The Independent Market Observer

11/8/12 - What the Election Means for Your Tax Bill

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Nov 8, 2012 9:53:20 AM

and tagged Fiscal Cliff, Politics and the Economy

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ImageNow that the election results are in, it is time to think about what they mean for your financial future. Even though the government will remain pretty much the same for at least the next two years, taxes will be changing substantially next year, and we can make some educated guesses about how they will be changing after that. Finally, we need to consider what the pending fiscal cliff might mean to our financial health and how to prepare for its effect.

Taxes are going up for higher-income families
Now that President Obama has been reelected, and the Democrats continue to hold the Senate, the chances of a repeal of Obamacare are minimal. That means that the surcharge of 3.8 percent on net investment income above $250,000 will take effect. The president’s stated preference is for marginal tax rates to rise for higher-income families, with the 33-percent rate increasing to 36 percent and the 36-percent rate increasing to 39.6 percent. Income below $223,000 (married filing jointly) would be taxed at the current rate.

Higher-income investors will also take a tax hit. The president has stated that he would like to see the 15-percent long-term capital gains tax rate go to 20 percent. Income above $250,000 would be taxed at ordinary income rates, plus the 3.8-percent surcharge. In effect, this would mean a 43.4-percent rate at the federal level for short-term capital gains or dividends over $250,000.

How can you prepare for this?

  • Consider taking gains before the end of 2012. It may make sense to take the gain, pay taxes, and reestablish basis at the higher level.
  • Review your investment strategies and determine how they can be made more tax efficient. Tax-advantaged investments, such as municipal bonds, life insurance, or annuity vehicles, and similar strategies can become relatively more attractive as tax rates increase.
  • Assess when you plan to recognize income or gift to others, as the timing could make a big difference.

Obamacare is baked in the cake, but the other changes are not certain. What does appear certain, however, is that either some sort of compromise will be negotiated, which might include extending current policy for another year, or the fiscal cliff will hit.

The fiscal cliff—taxes will go up for everyone
This fiscal cliff is made up of tax increases and spending cuts. The spending cuts will not hit most clients directly, but the tax increases will. Every taxpayer will experience a tax increase, with the lower incomes being hit proportionately harder. Moreover, the Alternative Minimum Tax (AMT) will spread to 21.7 million households, up from 4 million this year, per Bloomberg.

The advice here is similar to that given above, but it would apply to everyone. For example, because of the expansion of the AMT, existing deductions will be limited to many taxpayers in completely unexpected ways. It will be important for all taxpayers to review their tax returns early to ensure that they are in compliance with AMT requirements.

Investment implications
Beyond the significant tax changes expected under any scenario, the fact that taxes will increase in general will mean slower growth in the economy at large, as consumer spending will be hit by the greater tax liability. Discretionary spending will also take a hit, for the same reason.

Top-line earnings growth, already experiencing a slowdown, can be expected to slow even further, while higher tax rates will hit corporate margins. Given these two negative factors, equity performance may well be adversely affected. Fixed income, including both government and corporate debt, may do well, as investors focus more on safety, and, in the case of Treasuries, the additional tax revenue will help reduce the deficit.

Going forward, tax planning will be increasingly important
Any way you look at it, taxes are going up for a large proportion of citizens. This is driven not only by the election results, but also by the fiscal realities of the U.S. government. Tax planning will be an increasingly important part of any financial discussion going forward, and the time to start is now.

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