If Congress fails to pass legislation preventing the fiscal cliff, tax rates will jump back to pre-Bush levels. The income tax rate will go back to a high of 39.6 percent, and some tax deductions will either be decreased or eliminated, such as the marriage penalty reduction. We will see other tax increases, as well. For example, payroll taxes will increase by 2 percent, and capital gains taxes will increase from 15 percent to 20 percent. Taxes on inheritance will jump from 35 percent to 55 percent, and the exemption will drop from $5 million to $1 million. In short, just about everyone will be paying more in taxes for 2013 if we go over the cliff.
How do the deep spending cuts that also are scheduled to take place impact investors?
The fiscal cliff would initiate deep federal cuts that could cost an estimated 2 million jobs nationally, more than 16,000 of those in Utah. The combination of cuts and tax increases could spell trouble for the country, with the Congressional Budget Office predicting that we could be in a recession by the middle of 2013. The last recession hurt millions of investors who were overexposed during market volatility, and the fiscal cliff could have a similar impact if investors aren't prepared.
What can people do to protect their investments?
To keep income taxes low, consider tax-deferred accounts such as an IRA or 401(k) when saving for retirement. Also look into tax-favored investments such as municipal bonds, which usually aren't subject to taxes the way normal equities are. If you are preparing an estate plan, using vehicles such as an irrevocable trust or life insurance can help you pass on your legacy as tax efficiently as possible. To prepare for possible market volatility, make sure you have evaluated your risk tolerance and adjust your investment strategy accordingly. The closer you are to retirement, the less time you will have to make up for a loss in your portfolio. Also consider alternative investment vehicles that aren't directly tied to the performance of the stock market, such as fixed annuities.
What if Congress acts in time?
There is the possibility that Congress could take action during a lame duck session. This would be good for the economy in the short term, preventing the tax hikes, spending cuts and a possible recession. However, the fiscal cliff does have an upside of sorts in that it would reduce the federal deficit. If the fiscal cliff is avoided, paradoxically the federal budget deficit in 2013 would be $1.037 trillion rather than $641 billion. But the fiscal cliff is a lose-lose situation for Americans, because neither outcome is desirable. Although we don't know what Congress will do, we can take steps to prepare our own finances for the potential effects of the fiscal cliff.
Dawn House Sean P. Lee, financial counselor.