The 'Fiscal Cliff' Could Be Kryptonite For Investors

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The “fiscal cliff” is to personal finance what kryptonite is to Superman.In the post-election world, if your stock portfolio has one weakness, one vulnerability, one negative financial force that’s sapping it of its strength, it’s the USA’s fiscal headwind. It has raised the threat of recession and the potential for higher tax rates on stock profits and dividends. That’s putting investors’ finances in a weakened state.

The fiscal cliff is the one-two punch of tax increases and spending cuts set to kick in automatically on Jan. 1 unless a Congress can agree on a deal to minimize the damage that the $600 billion fiscal drag will inflict on the economy. Fear that Democrats and Republicans won’t get a deal done by the end of the year, when the investor-friendly Bush-era tax cuts expire, has already resulted in a hit to stock portfolios. In the eight trading days since the election, which left the government divided, the Standard& Poor’s 500-stock index has fallen 4.8%.

Signs of progress and improved cooperation on Capitol Hill gave stocks a lift Friday, ending a three-session skid. But some investors fear a market meltdown similar to the one in August 2011, when a split Congress brawled publicly about raising the nation’s debt ceiling. The partisan bickering resulted in the first-ever downgrade of the USA’s triple-A credit rating. That dented investor confidence, causing a one-day plunge of 635 points, or 5.6%, for the Dow Jones industrials on Aug. 8, 2011.

“The market will be choppy until investors get clarity on the fiscal cliff issues,” says Mark Luschini, chief investment strategist at Janney Montgomery Scott.

One headache facing investors is how to protect portfolios from a potential increase in tax rates on capital gains and dividends. If lawmakers don’t extend tax cuts, on Jan. 1 investors will see the tax rate on profits from stock appreciation rise to 20%, from 15%. Individuals with incomes of $200,000 ($250,000 for households) will be hit with an additional 3.8% investment income tax in 2013 to defer the costs of President Obama’s health care law. The bottom line: High-income folks could pay a capital gains tax of 23.8%.

The tax rate on dividends is set to rise from 15% to an individual’s ordinary income tax rate. The nation’s highest earners will see their dividend tax rate jump to 39.6%. Add the 3.8% to that, and the tax on dividends will nearly triple, to 43.4%, for the highest earners.

What’s an investor to do to?

Sell your big winners now, not in 2013

Let’s say a year ago, you bought 1,000 shares of homebuilder Pulte, the S&P 500’s top gainer in 2012. It is “prudent from a tax perspective to at least consider taking profits” before the end of the year and lock in the 15% rate rather than risk paying a potentially higher tax rate in 2013, says John Stoltzfus, chief market strategist at Oppenheimer.

He dubs this strategy “tax gain harvesting.” Stoltzfus believes the heavy selling since the election is a clear sign that many investors are already employing this strategy.

Here’s how selling shares of Pulte now could save you money if capital gains taxes rise next year. If you bought 1,000 shares on Sept. 18, 2011, for $5.47 a share, that $5,470 investment is now worth $15,680 through Friday’s close. If you sell now, take the $10,210 profit and pay the current 15% capital gains rate, you’ll be taxed $1,532. If you wait until 2013, and the rate climbs to 23.8%, your tax bill would jump to $2,430, or nearly $900 more.

There is precedent for selling to avoid higher tax bills later, according to a report by Gina Martin Adams, senior analyst at Wells Fargo Securities. Following the Tax Reform Act of 1986, when the tax rate on capital gains rose to 28% from 20%, investor selling in advance of the tax increase doubled from the prior year, to $328 billion, or a record 7.4% of GDP.

“Investor capital gains realisations were more than twice the size of any prior year, and unmatched again for more than a decade,” she wrote. “Even the bubble years of the late 1990s failed to produce capital gains at so large a percentage of GDP.”

But there is a caveat, says Tim Speiss, a partner at EisnerAmper Personal Wealth Advisors. If you like a company’s long-term prospects, you might want to hold the stock and avoid paying any tax. “Paying a capital gains tax is voluntary, because you have to take the overt action of selling to incur the tax,” says Speiss.

Think twice before dumping dividend-paying stocks

For top earners, the tax on dividends could jump from 15% to 43.4% if there’s no political deal. That means high-income earners could pay as much as $434 in taxes on a $1,000 dividend payout next year, vs. a current tax hit of $150.

That maths sounds like a death sentence for one of the most successful investment plays in recent years: buying dividend-paying stocks to generate income in a low-yield world.

But while a tripling of taxes on dividend-payers on the surface screams “Sell,” a closer analysis says “Not so fast,” says a report by Strategas Research Partners. While Strategas won’t rule out short-term declines in dividend-paying stocks , it doesn’t expect a draconian 43.4% rate to become reality. Their guesstimate: Dividends will be taxed at between 15% and 28%.

Companies might also pay a “special dividend,” or a one-time payout, before year’s end to help investors avoid potentially higher taxes later.

“The number of special dividends is likely to spike in the next (six weeks),” says Dan Clifton, a policy analyst at Strategas. A bunch of companies have already done so, including IDT, FedFirst Financial and NIC, says Jeff Hoopes, a Ph.D. candidate at the University of Michigan. He’s working on an academic paper that found a surge in special dividends in 2010 when the tax-friendly status of dividends was also in question.

Hoopes’ research also found that about two dozen companies opted to pay their normal quarterly dividends in December rather than January to try to save shareholders money in case tax rates go up in the new year. In recent weeks Leggett& Platt, Myers Industries and Homeowners Choice moved up dividend payouts to avoid paying in January. (Dividends have accounted for 42% of the 9.96% annualized gain of stocks since 1926, says S&P Dow Jones Indices.)

One reason to hold on rather than dump dividend stocks for tax reasons: History says the most consistent dividend-payers perform well when taxes on dividends go up, Strategas research shows. Companies that have raised dividends every year for at least 25 years, outperformed the S&P 500 in 1990 both one month and three months after dividend taxes were raised, Strategas says.

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