The fiscal cliff has made year-end financial planning especially daunting this year.
Uncertainty, the saying goes, breeds uncertainty. And it’s up in the air as to whether Congress will take action to head off a significant reduction in federal government spending and the expiration of Bush-era tax cuts that are scheduled to take effect Jan. 1. Nor is there any clarity on what alternatives Congress might decide on as an alternative.
“We’re right in this no-man’s land,” said Frank Smith, a Raleigh financial planner.
Nevertheless, many – but not all – investment advisers counsel that the prospect of the nation possibly plunging over the fiscal cliff isn’t cause for overhauling a sound investment portfolio.
“Take a long view. This is something that will pass,” said Chip Hymiller, a principal at Beacon Financial Strategies, a financial planning and investment firm in Raleigh. “A long-term investment strategy shouldn’t be influenced by shorter-term issues like this. This is going to be solved at some point and life will go on.
“Usually, the market’s decline is the result of some sort of surprise,” Hymiller added. “This is definitely not a surprise.”
To be sure, many experts advise there are some steps investors should be examining given the likelihood of higher taxes next year – regardless of whether Congress reaches a compromise that somehow resolves the fiscal cliff.
But here’s the caveat: It’s important to consult an investment or tax adviser first.
“This is very complicated,” said Kathy Kraeblen, a Raleigh-based senior wealth planner with PNC Wealth Management. “There is no cookie-cutter approach to financial management. Everyone’s situation is different.”
Moreover, the prospects of higher taxes next year has transformed the landscape.
“Throw out all of the typical year-end planning strategies that we’ve had in the past,” said Melissa Labant, tax director at the American Institute of CPAs. “Throw them out the door.”
For example, a typical year-end tax maneuver would be to sell off losers in your investment portfolio.
“Hold off this year,” Labant said. “Don’t run out and trigger capital losses to offset capital gains or ordinary income” given that this year’s tax rates on both capital gains and ordinary income are likely to look like a bargain compared to the rates that take effect in 2013.
“I’m concerned that a lot of taxpayers are in the habit of taking certain year-end planning steps every year and that they’re automatically going to do the same thing this year,” Labant said. “That would be their biggest mistake.” Labant is based in the Washington, D.C., office of AICPA, which has more than 500 workers at its office in Durham.
What makes the current situation tricky is that people have until Dec. 31 to address tax issues that may not be resolved before the end of the year.
Although Congress conceivably could end up extending certain deadlines for taxpayers, “it’s unlikely and I wouldn’t rely on it,” Labant said. “If you want to make changes (for your 2012 taxes), you should plan on taking those actions by Dec. 31st.”
Investors are looking to make the best of the situation.
David Wright, owner of Capital Insurance and Financial Services in Raleigh, said his clients “understand that they are going to be paying more tax, but they want to make sure they are doing everything possible to limit the impact that the new tax rates are going to have on them.”
Here are a few tax-inspired strategies worth considering as 2012 draws to a close.
Capital gains: Take advantage of historically low taxes on long-term capital gains, which apply to stocks and other investments owned for at least a year.
Regardless of what tax bracket you’re in, “the probability is that (taxes on) capital gains are going up,” said Janet Fox, president of ACH Investment Group in Raleigh.
Currently, individuals with ordinary income above $35,350, or married couples with ordinary income above $70,700, pay 15 percent in capital gains taxes. Those below that level pay no capital gains taxes. Ordinary income includes all income except for income eligible for reduced tax rates, such as dividends and long-term capital gains.
Odds are that “we’re not going to see zero again, we’re not going to see 15 percent again,” Fox said. In addition, a 3.8 percent Medicare surcharge tax on capital gains is scheduled to take effect for high-income individuals in 2013.
Consequently, it makes sense to look at selling stocks that have appreciated significantly before the end of the year to avoid a higher tax bill down the road.
Something else to consider: If you’re selling a stock and taking a gain on it, there are no negative tax implications if you turn around immediately and buy the stock again. That’s different than when you sell a stock for a loss. In that scenario, you can’t claim a loss if you buy the stock again within 30 days.
IRA withdrawals: If you’re over 59 1/2 and you’re planning to tap your IRA for cash in the near-term, consider doing it before the end of the year.
“I’ve had a handful of clients who have taken money out of their IRAs this year ... because they think it will be less expensive to get it out this year than next year,” said Ben Brooks, director of wealth management at Capital Investment Companies in Raleigh.
If tax brackets on ordinary income rise next year – as many think they will – then taking cash out now would mean a lower tax bill. That’s because IRA distributions are taxed as ordinary income.
Once you’re older than 59 1/2, you can draw money out of your IRA without paying a penalty.
Roth IRA: If you’ve been contemplating converting your traditional IRA to a Roth IRA, the time may be ripe.
With traditional IRAs, you invest pre-tax dollars and pay taxes when you withdraw funds. With a Roth IRA, however, you invest after-tax dollars but pay no taxes when you withdraw funds.
Now could be a good time to convert to a Roth IRA, said Chip Hymiller.
“In future years, your tax rates are likely to be higher,” he said.
A conversion is not to be taken lightly, however, because you’ll have to pay taxes on the converted funds.
“You need to have a good handle on the tax implications,” Hymiller said. “You need to have a good relationship with your CPA or someone who can do a tax plan for you.”
Be prepared: There are a multitude of what-if scenarios that could play out in the next few weeks.
Capital Investment’s Brooks suggested investors have a conversation now about what actions might make sense depending on what Congress decides.
If you do that spade work, “when and if things change, you can act quickly” if necessary, Brooks said.