How to Prepare for Tax Changes From the Fiscal Cliff

by Kevin on December 20, 2012

Come January 1, 2013 the United States tax code will change drastically from what we lived under in 2012. These dramatic changes are due to an agree-to-disagree moment with Congress that says, essentially, if we don’t agree on a new plan by this date then we’re just going to make massive cuts across the board and increase taxes across the board either through not continuing old tax cuts or implementing higher taxes.

If it sounds confusing, it certainly is, and all of this is being called the fiscal cliff. The root of the problem? We spend more than we make on a national scale. Just like in your budget and mine, when you spend more than you make you have three options to fix the problem:

  • Make more money
  • Spend less money
  • Both

The default plan right now is to do both with dramatic consequences across the board. But with so much unknown leading up to the fiscal cliff, how can you prepare?

Preparing Your Finances for the Fiscal Cliff

There are two things I am doing to prepare for the fiscal cliff that I think every person should do as well:

Understand the Tax Changes

Here is a brief summary of the upcoming tax changes for the average American:

  • Payroll tax cut expiration (payroll taxes go from 4.2% to 6.2%; your taxes go up 2%)
  • Income tax brackets all increase (10% to 15%, 25% to 28%, 28% to 31%, 33% to 36%, 35% to 39.6%)
  • Capital gains tax increases from 15% to 20%
  • Dividend tax rate will skyrocket from 15% to 39.6%!

That is a lot of changes in the wrong direction… taxes up across the board, higher taxes for investors that sell investments or just get a dividend payment.

But what can you do?

Make Necessary Moves

There are some aspects of the fiscal cliff that you simply cannot control. Payroll taxes are going to return to their normal levels by increasing 2%. You can’t do anything really to offset that other than make more money or set aside more money into your 401k to lower your taxes off of each paycheck.

The same is true for the tax bracket increases: aside from finding ways to get out of a higher bracket, there isn’t much you can do because you still want a high income even if you have to pay more tax on it.

The big changes I can see being feasible would be for investors, especially investors that focus on dividend paying stocks or ETFs. For these investors it may be too late to get out of those investments because the markets may have already driven some of the prices down due to fears of the fiscal cliff. But if you have a chance to get out — and it makes sense for your portfolio — it would probably be wise to do so.

However, this comes with a big caveat. It must make sense for your portfolio. Simply dropping investments left and right because of (at this point) potential tax concerns is a little heavy handed. You never know, Congress may step in on the last day of the year to save dividend investors.

At the same time simply ignoring the problem probably isn’t wise. So take a good look at your investments, your portfolio, and your portfolio’s goals and plan. If making some shifts in your investments makes sense, then do it. Otherwise hold on for the potentially bumpy ride we are all about to enjoy.

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