If you haven’t prepared for the fiscal cliff, you should consider starting now, because we are headed right toward it.
The fiscal cliff is the nickname for a series of federal tax hikes and spending cuts that are set to take place at the end of this year. This includes the end of the Bush tax cuts and the implementation of the Budget Control Act of 2011, known as the sequestration. It is believed that these tax hikes and spending cuts will reduce the federal budget deficit, putting the country on a more sustainable long-term path. However, the Congressional Budget Office has warned that allowing these fiscal cliff changes will cause the economy to contract, probably into a recession.
Congress could take action to prevent these measures, but with legislators on recess until after the November elections, many wonder if a compromise can be reached in time. Along with other taxpayers, Utah residents can’t rely on Congress to reach an agreement; instead, you should be preparing your finances for the many possible outcomes of the fiscal cliff.
The first thing to prepare for is higher taxes. If the country goes over the fiscal cliff, higher taxes could have a significant impact on your 2013 personal balance sheet. Taxes would be restored to the pre-Bush levels, and the average family could pay as much as $1,600 more in federal taxes next year, according to a White House report. Not only would income tax rates rise to as high as 39.6 percent, capital gains taxes would increase from 15 to 20 percent as well. The estate tax will also increase with the fiscal cliff, meaning that leaving an inheritance to loved ones will become much more expensive.
To protect yourself against these higher taxes, consider using tax-deferred investment accounts for your long-term savings. Retirement savings accounts like an IRA or 401(k) allow you to defer taxes today and only pay upon withdrawal in retirement. Another possibility is tax-favored investments like municipal bonds. Unlike stocks earnings that are taxed at the capital gains level, earnings from municipal bonds usually aren’t taxed at all. If you are preparing an estate plan, try vehicles such as an irrevocable trust or life insurance to pass on your legacy as efficiently as possible. Otherwise your heirs could be paying as much as 55 percent in taxes.
With a potential recession by the middle of 2013 if we go over the fiscal cliff, the second thing to prepare for is market volatility. Make sure you have evaluated your risk tolerance, especially if you are in or nearing retirement. The closer you are to retirement, the less time you will have to make up for losses in your portfolio if the markets do take a dive. Consider conservative investment strategies in your portfolio as well as noncorrelated investment options, like fixed annuities, that aren’t directly tied to the performance of the stock market.
Finally, there is the chance that Congress could make a deal and prevent the fiscal cliff from happening. While this could prevent a recession, there is still a downside when it comes to your finances. In this scenario, the federal budget deficit in 2013 will be $1.037 trillion, and with rising national debt comes rising inflation. Protect your savings from the harmful effects of inflation by choosing investments that grow at a faster rate. Consider Treasury Inflation Protected Securities to help ensure you will retain your purchasing power in the future.
The outcome of the fiscal cliff is uncertain, but there are many steps you can take to prepare. By being proactive now, you may be able to lessen the effects this massive change has on your balance sheet next year.
Sean P. Lee is the president and founder of SPL Financial, Inc. and has spent the past decade educating and coaching area residents through their transition into retirement.
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