Five Questions to Ask Your Adviser About the 'Fiscal Cliff'
Senior Editor, Enterprise
Eleanor Blayney is telling her clients not to freak out about the "fiscal cliff."
"We're not talking about the failure of the banking system …we're not talking about fraud or a housing crisis," said Blayney, president of Directions for Women and consumer advocate for the professional Certified Financial Planner Board.
"I'm actually telling people they should worry about the (Dec. 21) Mayan new year if they really want to worry about something scary," she said.
Blayney said she reminds clients that the dynamics of today's financial environment are nowhere near as dire as the 2008 financial crisis. "That did seem to be the end of civilization as we know it," she said.
The fiscal cliff crisis, she said, is more like the rollercoaster of August 2011, when the United States lost its AAA rating. "That was very short-term. And we've gone on and had a relatively strong equity performance this year," she said.
Blayney is a lot more sanguine – and light-hearted -- than many financial experts. But make no mistake, the fiscal cliff -- the package of tax hikes and deep spending cuts set to kick in automatically on Jan. 1 if Congress can't reach a deal -- will almost definitely impact you.The question is how much, and how can you minimize damage to your finances? We asked financial advisers for their advice. Here are the questions they're sifting through with their clients.
Will my taxes go up?
Probably. And they may go up a lot.
"We're looking at higher tax rates for a number of years," said Michael Amato, president of Independent Tax and Financial Planners in Holland, Pa. "People don't realize that rates were once much higher than they are today."
From the 1950s to the 1960s, he said, the rate on the highest earners was 90 percent. From the late 1960s the early 1980s, the highest rate was 70 percent.The rate didn't lower to 50 percent until the late 1980s. Starting in the early 1990s, the rate dropped to 39.6 percent.
Today, the top tax rate is 35 percent – but it's probably going up to 39.6 percent next year for the highest earners. And if you are married and filing jointly ($200,000 for single filers) and your income is over $250,000, you may be looking at additional taxes.
First, 0.9 percent of your wages above $250,000 will go toward an extra Medicare tax. Second, to the extent your income is above $250,000, you may also pay an additional 3.8 percent for unearned income such as interest, dividends and capital gains.
Which means that if you earn more than $250,000, and you have interest and dividend income, you will be paying 43.4 percent. (The rate is derived this way: If you are in the 39.6 percent tax bracket and your income is above $250,000, you'll also pay the 3.8 percent tax on interest, dividends, and capital gains.)
You should pay attention to capital gains because those are going to be taxed quite a bit higher. This year, if you sell a stock, your capital gains tax rate is 15 percent. Next year you'll probably pay 20 percent – and if you are subject to the 3.8 percent tax, you could be paying as high as 23.8 percent.
"I think we're locked into the 20 percent," Amato said.
How can I shelter income to keep my tax bracket lower?
Amato suggested that if you expect a bonus, take it in 2012, not 2013. In the old days, advisers always told clients to defer income. But now, the tax rate on a bonus is probably discounted from what it will be next year. "The blue light special is on, and it may be a sale that's going away," he said.
You also may want to wait until Jan. 1 to make charitable contributions, since those deductions will reduce your taxable income in 2013. If you have deductible expenses such as your real estate taxes or the cost of buying a business computer, wait until 2013. But be careful: there is some discussion about capping certain deductions.
You should also increase your savings through your retirement plans.
"You'll immediately reduce your pretax income," said Joel Redmond, a financial planner and vice president at Key Private Bank in Syracuse."So if conditions are lousy to earn and spend, you can save and defer the income."
Redmond also suggested shifting investments to tax-free bonds if you have a portfolio of dividend-paying bonds. "Municipal bonds are becoming more attractive because of the tax threat," Redmond said.
Another somewhat trickier move, Redmond said, is to start a business. "Clever people might consider starting a business because of the increased benefit in reducing the amount of income subject to tax," he said.
He also suggested that higher earners, such as physicians, create defined benefit plans for themselves or for their business, which could potentially shelter $250,000 annually. Redmond said this is a complicated and expensive move that requires an actuary. "Even if it takes you four months to set it up, it would save on the second half of next year's income, and that's probably worth it for some people," Redmond said.
(Read more: Financial Jargon Your Adviser May Throw at You)
So what can I do to prepare?
First of all, Amato said, "Don't make the tax tail wag the investment dog." In other words, don't freak out and move your investments around just because you're worried about higher taxes.
"From an investment perspective, we're not changing people's portfolios just because there may be a tough time in the near future," he said.
That said, he said there are moves you can make in the next couple weeks to get ready.
Know that tax rates across the board could be higher. Be aware that certain dividend income could be taxed at a higher rate, from 15 percent to as high as 39.6 plus 3.8 percent. Amato advised talking to your broker about how to handle your dividend-oriented stocks and mutual funds because the dividends will be taxed at a higher rate.
You might want to talk to your broker about buying municipal bonds as an investment if you expect your tax rate is increasing to around 40 percent because the after-tax return for municipal bonds may be more favorable.
You can also convert a traditional IRA to a Roth IRA this month, Amato said. You'll be able to accelerate the income now if you think the discounted tax rate of today will be better than your expected tax rate at retirement.
"With the prospect of higher tax rates, Roth IRAs can provide an excellent shelter from taxes in the future," Amato said.
Amato is a fan of Roth IRAs because all the potential future growth from a Roth is sheltered from taxation; in addition, a Roth can be inherited and the future growth can go to heirs without income taxation. It's also a form of tax diversification at retirement, Amato said, because a retiree can take a chunk of money out of a Roth (which is untaxed) and a chunk of money out of a traditional IRA (which is taxed) to take advantage of his or her tax position in a particular year.
If you own a business, you can accelerate billings and slow down expenses. Don't pay any unnecessary expenses until January.
Before the gift and estate tax exclusion decreases in 2013, you can gift up to $5 million this year. You can also set up a trust – though that takes time and legal assistance. But if you have $25 million or more, the time and trouble is worth it from a tax perspective, according to Redmond. But you should talk to a competent estate planner before you take any action.
(Read more: Next Battle on the 'Cliff's' Edge: Estate Taxes)
Will the fiscal cliff impact my retirement?
"People are reacting like they should move their whole retirement account into cash," Blayney said. "It's war fatigue, especially for those nearing retirement because 2008 took the stuffing out of people. They ran and didn't come back and didn't recover."
Every financial planner said that the best thing you can do – for the near and longer-term future – is contribute more to your retirement funds.
"I've had a lot of people increasing the amount they are contributing to their 401(k) in 2013 as a way to get their income under $250,000 (or $200,000 for singles)," Amato said.
The extra money socked away in savings reduces taxable income when tax rates likely go up next year, and has the added bonus of increasing the amount you have available for retirement.
Amato said clients are also funding their IRAs, 403(b)s and annuities to shelter income in the future.
How will the economy react?
If the cliff isn't quickly resolved, the country may slip into recession. So Blayney said she is suggesting clients make sure they have an emergency fund to cushion them if they lose their job. She's also recommending clients polish their resumes, particularly if they have any fear of job loss.
"This is like having soup in the pantry," she said.
If the economy goes into a recession, stocks may take a beating – which is another reason to consider selling stocks.
But she said that's not a hard and fast piece of advice. Why?
"There is so much of a potential for a huge rally in stocks if some of this gets sorted out because corporations have huge amounts of cash, and individuals have more cash than is appropriate for their financial planning," Blayney said. "So if there is some resolution, we have just as big a possible upside in stocks if people unlock some of the stuff they've buried under the mattress."