A number of major tax cuts that were enacted in previous years are set to expire at the end of 2012. In 2013, taxpayers can expect to face higher taxes on their wages, higher capital gains taxes and a reversion to the full amount of withholding for Social Security.
The Fiscal Cliff
These increases, along with proposed spending cuts, have been collectively referred to as the fiscal cliff, and many Americans feel powerless to keep from slipping over the edge into financial disaster. Some withholding calculators are showing withholding increases in excess of 15%. Here is what you as a financial advisor can do to help those facing this dilemma (including yourself).
Things to Consider
1. Realize income this year - Because the fiscal cliff won't be seen until January, this is the time to sell long-term holdings while they can still be taxed at the lower rate. This could also be the time to exercise stock options and convert IRA or other tax-deferred retirement savings plan balances into Roth accounts. Stocks that pay dividends may have also worn out their welcome, as this form of income will no longer be eligible for capital gains treatment of any kind.
2. Take a second look at municipal bonds - Although muni bonds have traditionally been instruments that are primarily appropriate for rich investors, the tax crunch will make them appealing to some middle class investors as well. But you will still need to calculate the tax-equivalent yield on these in order to determine whether they are right for your clients.
3. Gift away assets - Because the Unified Credit is going to revert to $1 million per person next year and the top estate tax rate is climbing back up to 55%, this is the time for wealthy clients to unload some of their appreciated assets to the charity or relative of their choice. Those who were comfortably under the $5 million dollar estate tax limit in 2012 may need to start an aggressive annual gifting plan to shield as many of their assets from estate tax as possible.
4. Reduce education expenses - If your clients are either going to school themselves or are paying for their kids' educations, then perhaps a reduction in the number of courses taken is in order. This is because the education credits are being reduced, and a reduced course load can help them to take the remaining credits against a lower amount of tuition and other educational fees.
5. Create a new budget - Your clients may not have a realistic picture of just how the fiscal cliff is going to affect their pocketbooks in the new year. You may need to have them sit down with either you or their tax advisors so that they can get a clear picture of what they will be taking home after withholding and what they will owe on their investment income from now on. (They may also need to allocate funds for antidepressants after they do this.)
6. Brace them for an ugly tax return - If your clients have received big refunds the past few years, you will also need to fill them in on the reduced tax credits and deductions that are coming. The Child Tax Credit and Earned Income Credit are two of the main credits that are being reduced along with the educational credits.
7. Increase retirement plan contributions - It's never too soon to get your clients' money away from the tax man, and IRA and employer-sponsored retirement plan contributions are one of the best ways to do this. Traditional plan contributions can provide a much-needed deduction at the moment. Roth contributions offer no deduction, but clients can take solace in knowing that this money will never be taxed again. The right choice will depend upon your client's individual situation.
The Bottom Line
The most important step you can take is to educate your clients and make sure that they clearly understand what is coming so that the fiscal cliff doesn't catch them by surprise. If you are not a tax expert, then you probably need to send them to see one to go over their withholding and look at last year's return to what they will probably face this time. For more information on upcoming tax changes, visit the IRS website at http://www.irs.gov/.
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