2012 Investment and Tax Planning While Approaching the Edge of the Fiscal Cliff

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There is a lot of talk in the financial news about the coming “fiscal cliff” and its potential ramifications for investing, financial planning, tax planning, and estate planning. While there is a lot of speculation about what might happen in the coming weeks and how to plan ahead, investors still face an enormous amount of uncertainty, and many clients have called me with questions, concerns, and even downright confusion about how the fiscal cliff might affect them.

In this article, I’ll explain the basics of the fiscal cliff and its potential effects on your investment accounts. While these issues can quickly become complicated, knowing the basics will help you to ask your advisors the right questions and get the best advice possible for your situation!

What is the Fiscal Cliff Anyway?

The fiscal cliff is basically just a series of tax increases. The Bush tax cuts, along with a few other programs, are scheduled to expire at the end of 2012. Their expiration, alongside scheduled spending cuts to several government programs, including Medicare and defense spending, are expected to raise hundreds of billions of dollars in revenue for the federal government. However, given the weak economy, there is a lot of concern among commentators that tax raises could harm American economic growth in the coming years.

These scheduled tax increases would affect many different areas of financial planning, including dividend income, capital gains, income tax rates/credits, and estate taxes.

Income Tax Brackets

One very notable change driven by the fiscal cliff would be an adjustment to federal income tax rates. Instead of the current six tax brackets (10%, 15%, 25%, 28%, 33%, and 35%), we would move to five federal brackets (15%, 28%, 31%, 36%, and 39.5%). This may help to make those retirement savings contributions more attractive!

Currently, there are no specific changes scheduled when it comes to tax breaks for 401(k) and IRA contributions, but there is speculation that Congress may reduce these benefits. In my opinion, it’s best to assume that everything is on the table for the coming negotiations.  Of course, planning ahead without knowing what will happen to these tax breaks is impossible. However, keep in mind that with higher taxes and no changes to tax breaks for traditional 401(k)s and IRAs, you might want to consider increasing your savings to take advantage of the benefit.

Capital Gains and Investment Income

The fiscal cliff would also have an effect on your investment income. If a deal is not reached, existing legislation would mandate that long term capital gains taxes would increase to a maximum of 20% (from 15%) and all dividend income would be taxed as ordinary income (currently, qualifying dividends fall under the long-term capital gains structure of 15%). Should these go into effect, you may want to revisit the distribution of your holdings across taxable and tax-deferred accounts, as the incentive to keep dividend-paying and high- growth stocks in tax-deferred accounts could be a lot stronger.

You may have also noticed some of your holdings paying out special dividends in preparation for the fiscal cliff – companies such as Wal-Mart and Costco have already announced special dividends alongside several other publicly traded firms. This could affect your current-year tax bill depending on where you hold these stocks.

Another scheduled change is a new 3.8% Medicare contribution tax on unearned income for high-earning individuals. Unearned income is any income you receive from sources other than employment, such as interest and dividends, annuities, or rental income (among others). The new tax would apply only to people with an adjusted gross income (AGI) of over $200,000, or $250,000 for married couples filing jointly and $125,000 for married couples filing individually.

So, take for example a single taxpayer with an AGI over $200,000 who earned $50,000 in dividends and interest from her investments. Assuming she has no allowable deductions or other sources of unearned income, her net unearned income would be $50,000 and she would be taxed an additional 3.8% on this amount on top of any other taxes owed.

The Fiscal Cliff and the Markets

The markets already seem to be responding with volatility to the approaching fiscal cliff, and I expect this to continue. However, even if we do go off the cliff, I think it’s important to keep a level head. Remember that this isn’t the end of the world, and that tax cuts can still be enacted in the New Year. I believe a deal will be made whether we go off the cliff or not. However, as always, the devil will be in the details when it comes to what that deal might look like.

In the meantime, it’s important to keep in mind that the markets might be increasingly volatile as we approach year-end based on news developments and worry about what will happen next. Uncertainty, in my opinion, makes markets much more reliant on news rather than fundamentals, and this can add additional worry to an already uncertain time.

How do you deal with it? I believe that the market is likely to decline if we go off the cliff, but I also believe it’ll bounce back. I’m advising my clients to be prepared for some big swings over the next month, and I’m taking a cautious and nimble approach with higher-risk trading accounts. For accounts with more stable, long-term allocations I generally advise sticking with a well-diversified and actively-managed strategy that utilizes alternative investments and other asset classes less correlated to the overall market, as they generally provide some protection from big downward swings.

More Information

While the fiscal cliff is presenting investors and financial planners alike with a lot of uncertainty, keeping yourself informed about the basics and the moves you might be able to make in response should help reduce any fears or concerns you might be experiencing. To learn more, read about the fiscal cliff and its importance to tax planning and your investments. To learn more about building a solid long-term portfolio, take a look at my articles on Institutional Investing for the Individual Investor, Managing Market Volatility, and Managing Your Downside Risk.

Finally, don’t be afraid to ask questions and talk to your advisor as deliberations about the fiscal cliff unfold. Remember, knowledge is power!

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To learn about retirement savings, download my free eBook, “10 Tips You Need to Know About Your IRA Rollover.” This short book is packed with critical information that will help you make the right decisions about your retirement savings.

Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors

The views and opinions expressed in an article or column are the author’s own and not necessarily those of Cantella & Co., Inc. It was prepared for informational purposes only. It is not an official confirmation of terms. It is based on information generally available to the public from sources believed to be reliable but there is no guarantee that the facts cited in the foregoing material are accurate or complete.

Comments may not be representative of the experience of other investors. Investor comments and experiences are not indicative of future performance or results. Views and opinions expressed in the comments section are the author’s own and not those of Cantella & Co., Inc. No one posting a comment has been compensated for their opinions.

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