Almost 20 years ago, as a newly-minted prosecuting attorney in the district attorney’s office, I attended an educational workshop on effective witness cross-examination. The presenter was a 50-something year old, very accomplished litigation attorney from a major Boston law firm. In addition to the covering the fundamentals (such as: never ask a question to which you don’t know the answer), he stressed that one of the quickest and most effective ways to impeach the credibility of a witness was to lead him into a state of cognitive dissonance—or as he facetiously referred to it—“Tick-Tock”—during cross-examination.
Two elements were prerequisites to creating “Tick-Tock.” First, you needed a witness who clung assiduously to a false narrative. It was even better when the witness actually believed his story—typically because, in the interest of self-preservation, he had conditioned himself into an outwardly credible altered reality (see later, for e.g., People v. Orenthal James Simpson…although The Juice wisely never took the stand). Second, you needed at least one demonstrable fact that directly contradicted that witnesses’ account. If you had both, the final challenge was to have the witness comprehend and then internalize the contradictory fact while on the stand to the point where he actually realized he now held two mutually opposing viewpoints simultaneously. “Tick-Tock” then ensued. Picture the metaphorical pendulum of the clock swinging in metronomic fashion back and forth between fact and altered reality while the witness remains frozen; unable to reconcile two inapposite “truths”.
Although the concept of creating cognitive dissonance seemed simple and logical from a tactical standpoint, in the context of a criminal trial, my experience was that it was often difficult to achieve Tick-Tock during the “cross.” Back then, the absence of physical evidence in most cases made trials rest primarily on the credibility of witnesses instead of scientific (pre-DNA), videotaped (pre-iPhone) or even mathematical (such as accident reconstruction) evidence. As such, if a juror could simply identify with the witness, that was frequently enough to sway opinion and garner a favorable vote one way or the other in the jury room.
What does any of this have to do with Taxes?
Well, at a Meridian-organized event about 6 months ago in Las Vegas, to begin my CME lecture on finance to a large group of physicians I asked two simple questions: 1. Do you believe income taxes will go UP for you in the future? (Incidentally, almost every doctor in attendance answered ‘Yes’—either verbally or through a guttural groan normally associated with food poisoning.) If so, then 2. shouldn’t you get out of your tax-delayed retirement accounts such as IRAs, 401(k)s and 403(b)s NOW? And my question 2A was: Beyond any matching employer contribution you might receive, why are you continuing to ‘max out’ your employer-sponsored retirement plan?
I looked out at the audience and saw a lot of physicians in Tick-Tock at that moment.
In reality, no one can be absolutely sure that income taxes will rise in the future. However, unlike when I was prosecuting criminal defendants 20 years ago, in this case, there is overwhelming physical and mathematical evidence to suggest they must increase substantially. Inarguably, the most dominant variable in that mathematical equation is the debt service we have pledged as a nation to Social Security and Medicare recipients. Interestingly, when Social Security (SS) was first introduced as part of Roosevelt’s New Deal in 1935, the average life expectancy was age 62 and the earliest age at which you could begin receiving SS was age 65. So, even though the check was ostensibly available, most had already checked out before they could pick it up. And, if you were fortunate enough to make it to age 65 and begin receiving SS, your life expectancy was only 2 years—age 67. As such, the ratio of workers contributing to SS versus collecting it was 42:1 and the program was wholly solvent. Today, life expectancy for those who reach age 62 (the earliest age at which you can begin taking SS) is age 85. Consequently, the ratio of those pulling the SS wagon to those sitting in that wagon has decreased dramatically—it is now approximately 3:1. Moreover, in 10 years, due primarily to the Baby Boom Generation, that ratio is estimated to narrow further to 2:1.
In 2008, the above math led David Walker, Comptroller General of the United States for ten years under both Bush and Clinton, to calculate that U.S. income tax rates must DOUBLE in order for us to meet all of our promised obligations. And, according to Walker, each year that this mathematically-required tax doubling remains delayed, our National Debt will increase $3 trillion until we reach $53 trillion. Why stop there? Well, at that point, the country will be essentially bankrupt.
Is this path inexorable or can we count on politicians to alter the variables of the equation to the point where the Entitlement Can is not just kicked further down the road? I’ll leave that one for you, the putative jury in this case. After examining the physical evidence in its entirety, my humble opinion is that income taxes are currently on sale (recall that they once reached 94% and they were at 70% throughout the 1970’s). If this is true, then what can you do to Escape from the Tax Trap you’ve created? My best lawyerly answer is: “it depends.”
Although the most creative and effective Escapes are varied in structure—charitable planning (see one example in my article in the last edition of TP), life insurance using a variable loan rate arbitrage, tax credit programs or valuation discounts prior to a Roth conversion, there are two consistently important points to bear in mind. First, manage your expectations. You’re not going to be able to avoid taxes altogether so be prepared for a little financial pain. Think of it as a present-value discounted settlement to buy out a greedy business partner (Uncle Sam) who didn’t do anything to earn the money in the first place. Second, don’t let the tax tail wag the investment dog. In other words, when a specific financial product or structure is part of the Escape, ask yourself whether you would place your money into the product even if it didn’t possess the tax benefits that make it a critical component of the transition from tax-delayed to tax-free.
By way of an Escape example, one of our clients just purchased a fractional interest in a portfolio of life settlement contracts (i.e. previously sold, in-force life insurance policies) inside his IRA. Subsequently, he commissioned a valuation on the portfolio from a qualified appraiser that reflected a discount for lack of “marketability” and “liquidity.” Finally, he converted his IRA to a Roth IRA using the discounted value as the operative one for tax purposes. This will save him a substantial amount in income taxes that he would have otherwise had to pay upon conversion (and, of course, now all of his future gains in the account will be income tax-free). To him, however, the tax benefits were ancillary to the substance of an investment that afforded him tremendous upside potential (a 67% simple interest return was actually targeted by the fund manager) and was completely uncorrelated to the stock market or interest rates.
Alas, when executing an Escape from the Tax Trap, there is no silver bullet. As with all major financial decisions, it is wise to rely heavily on your team of trusted advisors to guide you through the most advantageous path for you and your family. Clearly, both your Financial Planner and your Tax Professional should be central figures in customizing an Escape that comports with your financial objectives and ultimately helps you distinguish facts from altered financial reality.