Your Money: 'Fiscal cliff' is arriving soon; what to do?

Investors follow a lot of metrics on Wall Street, but right now they are closely following a situation in Washington that involves our dysfunctional Congress.

So we need to examine some important dates leading up to the "fiscal cliff," which is creating uncertainty in the stock and bond markets.

What is the fiscal cliff? The term refers to a series of dates when automatic U.S. federal budget-spending cuts are supposed to begin, and some popular tax cuts - already extended - should expire.

On Jan. 2, 2013, for instance, $1.2 trillion in automatic, or "sequestered," spending cuts are set to start. Meanwhile, a series of tax cuts on dividends and capital gains enacted under President George W. Bush - and extended by President Obama - as well as reductions to payroll taxes, are scheduled to end.

Investors fear that if tax cuts are not extended again, and the government spending slows, that could knock off 3 to 4 percent of GDP next year. The U.S. economy grew at an annualized rate of 1.5 percent in the second quarter this year, so by definition our economy would once again be in a recession.

What should you do now? Doylestown-based financial planner Edward Kohlhepp Sr. normally recommends deferring income until next year and accelerating losses in the current year, when possible.

In 2012, however, he is telling clients to do the opposite: Book gains on winners in their portfolios now because it is possible that tax rates will be even higher on dividends and capital gains next year.

"Because of new taxes that go into effect in 2012, and the possibility of long-term capital gains taxes increasing to 20 percent from 15 percent, we recommend the following: accelerate income into 2012 wherever possible; sell stocks and mutual funds on which you have gains in 2012; defer deductions and losses until 2013; consider converting IRA assets into Roth IRA assets in 2012."

Because investors don't know what the tax rates will be, he added in an interview, "That could cause an acceleration of sales in the stock market between now and the end of this year. We already know the fiscal cliff won't be addressed before the elections. So a lame-duck Congress has only a few weeks from Nov. 6 to the end of 2012 to address the fiscal cliff."

Among some funds Kohlhepp uses to generate some income in his portfolios are high-yield corporate bond funds. In addition, he suggests a small percentage of a portfolio be invested in precious metals such as SPDR Gold Shares (symbol: GLD) or Permanent Portfolio (symbol: PRPFX) mutual fund, which has some of its net assets in gold, silver, Swiss franc assets, stocks of real estate and natural-resource companies.

There are no adverse tax consequences to selling a position at a gain and immediately repurchasing the same position, adds Nicholas Boxter, a CPA at his family owned firm in Whitehouse, N.J. Keep in mind that if you repurchase the position you will need to have available cash flow to cover the tax liability.

Consider other income-deferral methods, he adds. This can be as simple as making sure to contribute the maximum to your 401(k) at work. If you are a business owner, be sure you have the most advantageous retirement plan.

Taxes make a difference in your portfolio's returns. Consider that from 1926 to 2011, the average return on stocks after taxes was 7.7 percent, compared with 9.8 percent before taxes, according to data compiled by Sensenig Capital. (For a great chart showing how taxes eat into returns over time, visit Sensenig's blog at www.philly.com/sensenig.

Bonds averaged a 3.7 percent return after taxes, compared with 5.7 percent before taxes in that same period. After taxes, on average, bonds barely outpaced the inflation rate. Lastly, cash earned an average of 2.2 percent after taxes, compared with 3.6 percent before taxes, over this time period. Comparing the after-tax return to the rate of inflation, cash actually lost money in terms of purchasing power.

A timeline of the "fiscal cliff" dates.

2011

Aug. 2: Congress passed a bill that raised the U.S. debt limit to $16.4 trillion and included more than $2 trillion over 10 years in projected spending cuts, from capping annual spending bills and a flat $109 billion per year cut in spending (the "sequester") that would take effect if a deficit-reduction commission - the super committee - failed to agree on $1.2 trillion in savings.

Aug. 5: S&P downgraded the U.S. long-term sovereign credit rating to AA+ from AAA.

Nov. 21: The super committee announced failure to produce a deficit-reduction agreement.

2012 

July 25: Senate voted to extend middle-income tax cuts

July 31: Congressional leaders announced a six-month extension of discretionary spending authority, which expires at the end of the federal fiscal year on Sept. 30.

Aug. 1: House voted to extend all (middle and upper) income tax cuts.

Sept. 30: End of U.S. fiscal year

Nov. 6: U.S. presidential and congressional elections.

Post election through end of the year: Lame duck period for Congress and potentially the Presidential/Debt ceiling likely formally reached, although measures can extend financing capacity until February 2013.

Dec. 31: Fiscal cliff takes effect.

2013

Jan. 2: Sequester takes effect.

Jan. 3: New Congress takes office

Jan. 20: Presidential inauguration.

SOURCE: Goldman Sach Global ECS ResearchEndText