WASHINGTON, Oct 10 (Reuters) - It’s time to watch Washington to see just how bad your New Year’s eve is going to be. Without any action in the Capitol, the U.S. economy is said to be poised to fall off of a “fiscal cliff.”
Projected increases in taxes and cuts in spending would throw the economy into another recession, says the Congressional Budget Office, and it could throw your family finances over the edge, a cc ording to analysts.
That’s because of several issues all hitting at once. The George W. Bush-era tax cuts expire on December 31, and without any extensions personal income tax rates will rise, as will rates on capital gains and dividends. Also expiring is the temporary 2 percent payroll tax cut that has boosted workers’ paychecks for the last two years. Beginning on January 1, there’s a new 3.8 percent surtax on investment income for people earning more than $200,000 ($250,000 for couples).
At the same time, $109 billion in across-the-board federal spending cuts on everything from education to Medicare to national park budgets are supposed to hit in January; they are the result of a process called “sequestration” that was part of the 2011 debt ceiling deal.
Oh, and another passel of tax breaks, including the perennial patch that exempts some 30 million Americans from the alternative minimum tax (AMT), already expired on December 31, 2011, and has not been extended - yet.
Does all of that make you feel like jumping off that cliff? Don’t panic. It’s unlikely that everything will get fixed by January 1, but it’s also unlikely that nothing will get fixed. (For example, the folks at Intuit Inc’s TurboTax unit are so sure the feds will eventually do that AMT patch, they are already programming their software as if it’s a done deal.)
But here in the District of Columbia, nothing is moving now except jawbones. After the election, Congress could jump in and enact some quick fixes - extensions to the 2011 tax breaks and another kick-the-can-down-the-road measure to smooth the tax and budget issues for 2013. Or not.
Meanwhile, we all have to protect ourselves. Here’s how to put up your own guardrails and then stand aside as policymakers rush to the precipice. It’s where they do their best work.
— Sell or give away winning stocks. Right now, long-term capital gains are taxed at a maximum rate of 15 percent. They have a 0 percent tax rate for people with adjusted gross income under $35,350 ($70,700 for couples).
“That is the lowest rate they have ever been in our near-term history, and it’s scheduled to go away,” says TurboTax’s Bob Meighan. You can’t get a better tax rate than zero, so if you have the wherewithal to help your low-bracket young adult kids, you might start by giving them shares of appreciated stock.
Even if you don’t have anyone in the zero bracket to give those shares to, you could sell them yourself, locking in gains at comparatively low tax rates. The best-case scenario for investors would be that the 15 percent rate get continued; nobody is predicting it will get lower than that. And folks earning enough to be hit by that 3.8 percent investment surtax would save by selling this year too.
— Be very charitable. There are many scenarios in which your charitable deductions could be worth less in the future. Republicans have been talking about capping those deductions for high-income taxpayers. There’s some talk of a Reaganesque rate-lowering, deduction-trimming tax reform that could reduce the value of your contributions as tax breaks. And wealthy folks - anyone with more than $1 million to pass on to their heirs - could see tighter estate tax limits in 2013 and beyond.
The bottom line? If you can afford it, 2012 is a good year to set up your own donor-advised charitable fund, or give more than usual to your favorite cause. It’s also a good year to fund a family trust or give a large estate-tax escaping gift to family members, but hurry up: Most estate tax attorneys have been slammed since mid-summer.
There’s one exception. Retirees over 70 1/2 who have to take mandatory distributions from their individual retirement accounts had been permitted to make contributions to their IRAs without taking a tax hit. That went away at the end of 2011. Will it come back for 2012? Experts like Meighan view that as unlikely, but it could happen. He’s telling folks who would be affected to wait and see what happens in November and December.
— Live below your means. Your paycheck is highly likely to go down in January, because there’s scant defense being mounted of that temporary payroll tax cut. Assume you’ll be paying 2 percent more in payroll taxes come January, so don’t commit to spending every bit of every paycheck.
— Do the opposite of what you’d usually do. “This year we are telling people to accelerate income and defer deductions,” Rick Bailine of McGladrey & Pullen LLP told Reuters journalists recently. He’s expecting some tax rate increases to materialize, especially for high income taxpayers. That means grabbing your bonus now if you’re given the option, instead of in January - if there’s a bonus to be had. His view is that tax rates are headed up; even if that doesn’t happen immediately, the very long-term view is that we’re currently in a low-rate period by historical norms. “Even if you are wrong by six months, that still makes good sense,” he says.
— Just wait and see. Charles Rotblut of the American Association of Individual Investors is telling members not to do any dramatic portfolio adjusting in advance of congressional action because anything can happen. “People will do more harm by placing a big bet assuming one outcome and having another outcome appear,” he says. Instead, he’s telling people to look ahead many months or years, to the long-term trend.
That trend could have you cherry-picking a different kind of stock to hold, however. Defense and healthcare companies both could suffer if even a portion of the across-the-board budget cuts are allowed to phase in, and both sectors could suffer anyway as the war in Afghanistan phases down and healthcare reform phases in. Dividend-paying companies could take a hit, too, if taxes are to rise over the long term on dividends.
— Plan for a busy December. Perhaps the best news now is that you don’t have to jump on any of this. You can wait to see whether the lame duck Congress that comes back after the election does anything in a hurry. If the past is any guide, all will become clear right around Christmas eve. That gives you a week to buy, sell, write checks, make gifts and talk to your adviser. Maybe you should make that appointment now.