It’s a deadline in fiscal disaster for the United States: If Congress fails to address the “fiscal cliff” by year’s end, at 12:01 a.m. Jan. 1, economists say the American economy could face another recession.
“The word cliff invokes danger for most people,” said Patrick Morrison, a financial adviser with Edward Jones Investments in Ozark. “Fear of the unknown, and its associated anxiety, is almost always worse than the actual truth, whichever way it happens to fall. Uncertainty usually translates to volatility – ups and downs – in the financial market.”
The metaphorical image of the hour popularized by U.S Federal Reserve Chairman Ben Bernanke, the so-called fiscal cliff is built on a $16 trillion mountain of national debt that continues to grow and could give way to a series of compounding events, including possible tax increases and automatic spending cuts intended to reduce the federal deficit.
Morrison said the familiar scenario is the result of the federal government operating in a budget deficit and increased government spending, adding, “the steps required to achieve [a solution] at year’s end could cause a strain on our economy that could lead us to a modest economic recession.”
According to the Congressional Budget Office, the fiscal cliff is a sharp drop in the federal deficit caused by automatic changes in taxes and spending. The more than $600 billion in tax increases include:
- the end of the 2 percent reduction in payroll taxes;
- a 3.8 percent tax rate increase for high-income taxpayers;
- a decrease in the federal estate tax exclusions to $1 million from $5 million;
- an increase in payroll tax rates to 6.2 percent from 4.2 percent;
- a capital gains tax rate increase to 20 percent from 15 percent; and
- increased tax rates on dividend income.
Changes also include automatic government defense and nondefense spending cuts known as the sequester, a component of the Budget Control Act of 2011 that mandated $1.2 trillion in budget reductions during the next 10 years. Congress created the conjoined deadlines on tax and spending policy as a way to prod itself to resolve long-running disputes on fiscal issues.
The Congressional Budget Office estimates the combined effect of these changes should reduce the deficit by about $500 billion in 2013, or 3.1 percent of the country’s gross domestic product.
Portfolio problemsWhile taxes are poised to rise across the board, BKD Wealth Advisors Chief Investment Officer Jeff Layman said the expiration of tax cuts under President George W. Bush – known as Bush-era tax cuts – could hurt investors most.
“The most important thing going on within this issue for investors is really a reversion to tax rates that were in place before changes were made in 2001 and 2003,” Layman said. “At that point, we got some very favorable capital gains and dividend rates, and barring any action from Congress, these are going to reset.”
According to the CBO, when the Bush-era tax cuts expire, the capital gains tax rate will rise by 20 percent, taxes on top-level income earners will increase to 39.6 percent from 35 percent, and dividends will be taxed as income rater than capital gains, raising taxes to as much as 39.6 percent from 15 percent, depending on the earner’s tax bracket.
“For investors, that’s a fairly significant increase for that activity,” said Layman, a 26-year financial advisory veteran. “Most of our clients are very concerned. Whether you are a small-business owner or investor, uncertainty is not a good thing. I think they can make the best of the hand that is dealt them if they know the rules – at least they can make an informed decision. But if you don’t know what’s ahead of you, you can’t plan.”
In light of the impending cliff, Layman suggests investors take the “inverse of typical tax planning.”
“Normally, we would say to defer income and accelerate deductions, but it’s very likely tax rates will be higher next year, so really we have a flip flop – accelerate income into this year and defer deductions into next,” he said. “A charitable contribution you typically make can be deferred into 2013, maybe double up next year, because in all likelihood the tax benefit will be greater next year.”
Despite the unknown tax benefits, Community Foundation of the Ozarks President Brian Fogle said the Springfield-based nonprofit is seeing an uptick in year-end donations.
“We are seeing an increase in activity because I think people want to maximize what they can this year. They are uncertain what next year will hold, but they know what they can do now,” he said. “We have been fielding an above average number of calls from donors who are uncertain about their options of what the future after the fiscal cliff might hold.”
With the uncertainty, Fogle said more donors are exploring the option of establishing charitable accounts through CFO.
“You can give money this year and take the tax benefits, but not have to actually disperse the money until later in the year. It allows folks who are thinking ahead more time to evaluate their options.” he said.
Exploring other avenues, Layman also suggests investors harvest unrealized losses from investments within the portfolio to offset future capital gains and look at opportunities to maximize contributions to tax-deferred retirement plans. Morrison said investors should evaluate tax diversification of investments, consider other tax-advantage investments such as education savings plans and tax-free municipal bonds, and “don’t put all your eggs in one basket.”
Nearing the edge“I’m optimistic that some form of compromise will be reached. However, the timing, whether 2012 or 2013, is the larger question,” Morrison said. “It could be a bumpy market ride until a decision is reached.”
With just more than two weeks until the new year, Morrison said he doesn’t believe Congress will send Americans over the cliff, but Layman isn’t as optimistic.
“I don’t think either party really wants to send the economy back into recession, and I think most informed observers would say there will be some sort of compromise on these issues,” he said. “But there is some political gamesmanship to be had here and there is a growing sentiment it could play out.”
Layman said if Congress members reach a compromise, they will most certainly have to raise taxes somewhere, but if they fail to act, they can lower taxes in retrospect and come out as the good guys.
“If automatic increases occur and later in January you lower taxes – even though they are higher than before – you can tell your constituents you have cut taxes,” he said. “If we go over the cliff, whatever they do later in January will most likely be retroactive to Jan. 1. In practicality it doesn’t make any difference but is political posturing at its finest.”
Compromise or careening over the cliff, Layman said one thing is for certain – everybody must share the financial pain.
“The question is how do we get our financial house in order as a country?” Layman said.
“I don’t think there is an easy fix. This is a very complex problem, and no matter which way you turn there are going to be people against you. Everyone wants the government to fix this problem, but nobody wants it to affect them or their income. You just can’t do that.”
