Politicians in Washington are headed for a unique situation between Thanksgiving and Christmas of this year. Congress will have to make big decisions on several pending legislative issues, including spending cuts, a government budget for 2013, the pending reversal of the Bush tax cuts, and the debt ceiling. Andy Friedman, principal of The Washington Update, calls it “the mother of all lame duck sessions,” and he expects markets to get more volatile as a result of the uncertainty. But advisors now have an opportunity to get in front of it.
During Raymond James Financial Services’ National Conference for Professional Development in Orlando, Fla. yesterday, Friedman gave advisors a gloomy view of what’s ahead for Washington: A lot of deadlock within the Congressional ranks, and either way, affluent Americans will likely face higher taxes next year.
“What are the odds that after a rancorous campaign, in those three weeks everybody in Washington links arms, sings kumbaya and extends the Bush tax cuts?” Friedman asked, sarcastically. “I’d say pretty low.”
The Bush tax cuts are set to expire at the end of the year if Congress does nothing; that will provide extra revenue for the government and put off the deficit issue for a few years, Friedman said. At the same time, you need about $2.50 to $3 in spending cuts for every $1 in tax increases, but this would be $3 in tax increases for every $2 in spending cuts. That doesn’t bode well for next year.
In particular, Friedman said, there’s a new expression in Washington: the fiscal cliff. This is the slowdown in GDP that would happen if taxes go up as high as they might, and spending goes down as much as it might.
“That is the happy Washington news. Now let’s bring it down to your clients.”
Markets are likely to be extremely volatile for the rest of the year; markets are volatile in election years anyway, but this year stands out due to folks worrying about the lame duck session and how future tax rates are so uncertain, Friedman said.
“As people realize taxes are likely to go up, you’re going to see a tremendous amount of money in motion and you may see a sell-off in the markets. This is your opportunity to capture money in motion and give your clients new ways to invest it.”
For clients looking to sell a business, trying to dissolve a concentrated stock position, or just need to rebalance, Friedman suggests advisors make the moves now while we still have a 15 percent capital gains rate. Next year the rate may increase to 24 percent. One area to invest clients’ money in is municipal bonds as their payouts, free of federal tax, become more valuable, Friedman said.
Dividend-paying stocks are less clear. The dividend tax rate may triple next year, from 15 percent to 44 percent. If Congress can come to a global deal at the end of the year, they’ll probably keep the dividend tax rate commensurate with capital gains, raising both into the low 20 percent. But if Congress deadlocks, the dividend rate will triple, and if investors are holding stock just for dividends, like public utilities, the value of that stock is likely to decline for the same reason that municipal bond values go up.
If the dividend rate triples it could also affect companies’ dividend-paying policies. Some may stop increasing their dividends in the future, and instead use the money to buy back stock.
Friedman also suggests taking another look at Roth conversions this year. For clients in the same tax bracket in retirement that they are now, converting can make sense because tax rates will likely be higher.
Same with wealth transfers. The $5 million gift and estate tax exemption is quickly coming to an end. “We may never see an opportunity like this to transfer wealth again.”
Lastly, Friedman expects some form of entitlement reform, or a curtailing of Social Security and Medicare benefits to help solve the deficit problem. Clients over the age of 55 will likely not be affected. But when calculating retirement projections for clients under 55 years old, Friedman said he wouldn’t include all their Social Security benefits.