What is the “Fiscal Cliff”?

If you have read or listened to the financial news at any point in the last few months, you have likely heard the term “fiscal cliff” thrown around as if it has long been part of the lexicon. It certainly doesn’t sound good, but what exactly does the term mean?

The fiscal cliff refers to a combination of automatic tax increases and spending cuts set to take hold in January 2013. If you recall, the Bush-era tax cuts were extended two years ago. That extension and those lower tax rates are set to expire on January 1, 2013. That means that if nothing is done by Congress the following tax rate changes will take effect:

– Top income tax rate: 35% → 39.6%

– Top tax rate on dividends: 15% → 39.6%

– Top tax rate on capital gains: 15% → 20%

– 3.8% tax on investment income for high income earners

– Social Security payroll tax rate: 4.2% → 6.2%

In addition to these tax increases, a host of automatic spending cuts over the next 10 years are set to commence in 2013. Approximately half would come from the budgets of domestic programs. The other half would come from military spending.

So what effect will this fiscal cliff have on the economy? According to the Congressional Budget Office, the spending cuts would reduce the budget deficit by $600 billion in 2013. That’s good. However, they also say that the spending cuts combined with higher taxes would likely push the U.S. economy into recession. That’s not good.

The positive take away in all of this is that President Obama wants to extend the tax cuts…for most folks. His plan is to extend it for all but “high income earners.” We have heard multiple definitions of “high income earners.” One would be households making over $250,000 in adjusted gross income per year. Another source has that dividing line at $1 million per year, which would be a bit more palatable to Republicans and more likely to gain bipartisan support.

So with the “fiscal cliff” looming just a few weeks away, what should you be doing prior to year-end? Our advice is to do nothing at this time. While we think that some extension of current tax rates is likely for most people, the extension may occur in 2013 and be applied retroactively to the start of the year. So there is no need to panic if an extension is not enacted prior to year’s end.

Because you’re flying blind on what future tax rates will be, we advise against making any changes in portfolio strategy or any other financial planning and tax-related moves until it is clear what the tax rates will be next year. In the past, we have suggested that it might make sense to realize long-term capital gains this year to get the lower rate, but that is not something we are recommending any longer because we don’t know for certain whether capital gains tax rates are going up or not. And we certainly don’t want you to realize a capital gain unnecessarily.

If it makes you uncomfortable to take risk in an uncertain environment, consider that history shows no correlation between rising tax rates and poor market performance. And as for the automatic spending cuts, they are less immediately-impactful than the tax increases and less likely to trigger a recession in 2013 on their own because they are spread out over 10 years and back-loaded, with the larger cuts coming in later years.