By Robert Powell, MarketWatch
Last Update: 12:01 AM ET Jun 28, 2012
BOSTON (MarketWatch)Its impossible to say what, if anything, lawmakers will do as the U.S. economy approaches the so-called fiscal cliff at the end of this year. But investors need to have a plan, maybe two or three plans, to protect themselves.
At a minimum, you need to figure out what to do with your portfolio should the scheduled spending cuts take effect and the Bush-era tax cuts expire.
First, heres whats scheduled to happen: Come Jan. 1, if the Bush-era tax cuts expire, basic income-tax rates will rise, as will taxes on long-term capital gains and stock dividends.
For instance, the maximum tax on long-term capital gains from the sale of securities would rise to 23.8% in 2013, up from 15% in 2012, according to Eaton Vance. Meanwhile, dividends will resume being taxed as ordinary income as they were before the Bush years. So, so you will paydepending on your annual incomeanywhere from 15% to 43.4% on dividends, according to published reports.
Under that scenario, pundits including Michael Kitces, Robert Keebler, Andrew Friedman and others suggest harvesting your capital gains now.
Assuming the tax increases and spending cuts take effect simultaneously, harvesting gains in 2012 works for several reasons. One, (to state the obvious) your gain would be taxed at a lower rate if you sell now rather in 2013. Two, the length of time that you must hold a security to generate the same after-tax return is greatly increased should the Bush-era capital gains rate return. And three, youre more likely to have a gain in 2012 than later, especially if the economy falls back into a recession and the stock market tanks.
If the U.S. falls off this fiscal cliff, the economy will probably contract 1.3% in the first half of 2013 and the unemployment rate would rise to 9.2%, the congressional Budget Office (CBO) said in a recent report.
Read Keeblers reports Capital Gains Harvesting Chart - 2012 and The Mathematics of Harvesting Losses and Gains.
Read Kitces report on the harvesting of gains.
Read the CBOs report.
Read Friedmans eight strategies that investors can use in this rising tax environment.
Damon Barglow, an independent financial adviser, is among those who say the economic impact will be dramatic if the fiscal cliff becomes a reality. Whats more, he said, the outlook is even worse when you factor in the payroll tax cut reversal and the removal of other sources of fiscal stimulus.
If we go off the cliff, growth in the U.S. will be even slower and the probability of a recession increases, he said. So, his advice is to consider investing in gold, specifically the SPDR Gold Shares , even at current levels.
Investment professionals are currently debating whether its wise to buy dividend-paying stocks right now given that the tax rate on dividends could rise threefold next year.
In one camp theres Friedman, the principal of the Washington Update who believes dividend stocks are headed for trouble. For one, he said, companies that now pay dividends are unlikely to increase their payouts in the future. Businesses will keep that money to buy back stock so shareholders get capital gains (instead), said Friedman, according to a published report. And two, Friedman predicts the value of dividend-paying stocks will likely decline given that those stocks are not priced to reflect the potential tax increase.
Read Andy Friedman: Dividend stocks headed for trouble
Others, however, say that nows the time to buy dividend-paying stocks. For instance, Sean Barron, a portfolio manager with Delta Trust & Bank, says the price of dividend-paying stocks do reflect the potential tax increase. This is not a surprise event and if there is a change in the after-tax value of a stock resulting from a higher dividend tax rate, some of this increase should already be priced in, he wrote in a recent commentary.
In his commentary, Barron compared what might happen to the price of a dividend-paying stock, Altria Group Inc. , in a taxable account and in a nontaxable account if the Bush-era tax cuts expire.
Using a simple constant-growth dividend discount model, he said the value of Altria would not change for the investor who owned that stock in a nontaxable account. By contrast, the value of Altria would fallworst case7.7% for the investor who owned that stock in a taxable account. And thats not all that meaningful, Barron wrote.
Since most stocks are more reliant on future growth and the stock market has known about this tax horizon for 10 years, I would expect the effect on the S&P 500 as a whole to be much less, Barron wrote. My guess would be 1.5% to 2.5% at most. Would we even notice that over and above daily fluctuations?
Read Barrons analysis.
For those who dont currently own dividend payers, Barglow recommends adding securities such as the Vanguard High Dividend Yield and Vanguard Dividend Appreciation in two tranchesbefore and after the projected fiscal cliff.
It will be difficult for these strategies to gain traction ahead of Jan. 1, when the 15% rate on dividends is expected to move higher if tax cuts are not extended, Barglow said. That said, I think these strategies will serve investors well over a longer time period. Investors can manage the expected volatility in dividend-related strategies leading up to the fiscal cliff by averaging into a full position.
Avoid big bets
And last but not least, Jeff Augustine of Augustine Financial Solutions agrees with Morgan Stanley economist David Greenlaws view that the policy volatility will be high. Congress is at an historically high level of polarization, Augustine said. At the same time, a lame duck session has limited time to get it all done.
Read Greenlaws report, How Big is the Fiscal Cliff in 2013.
I have focused on the asset allocation and asset location decisions as the issues of greatest importance, Augustine said. If anything, I have allowed client portfolios to be slightly under-allocated to riskier assets.
Augustines recommendation is to stay away from big bets relative to the policy allocation.
To be sure, our Plan A works only if the scheduled spending cuts take effect and the Bush-era tax cuts expire. Youll need to work up some other plans should Congress decide to act. But thats unlikely to happen before the election in November. In other words, youve got time to work on plan B, C, D and beyond.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. . Follow his tweets here.
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