Taxing task: Preparing for the unknown

As summer winds down and the presidential election looms, financial advisers' thoughts must turn to 2013 tax investment planning for their clients. They face an almost overwhelming task — trying to position their clients in a way to minimize the impact of a plunge off the so-called fiscal cliff. That cliff is the combination of the end of the Bush-era tax cuts, which will subject most workers to higher income taxes; the expiration of the most recent fix for the alternative minimum tax; tax increases attached to the Patient Protection and Affordable Care Act; and a package of mandatory federal spending cuts totaling $1.2 trillion over 10 years. According to the Congressional Budget Office, if Congress doesn't act and the country plunges off the cliff, a recession is likely in the first half of 2013, with gross domestic product contracting by 1.3%.

HIGHER AND HIGHER

The effect on investors is obvious, especially the implications of the expiration of the Bush tax cuts. Without compromise between congressional Democrats and Republicans, the previous, higher tax rates will apply for all taxpayers. Income tax rates will rise to 15%, 28%, 31%, 36% and 39.6% from 10%, 15%, 25%, 28%, 33% and 35%. Further, high-income households may be unable to take some itemized deductions or the personal exemption. The estate tax exemption of $5 million reverts to the pre-Bush level of $1 million, and the top tax rate on taxable estates rises to 55%, from 35%. The qualified-dividend tax rate will rise to the taxpayer's top income tax rate, from 15%, and the capital gains tax rate will rise to 20%, from 15%. These changes will have drastic effects on investment and tax strategy. For example, municipal bonds will become more valuable since interest on muni bonds remains tax-exempt. If the AMT patch isn't renewed before the end of the year, the level of income exempt from it falls to $33,750 for individuals and $45,000 for couples, down from $50,000 and $78,750, respectively. These levels apply to 2012 income, so people will get a surprise as they complete 2012 returns and have to write checks to the Internal Revenue Service. On top of all of this are the tax increases triggered by the Affordable Care Act. The law applies a 0.9% surcharge on earned income of more than $200,000 a year for singles and $250,000 for married couples. For the first time, taxpayers at those income levels will be subject to a 3.8% Medicare surcharge applied to investment income. The surcharge also will apply to taxable estates. All this gives advisers a lot of work to do in preparing clients for potential changes. The situation is further muddied by the possibility that, immediately after the election, members of Congress will pull us back from the fiscal abyss through a compromise, rendering some changes made in the coming months obsolete. The shape of any such deal is impossible to discern. Advisers will have to prepare their clients for the worst but remain flexible and ready to make changes as the outlook becomes clearer.