At the end of this year, major tax cuts are set to expire while deep spending cuts are scheduled to take place. This “fiscal cliff” as it has come to be known, is a source of huge contention in Congress, but more importantly, is a cause for uncertainty for every American’s financial plan. If Congress fails to take action, Pennsylvania residents will not only be faced with increased tax liabilities, but an estimated 78,454 state jobs could be lost, according to a study done by George Mason University.
Multiple changes will be taking place at the end of December or the beginning of 2013 if Congress doesn’t act. These include the expiration of the Bush Tax Cuts, formally called the Economic Growth and Tax Relief Reconciliation Act of 2001; expiration of payroll tax cuts; cutting expanded unemployment benefits; and reduction of Medicare, defense and other spending from the Budget Control Act sequestration.
The Congressional Budget Office has said that allowing these tax cuts to expire will cause the economy to retract, probably into a recession. But the fiscal cliff will also drastically reduce the federal budget deficit, putting the government on a more sustainable long-term path.
There are a number of possible solutions that Congress could reach, including preventing all changes, allowing them all or a combination of the two. Congress, though, has yet to reach a compromise that is acceptable to both parties. Furthermore, the upcoming presidential election makes it unlikely that a solution will be found before November, leaving action to the lame duck Congress or to the new government.
Financially, the fiscal cliff is a lose-lose for many Americans, because each of the possible outcomes could potentially have a negative effect their wallets. Deciding which of these outcomes is the lesser evil is the job of our politicians. Consider the following fiscal cliff outcomes and what you can do to protect your financial livelihood through this uncertainty.
The first possible outcome is higher taxes, which would begin in 2013 if Congress does nothing and we go over the fiscal cliff. The income tax rate would go back to the pre-Bush level of a high of 39.6 percent and many tax deductions would be decreased or eliminated. The average family could pay as much as $1,600 more in 2013. Furthermore, capital gains taxes would also increase from 15 percent to 20 percent. This will make tax-advantageous wealth management strategies even more important. Consider utilizing tax-deferred investments for your retirement savings, such as an IRA or 401(k). Also look into tax-favored investments like municipal bonds, because the after-tax yield of these will not go down like regular stocks. Taxes will also be an issue if you are preparing an estate plan. Make sure you educate yourself on how to efficiently pass on your legacy to your heirs with the least amount of tax obligations possible, using vehicles such as an irrevocable trust or life insurance.
Higher taxes could possibly result in an economic downturn. The CBO estimates our GDP will decline by 3.9 percent, making the total growth rate negative, and by the first half of 2013 the contraction in the economy will probably be deemed a recession. Though the R-word is hard to hear again, our experiences since 2008 have taught us how to prepare for one. In case of another recession, make sure you have evaluated your investment risk tolerance and made adjustments to your investment strategy. Many soon-to-be retirees can’t afford another stock market drop, so be sure to consider alternative or more conservative investment strategies in order to protect your savings and investments. Also explore non-correlated investment options that are not directly tied to the performance of the stock market. Diversification is key to preventing market volatility from derailing your retirement goals.
If Congress extends the current tax cuts and prevents the spending cuts, the federal budget deficit in 2013 will be $1.037 trillion rather than $641 billion. In this scenario, by year 2022 public debt will reach 90 percent of GDP. With rising national debt comes rising inflation. To protect your savings and preserve your future purchasing power, consider investing in products that grow your money faster than the rate of inflation. This could include Treasury Inflation Protected Securities (TIPS) or insurance products such as fixed annuities, which often can include an inflation rider. This will help to ensure you can keep up with the cost of living in the years to come.
Lastly, in addition to the fiscal cliff’s impact on taxes, market volatility and inflation, the CBO estimates that if the tax cuts expire and the spending cuts take effect, unemployment will increase to 9.1 percent by the end of 2013. In Pennsylvania we could lose 78,454 jobs in both the Department Of Defense (DOD) and non-DOD agencies. As a precaution, it’s important to work hard to build an emergency fund composed of six to 12 months of living expenses.
Christopher Scalese, financial advisor and author of the book, “Retirement is a Marathon, Not a Sprint,” is president of Fortune Financial Group. Visit www.fortune-financial.org. The ideas and opinions expressed are the author’s and not necessarily those of the Business Journal.