When the 'fiscal cliff' hits at the end of the year, automatic tax increases will push up taxes on income and capital gains and dividends. Here's how taxpayers can minimize the potential damage.
Here's some unexpected advice for taxpayers this year: Take as many tax breaks as you can, but try to pay more taxes before 2013 rolls around, especially if you're an investor.
That's because 2013 is no ordinary year. The "fiscal cliff" looms. If Congress does nothing, automatic tax increases will push up taxes on income and capital gains and dividends. The combination of higher taxes and automatic sharp budget cuts is something Congress wants to avoid because it could send the recovery into a tailspin. But it's not clear that any compromise it reaches will be much better. Some of your favorite tax breaks could disappear.
With so much uncertainty, investors could be tempted to build bunkers and brace for every worst-case scenario. A better bet, though, might be to pare back future tax liability, according to Brian Pon, principal of the Financial Connections Group, a financial-planning firm in Corte Madera, Calif. "The overhang of the fiscal cliff might be something that kind of nudges you along on that path." Even if Congress finds a much gentler solution for taxpayers in 2013, it's a good bet that taxes overall aren't going to go down.
The fiscal cliff would hit other taxpayers, too. Dual-income married couples would see their standard deductions shrink with the sunset of Bush-era tax cuts. Others who've benefited from a payroll tax cut and tax credits for children would see perks disappear. Those who can control how much they earn before year's end might want to claim more in 2012 and less in 2013.
"Accelerating income to pay tax in the current year at hopefully a lower rate" than one would pay next year could be a wise strategy, says Mark Luscombe, principal tax analyst for accounting firm CCH, based in Riverwoods, Ill.
For investors, capital gains taxes loom large because they shape how much of a portfolio goes to Uncle Sam. If the fiscal cliff occurs, earners in low income tax brackets who now pay zero capital gains tax would pay 10 percent next year. Those who pay 15 percent (which is most investors) would start paying 20 percent. Those earning more than $250,000 would pay even more at 23.8 percent to account for a new Medicare surtax. What's more, dividend income would be taxed as ordinary income rather than at the current 15 percent rate, which means new rates as high as 39.6 percent.
Some investors should consider selling equities that have accumulated gains before year's end, Mr. Pon says, even if they buy them back immediately, in order to take advantage of today's low rates. But be careful, he adds, not to incur a burdensome tax bill. And if you plan to hold a stock for your lifetime, then there's no sense in selling and repurchasing because heirs will get the stock at its then-current value and pay no tax if they sell immediately.
Even investors who plan to hold a stock for five or 10 years might hurt themselves in the long run by rushing to pay taxes now, says David Kelly, chief global strategist for J.P. Morgan Funds in New York. "You could sell and buy it back, but some of the money that could be growing for you is now growing for the tax man instead.... You want as much of your money as possible growing for you for as long as possible."
Those worried about higher taxes on the horizon can take advantage of tax-sheltered retirement accounts by converting assets to a Roth IRA (individual retirement account). Since Roth assets grow tax-free, tomorrow's higher tax rates would have no impact. Investors may also want to tweak their portfolios. For example, a low-volatility exchange traded fund (ETF), such as the PowerShares S&P 500 Low Volatility Portfolio, would tend to fluctuate less than the market overall if fiscal cliff fears take hold.
"One thing is certain: The market has not priced in [the fiscal cliff] as most people believe politicians will reach agreement," says Neena Mishra, director of ETF research for Zacks Investment Research in Chicago. "But I don't think an agreement will be reached before the election … so there will be a period of high uncertainty for at least a few weeks" after the election.
Another alternative: Municipal bonds could help investors' portfolios in 2013 since they're exempt from federal taxes (and state taxes in some cases), Ms. Mishra and Mr. Luscombe point out. But you should load up on them only if you think interest rates will stay low.
"If you have a long-duration municipal bond, yeah, you may save a little bit on the taxes," Mr. Kelly says. "But you could get really hurt by rising long-term interest rates." He recommends against a big investment in municipals and other fixed-income securities.