The popular press is referring to upcoming changes tax law changes as a “fiscal cliff.” That’s putting it nicely because it suggests that its a natural disaster. The fiscal cliff is actually a function of intransigence on behalf of those who write the laws. They can’t agree on what is the right thing to do so they instead concentrate on (a) getting themselves re-elected and (b) consolidating power for their respective political parties. At this stage in my life, my general interest in politicians and their election-year shenanigans has waned. I am more concerned about how they place our economic and retirement futures in jeopardy and what to do about it.
Fiscal event 1: Automatic Spending Cuts. As a consequence of the most recent decision by Congress to kick the economic can down the road, $1.2 trillion (over ten years) in automatic spending cuts will commence on January 1. Even if these cuts commence, they won’t last long. If nothing happens between now and January 1, I think you can count on another market drop. My best guestimate is that a lame duck Congress may amend current law to delay the start of the spending cuts by 60 days or so. This will theoretically give the new Congress time to scream at each other and find another solution. Either way, if you don’t like volatility, adjust your allocations accordingly.
Fiscal event 2: Increase in Personal Income Tax Rates. The so-called “Bush tax cuts” (enacted into law by Congress, not by Bush), are scheduled to expire on December 31. Personal income tax rates will increase to 15% (from 10%), 28% (from 25%), 31% (from 28%), 36% (from 33%), and 39.6% (from 35%). My take is that some form of federal income tax increase is inevitable. How can you prepare? One strategy is to be sure you are maximizing your contributions to tax-deferred retirement plans, e.g., 401(k), IRA, and HSA. (Yes, your health savings account can be a retirement account.) Another school of thought is that because tax rates must go up and stay up, the rates in our retirement will be higher than they are now. Therefore, the smarter move is to pay your taxes now, not later.
Fiscal event 3: Increase in Dividend Tax Rates. Qualified stock dividends are presently taxed at 15%. On January 1, this rate is scheduled to disappear. At that time, dividends will be taxed at your top marginal personal income tax rate. If you are a high earner, this is significant. If you own funds or ETFs that are dividend oriented, the share value may decline because dividend stocks will become less attractive. Be ready for this.
Fiscal event 4: Increase in Capital Gains Tax Rates. For most tax filers, the capital gains rate will increase from 15% to 20%. Therefore, if you are planning on selling and capturing some gains, consider doing it before the end of the year. This won’t affect holdings in your tax-deferred retirement accounts.
Fiscal Event 5: Payroll Tax Holiday Ends. The current payroll tax holiday has reduced the Social Security payroll tax rate to 4.2%. At the end of this year, the rate will revert to 6.2%. Plan on a slightly smaller paycheck.
Fiscal Event 6: Expansion of Alternative Minimum Tax. The income exemption level for the Alternative Minimum Tax drops to $33,750 for individuals and $45,000 for married couples. Compare that to $50,600 and $78,750 for 2012. This will substantially increase (by millions) the number of people who will be hit by the AMT. One of them could be you, meaning a larger tax bill.
Fiscal Event 7: Medicare Surtax. To help pay for the new health care law, starting in 2012 a new 0.9% surtax will be imposed on earned income over $200,000 for individuals and over $250,000 for married couples. In addition, these same high-earners will pay a 3.8% Medicare surtax on investment income.
Bottom line: Unless Congress is able to act (and the President doesn’t veto), many people will experience smaller paychecks and larger tax bills in 2013. This will make it even harder to save for retirement. To compensate, you may have to make cuts in your lifestyle.