We are on the verge of a possibly significant shift in the tax and investment landscape in the United States. Given the changes that may be implemented late in 2012 or early in 2013, we think it is wise to consider some tax-smart financial planning options.
First, the tax story.
Tax rates on income, capital gains and dividends are at multi-decade lows. The following charts from J.P. Morgan visually set the scene for where we are today.
The lower portion of the graphic shows the decline in tax rates for the highest tax brackets. The upper two charts show how tax collections and spending have changed with the added context of recessionary periods in the dark gray vertical bars.
Federal revenue in 2012 is expected to be just 15.7% of Gross Domestic Product. This figure is about 13% below the average of the past 50 years. At the same time, Federal outlays are running at 23.4% of GDP, about 14% higher than their 50-year average.
Most financial planners and tax professionals that we know agree that given our large federal government debt levels and in spite of our slow economic recovery, it is doubtful that tax rates can stay low for much longer. We think that it will be difficult for congress to agree on answers to two important issues that it will face during the lame duck session at the end of the year:
1) Whether to overturn the $1.2 trillion of spending cuts that are required as a result of the failure of Congress’ budget deficit supercommittee to agree on how to raise revenue and lower spending for the federal government.
2) Whether to extend the 2001 and 2003 Bush tax cuts, which includes lower taxes on income and capital gains.
If Congress can’t agree on how to proceed, the new year could bring us a combination of higher tax rates and large cuts to our federal defense and education budgets. The combination of potential tax increases and reduced government spending create a scenario that you may have seen referenced as the coming Fiscal Cliff.
When measuring the impact of tax increases and government spending, it’s clear that the U.S. economy may face a significant headwind in 2013. This chart from Strategas and Fidelity Asset Management shows the size of the increase as compared to other tax increases over the past 45 years. The mix of higher taxes and spending cuts could remove as much as $7 trillion from the economy.
To make matters worse, it’s possible (likely?) that politicians will choose not to address the situation until early in 2013, making retroactive decisions. The uncertainty of this situation may weigh on markets over the remainder of the year.
THREE IMPORTANT CONSIDERATIONS FOR 2012
Given the likelihood of tax increases on all forms of income, consider these important financial planning opportunities between now and the end of the year.
- Business owners and others who can manage the timing of their income should try to maximize their income in 2012.
- If you have long-term capital gains in stocks and mutual funds that you don’t want to hold until you die (to receive a step up in taxable cost basis), then selling all or a portion of these before the end of 2012 could be very advantageous. You could pay 33% less tax this year at a 15% long-term capital gains tax rate rather than next year at 20%.
- If you have considered converting a portion of your IRA to a Roth IRA, this could be the last chance to make this conversion and pay income taxes on the amount converted at the (likely) lower 2012 rates.
Before you take advantage of any of these opportunities, contact your accountant or financial advisor to see if one or more makes sense for you.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA