These days, you can’t turn on the television, turn up the radio or log onto the internet without hearing something about the “Fiscal Cliff.” After all, if Capitol Hill can’t reconcile their differences by January 1, the automatic tax hikes and program cuts could possibly send the U.S. back into a recession later next year.
So there’s no doubt that the impending deadline is weighing on the market right now. And it doesn’t help that outfits like Fox News and CNBC have been devoting a lot of their air time to telling everyone to keep out of the markets. I have good reason to believe that cashing out is one of the worst things you can do right now, so in today’s post I’m going to walk you through all you need to know about the Fiscal Cliff as an investor.
What Happens if Congress Doesn’t Work out a Deal?
If January 1 arrives and Congress hasn’t agreed to a deal, federal taxes will automatically increase by $500 billion and $200 billion will be cut from federal spending. Economists expect that this will subtract 4% from economic growth.
How Likely Is The Fiscal Cliff?
But considering that either deal on the table is preferable to the automatic cuts and hikes, Congress is probably going to make the deadline. More than eight in 10 Americans agree that it is extremely or very important to Congress and the President to reach a deal, so failing to do so would seriously impact public opinions of Washington. Additionally, I seriously doubt that Congress wishes to work through the holidays, so I believe that a deal will be worked out by Christmas Eve.
Should we Take Profits while the Capital Gains Rates are Good?
I strongly advise against cashing out entirely is because the truth is that there’s nowhere to go. The stock market now yields more than the banks, with the S&P 500 yielding an average 2.2%.
If you’re feeling nervous about the Fiscal Cliff, I feel that a good way to play the situation is to trim your winners. I wouldn’t take full profits, though, because I see a lot of fundamentally superior stocks at the lower end of their trading ranges. If you’re comfortable with a more proactive approach, you can take advantage of pullbacks to buy the A- and B-rated stocks in my Portfolio Grader tool.
If you just feel better about paying 15% now versus higher taxes this year, you’re welcome to take more profits. But again, I’ll leave that up to your discretion because I still expect many of these stocks to rally though year-end.
What tax increases can we expect on dividends next year?
Worst case scenario, you can expect a 43.4% tax on dividends. To break it down, that’s 39.6% for the original proposed hike plus 3.8% for the tax hike associated with ObamaCare. Best case scenario, we’ll be looking at a 23.8% tax rate. Right now, of course, we’re at a 15% tax rate for dividends. To clarify, this is what’s proposed at the Federal level; your state taxes will of course vary. As a result of these increases, we may see more companies file for Limited Partnership status to become “pass-through” entities.
I’m sorry that taxes are expected to go up next year, but there’s not a whole lot we can do about it, because it will be the law of the land. My only advice is to put as much as you can in tax-differed accounts.
When is the market going to turn around?
It’s true that the post-election consolidation was somewhat unexpected because a lot of investors expected Mr. Romney to win. I believe that we’re still dealing with the aftershocks of the Presidential Election and with concerns surrounding the Fiscal Cliff.
But I do expect these concerns to dissipate with time. The last time we saw a big showdown between the House of Representatives and President Obama, the House won. This time, President Obama has a bit more political influence in Washington, but he has said that he wants to extend the Bush-era tax cuts for essentially 98% of the population. It’s anticipated that the spending cuts will take a bite out of GDP growth, but only time will tell us by how much.
So I think we’re going to turn around in short order. For those who are concerned about public spending, we need to remember that Congress controls that part of the government, and a Republican House will keep spending down. It will be interesting to see what the national priorities are, but I believe that Congress will work to broker a deal before the holidays.