Planning for the Unknown
Year-end planning always involves a degree of guesswork, but the path through the balance of 2012 and into 2013 seems especially unsettled. Therefore, preparations this fall should align with long-range financial objectives.
Usually about this time of year, financial advisors pull out their trusty crystal balls, assess the landscape for the remaining months of the current year and form bold predictions for the coming months.
The challenge is 2012 is a year unlike most in recent history. While the upcoming U.S. election has magnified growing philosophical divisions between Americans, European Union (EU) governments continue to sort out how to contend with financial strife in member countries. Meanwhile, global financial regulation still dominates headlines. And without a cooperative effort in Washington, D.C., U.S. tax rates are poised to vault higher on January 1, 2013.
These conditions indeed contribute to a murky outlook for analysts, advisors and investors.
“It’s important to recognize that we’re dealing with a fluid, dynamic and uncertain environment,” says Suzanne Shier, tax strategist for Personal Financial Services at Northern Trust. “This makes planning very difficult because of the complex layers of uncertainty involved in facing potential but unknown changes.”
In such conditions, the ability to step back from the fray and adhere to a holistic financial plan helps steady nerves as one navigates the shifting sands.
Intertwined Political and Economic Outlooks
As the calendar grinds toward year-end, one of the largest variables for investors remains the U.S. government. More specifically, the actions – or inactions – of the administration and congressional leaders could have a considerable impact on the nation’s economy, taxes and financial markets.
Complicating matters are the November elections, in which the public will vote on a president, the House of Representatives and one-third of the Senate. In the culture of conflict that has permeated the U.S. government for a few years, bipartisan agreements are few and far between. Depending on election outcomes, the situation could ease in the coming months or drive a bigger wedge between the two major parties and their followers.
“More than anything, the market is looking for clarity on the composition of the new government so it can pick the winners and losers,” says Jim McDonald, chief investment strategist at Northern Trust. “The current odds favor a split government, which likely means that in 2013 we will see negotiated settlements on long-term entitlement spending and tax reforms.”
Political landmines aren’t limited to the United States, as turmoil seemingly is the new normal for the 27-member EU. Prospects for the coalition, of which 17 nations use the euro currency, ebb and flow depending on the latest developments out of fiscally challenged countries such as Greece, Portugal, Spain and Italy.
“A blowup in the European financial debt crisis would be a significant problem because it would further reduce European economic growth and dent investors’ risk appetite,” McDonald says. “But we believe leaders will continue to do just enough at the last minute to avoid a significant downturn.”
Overall, global growth is the top factor investors should monitor during the next 12 to 18 months, with economic activity in the United States and China propping up the world. McDonald cites fiscal and monetary measures as valuable in helping China avoid a dramatic slowdown and says lower commodity prices shouldn’t be as much of a drag on growth rates as they have been in recent years.
“The odds of a recession are measurably lower than they were in 2010 and 2011,” he adds.
Complex Tax Matters
While the U.S. economy seemingly has stabilized, U.S. residents face moving targets within the tax landscape. The combination of sun-setting provisions, expiring rules and new taxes is poised to recast the new year in a completely different light for most Americans, Shier says.
Most significantly, on December 31, 2012, the Bush-era tax cuts – implemented in 2001 and 2003, and extended by the 2010 Tax Relief Act – are set to expire. Without Congressional action and Presidential approval:
- The top two income tax rates will rise to 36% and 39.6% from 33% and 35%.
- Qualified dividends will be taxed as regular income instead of at 0% and 15% rates.
- The capital gains tax rate generally will rise to 20%.
- The so-called marriage penalty, in which a couple would receive a higher standard deduction and could drop into a lower tax bracket if they were not married and were filing singly instead of jointly, will return.
- Phase-outs of itemized deductions or personal exemptions will reappear.
Thresholds on gift, estate and generation-skipping transfer tax provisions also are slated to roll back to 2001 levels on January 1. As a result, exclusions on gifts and estates will tumble to $1 million from $5.12 million, and the exemption will fall to an inflation-indexed level of about $1.4 million for generation-skipping transfers from $5.12 million. Marginal tax rates on such transfers will increase to 55% from 35%, with an additional 5% surcharge on estates valued between $10 million and $17.184 million. Moreover, portability measures, which allowed surviving spouses to utilize the unused portion of a deceased spouse’s estate tax exclusion, no longer will apply.
Furthermore, many other tax provisions expired on December 31, 2011 and won’t apply to 2012 taxes without legislative action. Most notably, the alternative minimum tax exemption dropped to $45,000 for married filers ($33,750 for single filers), and individuals older than 70½ years no longer can move required minimum distributions from retirement plans directly to qualified charities.
On top of it all, a new 3.8% tax on net investment income, part of President Obama’s healthcare legislation, is slated to take effect January 1. The first phase of the $1.2 trillion in federal spending cuts mandated in the Budget Control Act of 2011 will surface the same day.
U.S. Federal Reserve Chairman Ben Bernanke calls the situation a “fiscal cliff”– one that’s causing analysts, advisors and investors alike to keep an especially watchful eye on the upcoming election.
What to Do
When contending with so many variables and unknowns, Shier urges clients to revisit their core financial goals.
“It’s true we’ll probably be operating in somewhat of a void through the end of the year, but that’s when it really helps to focus on broader objectives, whether it’s retirement, education, philanthropy or wealth transfer,” she says. “Taxes should be seen as an overlay or a consideration, not as the sole driving force.”
That said, Shier suggests clients refine planning strategies around these tax-friendly tactics:
- Annual gifts from individual donors up to $13,000 per recipient
- Charitable lead annuity trusts and grantor retained annuity trusts, which are especially attractive in low-interest rate environments
- Lifetime family access gift trusts, which may take advantage of the combined $10.24 million exclusion for married couples through the end of 2012
- Philanthropic efforts such as direct gifts or contributions to donor advised funds, which may be coordinated to optimize tax benefits
The full potential tax impact of any move should be weighed carefully. For example, dividends paid in a revocable trust could be subject to a 43.4% tax in 2013, depending on how tax laws evolve; the same dividends paid within an individual retirement account or 401(k) plan will remain tax-deferred.
Shier also suggests any moves be considered soon to ensure they can be implemented by year-end, if desired.
Of course, should the stars align and a wave of tax-friendly legislation sails through Washington in the coming months, any tax-focused steps taken today may not be as beneficial as initially anticipated. But given the broad uncertainties of the potential alternatives, sticking to long-range financial plans simply makes good sense.