Finally, Real Numbers on the Fiscal Cliff and You

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I've read a dozen articles on the fiscal cliff. They all say nothing. No real numbers, no action items, no real understanding of what it means and how it will impact me. It was frustrating until I read this post by David Hultstrom of Financial Architects. David’s has an amazing financial mind. I've shared some of his writings on this blog. I love this one on the fiscal cliff. Keep in mind, this is written from the perspective of a financial advisor and how the fiscal cliff will impact his decisions for his high net worth clients. Enjoy.

Attempting to predict what Congress will do seems foolhardy yet as financial planners and investment advisors we have to make the best decisions we can. We also need to keep in mind the uncertainty and fluidity of the situation. I am reminded of a quote from Voltaire:

Doubt is not a pleasant condition, but certainty is absurd.

In discussing this I will necessarily simplify some complex issues to make them easy to grasp, but I don't believe I have lost any of the essence or the issues in doing so.


In an attempt to encourage a budget deal, in 2011 a trigger was created that would gore the oxen of both parties beginning in 2013. A deal didn't happen. Half of the cuts are from defense spending (to motivate the Republicans) and the other half from everything else (to motivate the Democrats). The cuts may be a good thing or they may not depending on your political viewpoint, but without Congressional action they are coming.

The cuts are $1.2 trillion but that is over ten years. If we divide by 10 it comes to $0.12 trillion each year. For perspective, federal spending last year was $3.56 trillion. Thus, it amounts to reducing spending by about 3.4%. Given that federal expenditures have increased over 20% (net of inflation) since five years ago (and, lest you think I am partisan, up over 50% since the beginning of W's term) those cuts don't seem draconian to me.

Another way to look at the cuts is in terms of the deficit. The federal deficit last year (the amount the government spent in excess of its income) was $1.13 trillion. So essentially Congress is alarmed that each year they will only be able to spend $1.01 trillion they don't have, rather than $1.13 trillion they don't have. (To give further context, with the cuts that is still about $9,000 of _deficit_ spending per U.S. household.)

Estate Taxes.

There are two uncertainties here. The first is the amount excluded from taxation. 10 years ago it was $1 million and is scheduled to revert to that level again in January. In 2009 it was $3.5 million and is currently $5 million (plus inflation adjustments). The consensus seems to be that Congress will probably settle (eventually) on something in the $3.5 to $5 million range. The second issue is the estate tax rate. The top rate from 1984 until 2002 was 55% (that is the top rate, smaller estates pay a lower amount) and it is scheduled to revert to that level again in January as well. The current rate is 35%. The consensus seems to be that Congress will settle (again, eventually) on something between 35% and 45%.

We aren't making any recommendations in regard to estate taxes at this point other than perhaps encouraging gifting to heirs a little more strongly for clients who are now at risk of having a taxable estate. The gift limit this year is $13,000 per person, so a married couple with a married child could gift them $52,000 total. The limit is scheduled to increase to $14,000 for 2013. In addition, unlimited gifts for medical or education expenses are permissible (though with some caveats, contact us or your tax professional for details).

Income Taxes.

I want to organize this section by discussing the big picture, then what is likely to happen, followed by what steps to take (i.e. what we are doing for our clients) in light of those expectations.

The Big Picture. As Daniel Patrick Moynihan observed many years ago, "Everyone is entitled to his own opinion, but not his own facts." Here are some facts that will probably get folks on both sides of the political aisle annoyed with me.

First, and surprisingly, the tax system in the United States is more progressive than most European countries. In other words the rich here bear more of the relative burden. Despite this, we help the poor less because the overall tax burden is lighter. If we wanted to be more like Europe we would have to tax everyone – particularly the middle class – more and then spend more on social programs. (For a good explanation of this see this recent article from The New York Times.)

Second, for ordinary income (essentially wages and interest, not long-term capital gains) the "Bush tax cuts" made the tax burden more, not less, progressive and returning "back to the income tax rates we were paying under Bill Clinton” would hurt lower income taxpayers more than higher income taxpayers. But in fact that isn't what President Obama is calling for. The full quote is, "I just believe anybody making over $250,000 a year should go back to the income tax rates we were paying under Bill Clinton." That move would make the income tax system more progressive than it has been since the last fundamental rewrite of the tax code in 1986. (And the call ignores the 0.9% Medicare surcharge on earned income and 3.8% on unearned income added to fund "Obamacare" so we would not be going back to the old Clinton rates, but actually higher ones.)

Third, notwithstanding the previous point, many of the wealthy are much better off with the "Bush tax cuts" but it stems more from the reductions in the capital gains rates and dividend rates than the cuts in ordinary income rates. Under President Clinton the top long-term capital gains rate was lowered to 20% in 1997 and then was lowered further under President Bush to 15% in 2003. (Those rates are slightly lower than the actual rates experienced by some taxpayers due to phaseouts of various deductions.) The top rate is scheduled to revert to 20% in January. In addition, for higher income taxpayers there will be an additional 3.8% Medicare surcharge which was passed to help fund "Obamacare." Thus the top rate is currently scheduled to increase to 23.8%. (Again it will actually be a little higher for some taxpayers due to the previously mentioned phaseouts.) Dividends under Bush were changed from being taxed at ordinary income rates to being taxed like capital gains (which I think is appropriate for reasons too lengthy to go into here) but are scheduled to revert to the previous treatment in 2013 as well.

Fourth, there has been a lot of discussion regarding limiting the benefits of itemized deductions and other items for higher income taxpayers. This has the effect of increasing the tax rate without it being highly visible. Ironically, removing the benefit of these tax breaks for higher income taxpayers may eventually lead to the breaks being eliminated altogether. Simplifying the code is problematic because all the loopholes and benefits (technically called "tax expenditures") have proponents. Reducing the value to many people reduces the number of people lobbying for their continuation. Thus, in the long run, limiting these benefits for the higher income taxpayers could lead to a simpler tax code with a broader base, but lower rates (essentially moving in the direction of a flat tax). I, and most economists, believe this would be much better both in terms of raising necessary revenue efficiently and promoting economic growth.

What is likely to happen (Simply a prediction)

In my view it seems likely that capital gains rates will increase to 20% plus 3.8% for higher income taxpayers. Even for the lower income taxpayers they will probably increase from the current 0% (yes, you read that correctly) to 10%. (There are special 18% and 8% rates for longer holding periods though as well.)

It seems that ordinary income rates are very likely to increase somewhat at least for higher income taxpayers. It also seems likely that some tax deductions may be limited for those higher income taxpayers too.

In addition, it seems virtually certain that the temporary 2% reduction in FICA taxes will expire at year end. This is a 2% tax increase on wages for workers over what they paid this year and last.

What steps to take. (this is not advice but helps to understand the options)

As mentioned at the beginning of this newsletter, the situation is uncertain and is likely to remain so. Thus drastic moves aren't warranted or recommended. Nonetheless, in light of the near certainty of an increase in capital gains rates it may be prudent to harvest (i.e. take) some capital gains prior to the end of the year. For example, suppose a higher income client is anticipating an expense in two years that will require selling an investment that currently has an unrealized capital gain. With a current tax rate of 15% and an anticipated one of 23.8%, the annualized rate of return from harvesting that gain now is approximately 26%.

In our client's portfolios there are some specific positions that 1) generally have large gains (depending on when they became clients) and that 2) we want to replace with what I feel are better alternatives anyway. Thus, we will be selling those holdings and buying the replacement ones. In taxable accounts this will lead to additional taxes this year, but almost certainly much lower taxes in the future. In non-taxable (i.e. retirement) accounts there won't be any tax implications, we are merely swapping one investment for what we believe to be a slightly better one. There is an occasional exception. For example, we have a client in her mid-90's who has _very_ large gains in her holdings in her taxable account. If held until her death, under current (and anticipated) tax rules, her heirs would pay no capital gains tax at all. Thus, needless to say, we won't be harvesting gains in her account.

Similarly, if there are unrealized capital losses in the portfolio (i.e. you hold something that has gone down from where you bought it), it will frequently (but not always) make sense to wait until next year to recognize those losses.

Contributing to retirement plans is even more advantageous than it was previously and doing Roth conversions may be more compelling as well. The End.

What do you think about David's perspectives on the fiscal cliff? What are you doing to prepare for the possibilities? Should you do anything at all?

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