $12 trillion really looks like, so I decided to investigate. When you write down the number, $12 trillion is the simply 12 followed by 12 zeroes:

$12,000,000,000,000

That looks innocent enough. I mean, after all, it’s not real money. It’s just government figures and estimates, etc., right? Unfortunately, no.

Let’s try to put just $1 trillion into perspective. Here is what I found on the Mint.com blog:

Just $1 trillion equals…

$1 Trillion Rent and Mortgage Equivalent

And just $1 trillion equals…

$1 Trillion Australian Goods and Services Equivalent

And just $1 trillion equals…

Comparing $1 Trillion to the Cost of the Current Government Bailout

And probably the most disturbing example of all…

The $1 Trillion Federal Government

So how did we get into such a debt mess? Since this is a financial post, I will mercifully steer clear of any political opinions and ramblings, but it is important to remember that the money being spent belongs to the citizens of America. As mentioned previously, there is plenty of blame to go around on both sides of the aisle in Congress. But how does the richest country in the world become such a huge debtor nation?

It’s quite simple, actually. You can think of it in terms of your own budget. If you are employed or if you own your own business, you likely have a stream of income in the form of a paycheck from your company or revenue from your business. Unfortunately, your income is limited. Sure, you may make more money this year than you did last year, but your income is not – and never will be – unlimited. The same holds true for the U.S. government. The government’s income flows from taxes on personal income, taxes on business income, etc. and this income is finite or limited. So, you and the government have to figure out how to spend money throughout the year in accordance with your income.

Whenever you spend more money than you bring in throughout the year, you are likely forced to use debt to cover your excess spending. Likewise, when the government (Congress, specifically) spends more money than it brings in each year, it is forced to use debt to cover its expenses. If you choose to spend more money than you bring in over a long period of time without additional sources of income or savings to offset the expenses, you will go deeper and deeper into debt and may even be forced to declare bankruptcy. It’s the same with our government. When Congress chooses to spend more money than it brings in on expenses like national defense, entitlements, and other federal programs, the only option is to go into debt to cover the excess spending. This creates what is known as a budget deficit. And this type of reckless and irresponsible deficit spending has been going on for years and America’s debt load is now approaching astronomical levels.

When you are faced with a budget deficit, you have a number of opportunities to remedy the situation. You may choose to spend less going forward and use the savings to pay off your debt. You may choose to go to school or learn a new skill or trade that allows you to land a new job or make more money in your current position. You may start a new business or land even take on more than one job to increase your income. The choices are endless.

The government, on the other hand, has fewer alternatives. To deal with budget deficits and their associated debt problems, the government cannot take a second job or learn a new skill to increase its income. To deal with its debt problem, the government must choose one of two options:

1. Reduce or even eliminate its spending commitments so that the amount of money that the government spends is less than the amount of money it brings in, or
2. Increase its revenues. This, of course, means raising taxes on companies or on your personal income or both.

China is a major player when it comes to funding America’s debt problem. To better understand this relationship, check out this related post.

One other note related to loans and IRA’s: If you pledge any portion of your IRA account as collateral on a loan, the portion of the IRA that you pledged as collateral is immediately charged to you as income, with all of the applicable taxes and potential penalties applied.

Most retirement plan loan repayments are handled by simply reducing your paycheck by the amount of the loan payment. Make sure you have some level of job security, however, if taking a loan from a retirement plan because some plans consider a loan in default when you leave employment and are no longer able to repay your loan via payroll. If you are unable to completely repay your retirement plan loan for any reason, the loan is considered in default and the entire outstanding loan balance is considered a “deemed distribution” by the IRS. This means that the entire outstanding loan balance is immediately charged to you as income, with all of the applicable taxes and potential penalties included. The good news is that a retirement plan loan default will not negatively affect your credit in any way; however, the plan may limit your future loan eligibility.

To better understand the potential pitfalls associated with borrowing from your retirement account, check out this related post.

In most cases, when you take a loan from your retirement account, you are essentially taking a significant chunk of money out of your retirement account all at once and repaying it back in small pieces over a number of years. The wager you are making – whether you realize it or not – is that the interest you pay to yourself throughout the repayment schedule will be greater than the earnings you would have made on your investments had you not taken the loan and, instead, left the money invested in your account. In a market that is declining or in a market that is relatively flat throughout the life of your loan, the interest you pay to yourself in the form of loan repayments will likely be higher than the earnings you would have made had the money remained invested. In this case, your gamble will have paid off. In an up market, however, the interest you pay to yourself in the form of loan repayments is likely to be lower, sometimes much lower, than the earnings you would have made had the money remained invested. And due to compound interest, that situation can be detrimental to your retirement account accumulations in the long run.  It is important to mention that the interest you pay on a retirement plan loan is also not tax deductible in the way that your home mortgage interest or the interest you pay on a home equity line of credit is tax deductible.

Retirement accounts such as 401(k) and 403(b) plans are what is known as “tax-deferred accounts”. This means that all of the contributions you make to these plans are not taxed as income to you in the year in which you make the contributions. On top of that, you are not taxed on any of the earnings you make on those contributions as long as you leave them invested in the account. This is a really good deal for you. Once you retire, however, the IRS is going to get its hands on as much of that money as they can. In other words, when you withdraw money from your retirement account to fund your expenses in retirement, the IRS is going to tax you on that money using income taxes – the same way they tax you when you draw a salary from your employer.

All of that to say that when you take a loan from your retirement account, you are withdrawing money that was sheltered from income tax in your retirement account. When you make repayments on the loan, you are repaying the loan with money from your checking account that you have likely already been taxed upon as salary or income from your job. So, in essence, the money that you put back into your retirement account as a loan repayment will already have been taxed once. Where this really hurts you is when you decide to withdraw money from your retirement account to fund your expenses in retirement. The portion of the money that you withdraw from your account that was used to repay your loan will be subject to income tax again. In other words, that money has been subjected to double taxation because you were already taxed on the money you used from your checking account to repay the loan and then you were taxed again on those same dollars again as you withdrew them from your retirement account.  Why in the world would you subject your money to income taxation more than once?

The maximum allowable loan from a retirement account as defined by the IRS is as follows:

1. The greater of $10,000 or 50% of your vested account balance, or
2. $50,000, whichever is less.   

Your vested account balance is simply your earned ownership in your retirement account balance. Check with your employer’s HR department or with your retirement plan provider to find out the amount you are vested in your retirement plan account balance.  All of this is confusing, so let’s try to break it down with some examples:

Example 1:

You have a 401(k) plan with your current employer and it has an account balance of $30,000.

What is the maximum amount that you can borrow from this plan?

Well, it depends upon your vested amount in the retirement account. Let’s say you check with your HR department and they tell you that you are only 50% vested in your retirement account balance at this time. So, the amount of ownership you have in your retirement plan is $15,000 ($30,000 account balance X 50% vested = $15,000 vested account balance) and the maximum amount that you can borrow in most plans using this scenario is 50% of your vested amount, or $7,500. 

Note: Most retirement plan loan limit calculations stop right there.  However, according to IRS rule #1 above, the plan may allow up to $10,000 to be borrowed from the plan in this scenario.   

Let’s say, on the other hand, that you check with your HR department and they tell you that you are actually 100% vested in your retirement account balance. In this case, the amount of ownership you have in your retirement plan is $20,000 and the maximum amount that you can borrow is 50% of that vested amount, or $10,000.

Example 2:

You have a 401(k) plan with your current employer and it has an account balance of $120,000.

What is the maximum amount that you can borrow from this plan?

Again, it depends upon your vested amount in the retirement account. Let’s say you check with your HR department and they tell you that you are only 50% vested in your retirement account balance at this time. So, the amount of ownership you have in your retirement plan is $60,000 ($120,000 account balance X 50% vested = $60,000 vested account balance) and the maximum amount that you can borrow is 50% of your vested amount, or $30,000.

Let’s say, on the other hand, that you check with your HR department and they tell you that you are actually 100% vested in your retirement account balance. In this case, the amount of ownership you have in your retirement plan is $120,000, but the maximum amount that you can borrow is only $50,000 since the IRS rules state that the maximum amount you can borrow is the lesser of 50% of your vested account balance or $50,000.

The IRS does allow for participants to take multiple loans from their retirement plans, but the rules associated with calculating the maximum amount that can be borrowed in this scenario is complicated and beyond the scope of this post. For more information about multiple loans, review the IRS retirement loans article.

To better understand the potential pitfalls associated with borrowing from your retirement account, check out this related post.

View Krulwich’s report here