The fiscal cliff is a combination of large spending cuts and tax increases that are scheduled to be automatically enacted at the start of 2013. There is nothing unusual about any of these spending cuts and tax changes in isolation, but it’s the sheer number of them happening simultaneously at the beginning of next year that’s the problem. The convergence of expiring tax cuts, reductions in spending, and a host of updates to the tax code have the potential to generate a perfect storm. In addition to higher income tax rates, higher capital gains rates, the reinstatement of itemized deduction limits and lower estate tax exemptions, there are probably 75-100 different tax breaks that will expire at the end of 2012. If Congress fails to act, nearly all taxpayers will experience one of the largest tax increases in history.
Since it’s not possible to know how all this is going to work out, it makes sense for investors to focus on what is known rather than on what is conjectured. For example, investors should utilize existing tax breaks while they are still around and reduce their vulnerability to unknowns without acting rashly. Above all, they should stay flexible. While many advisors, including myself, frequently talk to clients about asset allocation or the mix of stocks and bonds in their portfolios, it’s not relevant for today’s discussion. More important is asset location, which refers to whether assets are in a taxable, tax exempt or tax deferred investment vehicle.
First off, consider maximizing contributions to employer-sponsored retirement plans. A pretax contribution will bolster savings and at the same time reduce adjusted gross income, helping qualify for tax breaks that phase out at higher income levels. Consider converting taxable IRA accounts to tax free Roth IRAs. This is the ultimate flexible tax move because investors have until October 15, 2013 to reverse the conversion if circumstances merit it. The key is not to get too caught up in the math. The Roth conversion question should be addressed holistically, taking into consideration retirement and estate planning needs, income tax status and overall financial situation. Keep in mind that it doesn’t have to be an all-or-nothing decision. A partial Roth IRA conversion is always an option.
The new Medicare tax rate of 3.8 percent on investment income applies to joint filers with adjusted gross income above $250,000 and single filers with adjusted gross income above $200,000. However, this tax will affect more than just the ‘wealthy’ it was intended for. If a single taxpayer with $120,000 in wages receives a windfall gain of $150,000 from the sale of a long term investment, he or she will have $70,000 of investment income over $200,000, on which will be owed $2,660 of extra tax. To reduce the risk of being subject to this new investment tax, consider converting taxable interest to municipal interest which is tax exempt. Likewise with dividend income which is facing one of the biggest rate jumps if the Bush era tax cuts are eliminated.
Be careful about harvesting gains or losses to take advantage of the likelihood of higher tax rates next year. Even if capital-gains tax will be higher next year, selling a long-term holding indiscriminately just to qualify for this year’s lower rate on gains reduces invested capital and therefore future wealth. However, accelerating a sale into this year could make sense if you anticipate selling within the next few years to meet a specific objective such as paying for a house or college. Harvesting capital losses to offset investment gains, and up to $3,000 of ordinary income, could also be a good strategy, but remember, the wash sale rule prevents you claiming a loss if you acquire the same asset within 30 days of selling at a loss.
Because taxes are associated with so much emotion (most people hate paying them) investors are susceptible to letting the tax tail wag the investment dog. However, making a decision based on one perspective alone is nearly always a mistake.
Please note that this article is not intended as legal or financial advice.
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“Taxation: how the sheep are shorn.” Edward Abbey
Malcolm's Corner 
December 5, 2012 at 8:00 pm
I like the idea of simplifying the tax laws. Obama talks about “fairness” but refuses to use a flat tax. To me, and my simple brain, that seems like the most fair. Am I wrong?
December 5, 2012 at 8:24 pm
Somebody said “A sound tax system has as few moving parts as possible.” A flat tax would certainly qualify but politically it’s not going to happen. Too many people have a vested interest in the current system with all its quirks and loopholes.
December 6, 2012 at 5:15 am
A flat tax doesn’t make sense to me because lower income families have less disposable income and that tax would be unduly harsh on them. I do think that we have too many loopholes and deductions that need to be closed and eliminated. Unfortunately, that is unlikely to happen. Having said that, I continue to believe that a compromise will be reached before the end of the year.
December 6, 2012 at 4:53 pm
Thank you. I think something could probably be worked out for lower income families e.g. no tax below a certain level of income or a negative income tax. Just think of all those tax professionals and government workers that could be productively employed elsewhere if we had a flat tax. Furthermore, just think of all the time we, small business owners and ordinary citizens, could save, that we now spend on tax related activities because the system is so complicated.
December 6, 2012 at 6:35 pm
Didn’t the Simpson-Bowles plan call for a progressive tax with lower rates and the elimination of deductions that would raise more funds for the government? Sounds like a sensible plan to me.
December 6, 2012 at 9:56 pm
I don’t know if I would call it sensible. It includes taxing capital gains as income!