The dynamics of today's financial environment are nowhere near as dire as the 2008 financial crisis.
The fiscal cliff crisis is more like the rollercoaster of August 2011, when the United States lost its AAA rating. That was very short-term. And we've gone on and had a relatively strong equity performance this year.
But make no mistake, the fiscal cliff -- the package of tax hikes and deep spending cuts set to kick in automatically on Jan. 1 if Congress can't reach a deal -- will almost definitely impact you.The question is how much.
Will my taxes go up? - Probably. And they may go up a lot.
We're looking at higher tax rates for a number of years. People don't realize that rates were once much higher than they are today.
From the 1950s to the 1960s, the rate on the highest earners was 90 percent. From the late 1960s the early 1980s, the highest rate was 70 percent.The rate didn't lower to 50 percent until the late 1980s. Starting in the early 1990s, the rate dropped to 39.6 percent.
Today, the top tax rate is 35 percent – but it's probably going up to 39.6 percent next year for the highest earners. And if you are married and filing jointly ($200,000 for single filers) and your income is over $250,000, you may be looking at additional taxes.
First, 0.9 percent of your wages above $250,000 will go toward an extra Medicare tax. Second, to the extent your income is above $250,000, you may also pay an additional 3.8 percent for unearned income such as interest, dividends and capital gains.
Which means that if you earn more than $250,000, and you have interest and dividend income, you will be paying 43.4 percent. (The rate is derived this way: If you are in the 39.6 percent tax bracket and your income is above $250,000, you'll also pay the 3.8 percent tax on interest, dividends, and capital gains.)
You should pay attention to capital gains because those are going to be taxed quite a bit higher. This year, if you sell a stock, your capital gains tax rate is 15 percent. Next year you'll probably pay 20 percent – and if you are subject to the 3.8 percent tax, you could be paying as high as 23.8 percent.
How can I shelter income to keep my tax bracket lower? - So if you expect a bonus, take it in 2012, not 2013. In the old days, advisers always told clients to defer income. But now, the tax rate on a bonus is probably discounted from what it will be next year.
You also may want to wait until Jan. 1 to make charitable contributions, since those deductions will reduce your taxable income in 2013. If you have deductible expenses such as your real estate taxes or the cost of buying a business computer, wait until 2013. But be careful: there is some discussion about capping certain deductions.
You should also increase your savings through your retirement plans to reduce your pretax income.
Also consider shifting investments to tax-free bonds if you have a portfolio of dividend-paying bonds. Municipal bonds are becoming more attractive because of the tax threat.
So what can I do to prepare? - First of all, don't freak out and move your investments around just because you're worried about higher taxes.
That said, there are moves you can make in the next couple weeks to get ready.
Know that tax rates across the board could be higher. Be aware that certain dividend income could be taxed at a higher rate, from 15 percent to as high as 39.6 plus 3.8 percent.
Consider buying municipal bonds as an investment if you expect your tax rate is increasing to around 40 percent because the after-tax return for municipal bonds may be more favorable.
With the prospect of higher tax rates, Roth IRAs can provide an excellent shelter from taxes in the future.
With Roth IRAs all the potential future growth is sheltered from taxation; in addition, a Roth can be inherited and the future growth can go to heirs without income taxation. It's also a form of tax diversification at retirement, because a retiree can take a chunk of money out of a Roth (which is untaxed) and a chunk of money out of a traditional IRA (which is taxed) to take advantage of his or her tax position in a particular year.
Before the gift and estate tax exclusion decreases in 2013, you can gift up to $5 million this year. You can also set up a trust – though that takes time and legal assistance. But if you have $25 million or more, the time and trouble is worth it from a tax perspective. But you should talk to a competent estate planner before you take any action.
Will the fiscal cliff impact my retirement? - People are reacting like they should move their whole retirement account into cash. It's war fatigue, especially for those nearing retirement because 2008 took the stuffing out of people. They ran and didn't come back and didn't recover.
Every financial planner said that the best thing you can do – for the near and longer-term future – is contribute more to your retirement funds.
The extra money socked away in savings reduces taxable income when tax rates likely go up next year, and has the added bonus of increasing the amount you have available for retirement.
How will the economy react? - If the cliff isn't quickly resolved, the country may slip into recession. If the economy goes into a recession, stocks may take a beating.
But there is so much of a potential for a huge rally in stocks if some of this gets sorted out because corporations have huge amounts of cash, and individuals have more cash than is appropriate for their financial planning. So if there is some resolution, we have just as big a possible upside in stocks if people unlock some of the stuff they've buried under the mattress.
Source: Deborah Caldwell, CNBC
The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
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