Some 2012 Considerations for 2013 Fiscal Cliff
The “fiscal cliff” refers to the occurrence of many tax and financial changes from 2012 to 2013: the expiration of the Bush tax cuts, the Social Security payroll tax cut, the alternative minimum tax “fix,” an end to extended unemployment benefits, as well as the beginning of automatic spending cuts and the new Medicare taxes. Estimates vary as to the cliff’s size, but the range seems to be $540 billion and $720 billion of spending cuts and tax increases, which is 3.5 percent and 4.7 percent of the U.S. gross domestic product.
The new 3.8 percent Medicare surtax, enacted to help pay for health-care reform, will be levied on investment income for individuals who earn more than $200,000 a year, or $250,000 for a couple. While Republican candidate Mitt Romney said he will move to repeal the health-care law on his first day in office, he may not win and in any case wouldn’t be installed as president until January 2013. Even then, the most he could do would be to send legislation to Congress, where prospects for action this year are slim. Nothing will occur before the elections, and if Republicans win, they may be reluctant to act in the lame duck session, preferring to wait until the newly elected officials are installed.
The more difficult 2013 taxes to project involve capital gains and dividends. The capital gains tax of 15 percent and is set to go to 20 percent next year if the tax cuts from the George W. Bush administration expire. With the 3.8 percent Medicare surtax, the capital gains tax will be either 18.8 percent if the rate is extended or 23.8 percent for high-earners.
The current dividend tax rate is also 15 percent, but it would revert to the ordinary income tax rate if the Bush tax cuts expire and nothing is done. The rate on dividends for the highest earners would then be 39.6 percent, which would be subject to the additional 3.8 percent surtax, bringing the total dividend tax to as much as 43.4 percent. Until 2003, dividends, like interest, were taxed as ordinary income. It is easy to see how the dividend tax could significantly reduce the benefit of dividend-paying stocks for taxable accounts. The potential maximum increase, if it materializes, may make the after-tax yield on tax-exempt municipal bonds when compared to taxable interest or dividends compelling. However, with municipal finances in many areas on shaky ground, those bonds should be approached carefully.
The capital gains tax is paid only when one sells an investment that has appreciated. Nevertheless, the addition of the 3.8 percent to the existing capital gains tax can be significant, and if a capital-asset sale is contemplated, it clearly makes sense to close the sale in 2012 if possible, especially if there is a gain in assets that do not offer good prospects for future gain. Additionally, many publicly traded master limited partnerships, such as pipelines, have been excellent investments, and much of their income is tax-sheltered. However, since most are reported on a Form K-1 and not a 1099, they result in more complicated income tax returns and a higher CPA bill. That extra complication and cost, though, may be worth it.
Those with real estate investments managed by third parties could begin to manage them actively, which would mean that the rents would no longer be categorized as passive income subject to the new Medicare 3.8 percent surtax. If one has a small annual income from real estate, this probably will not be worth the effort, but it would be for holdings generating significant income.
Forecasts vary widely about what markets will do during the end of 2012 and early in 2013. How any tax increases would cause investors to act is not certain. Taxes on capital gains and dividends have been much higher in the past. The weak economy is a major factor, especially in light of the impending “fiscal cliff,” which refers to resetting the U.S. budget and making automatic across-the-board spending cuts.
If there is no credible fiscal plan to rein in deficits, that could unsettle the markets, perhaps prompting a major sell-off, regardless of which candidate wins the election. Those that believe this is a likely scenario may want to cash in many of their investments, pay down debt (other than a low-interest home mortgage), and invest the remainder in things that put safety first. In the near term, if there is even more Fed and perhaps worldwide financial easing, this could cause a rally, at least temporarily, perhaps this fall.
In the final two months of 2012, absent a budget and tax agreement in Congress—an unlikely development, in any case—market volatility is likely to increase dramatically. Investments generating ordinary income, such as real estate investment trusts, dividends and interest, can avoid increased taxes if held in a retirement plan or IRA.
Finally, if you are buying a house or have not yet refinanced, take advantage of the historically low mortgage rates now offered.
Al Martin is a partner with the Lathrop & Gage law firm's Overland Park office.
P | 913.451.5170
E | amartin@lathropgage.com
Return to Ingram's September 2012