Eight Ways To Protect Your Finances From A Fiscal Cliff Fall
Even if President Barack Obama and Congressional leaders somehow manage to patch together a last minute deal to avoid going over the “fiscal cliff” on New Year’s Day, Washington’s budget drama is likely to drag on for much of 2013, meaning continued high economic, tax and investment uncertainty. “Fiscal policy will be (weighing) on investors’ minds the way housing was four years ago,’’ predicts Joseph Davis, chief economist for the Vanguard Group.
If Congress does nothing at all, more than $500 billion in tax hikes and $100 billion in defense and domestic budget cuts automatically kick in for 2013, sucking enough cash out of the economy to send the U.S. back into a recession, most economists believe. What’s more likely, says budget expert Stan Collender, is that a falling stock market will pressure the pols to reach a “fig leaf” deal in January that postpones most of the pain, but makes little progress on resolving fundamental disagreements or cutting the long term budget deficit. In February, Congress will face another deadline, when the debt ceiling needs to be raised. And at the end of March, a six-month budget resolution funding fiscal 2013 federal operations will run out, raising the possibility of a government shutdown. After that, any deadlines set in the January fig-leaf will kick in. And come October, there will be a new fiscal year budget for the pols to fight over.
Here are eight steps ordinary investors can take to protect their sanity and their finances while this all plays out.
1. Raise cash for short term needs. “Money people need in the next year shouldn’t be in equities,’’ says Davis. That’s always good advice, but is even more crucial now since, after a period of relative calm, stock market volatility is increasing. If you were planning on paying a spring tuition bill or replenishing a depleted emergency fund from stock sales, sell now— even if your income is modest and your tax rate on capital gains is unlikely to go up. (No matter what happens to the Bush tax cuts, in 2013 those with adjustable gross income exceeding $250,000 face a new 3.8% Medicare surtax on their investment income, adopted to help pay for ObamaCare.)
2. Adjust your budget for lower take home pay. Most recent news coverage has focused on thefight over whether to extend the Bush tax cuts for the rich and on the $3,500 in extra 2013 tax an average household will owe if all the tax cuts are allowed to expire. The $3,500 extra burden is unlikely ever to be felt—the Internal Revenue Service hasn’t yet published income tax withholding tables for 2013 and Treasury Secretary Timothy Geithner has the legal authority to issue tables that reflect what he believes the law will eventually be, assuming a deal still looks likely. But take- home pay for average workers will drop anyway, since a 2% Social Security payroll tax cut in effect for 2011 and 2012 is unlikely to be extended. (Republicans oppose the $115 billion a year break and Democrats aren’t fighting hard to keep it.) For a worker earning $50,000 a year, that ‘s an extra $1,000 a year going to Uncle Sam–or about $20 less per week in take home pay. Those earning at or above the maximum wage subject to Social Security taxes ($110,100 in 2012 and $113,700 in 2013) will see their or Social Security tax bite jump $2425 in 2013.
3…And possibly a later (or smaller) 2012 tax refund. Most of the automatic tax increases would take effect on Jan. 1, 2013. But an alternative minimum tax “patch” that keeps 30 million additional families from owing AMT actually expired at the end of 2011, as did deductions for teachers’ out-of-pocket classroom expenses, higher education tuition and fees, and state and local sales taxes. Congress is likely to renew the AMT patch retroactively for all of 2012—and the IRS has programmed its computers assuming the patch will be adopted. But if the AMT patch issue isn’t resolved very soon, as many as two thirds of the 150 million households that file returns might be unable to do so until March, IRS Acting Commissioner Steven T. Miller warned Congress in a December 19th letter. (Last year, by mid-March, the IRS had sent out 65 million refunds averaging $2,899. ) “The impact of delayed refunds on the economy should be considered as Congress continues to dally,’’ says Claudia Hill, president of TaxMam in Cupertino, Cal. “The vast majority of those impacted are people who spend the refund as soon as it hits their account.”
To get a rough idea of how your tax liability might be affected by the missing 2012 AMT patch, try out Intuit’s free TaxCaster calculator available here and at Apple’ s iTunes APP store.
4. Don’t cut your 401(k) contributions. Sure, it might be tempting, what with your paycheck shrinking, your refund delayed, and the market wobbling, to cut your 401(k) contributions. Don’t. One advantage to investing the same amount each paycheck through a salary reduction plan is that you end up with more shares purchased at a a low price than at a high one, and a lower average acquisition cost. As Forbes Investment Strategies columnist William Baldwin put it recently: “You should be thrilled that stock prices are so loony. You will benefit as the market swings from irrational exuberance to extreme despondency. The reason you come out ahead is a simple algebraic fact: You will gain more from bargains picked up in bear markets than you will lose by overpaying in bull markets.”
5. But do review (and if need be, reset) your long-term asset allocation. The goal is to find the mix of stocks and bonds that will maximize your odds of earning a good return, while minimizing the risk that you’ll panic and sell at the bottom. Through your 401(k) or other other investments, you may have free access to a sophisticated web based tool (or a money management service) to help you come up with an appropriate allocation, adjusted for your age, assets and risk tolerance. For example, a program from Financial Engines, an independent advice company co-founded by Nobel prize winner Bill Sharpe, is available free to individual investors with with more than $50,000 in Vanguard and to 401(k) participants at a laundry list of big companies, ranging from Alcoa to IBM to Xerox. Fidelity Investments offers its own, similar tool, to its investors.
6. And then rebalance. Once you have an asset allocation you’re comfortable with, stick with it, rebalancing your portfolio at least once a year. Say you decide to put 60% of your money in equities, and stocks fall relative to bonds; when you rebalance you’ll buy more stocks to get the share back up to 60%—a process that forces you to buy assets when they’re cheap and sell them when they’re pricier. As with making regular equal contributions to a 401(k), the payoff from regular rebalancing is greater when the markets swing more.
7. Go long on volatility. If you’ve got an appetite for risk, consider making a small bet that Congressional dithering will cause the stock market to tank and the S&P Volatility Index (the VIX—or more colloquially, the “fear index”) to spike. You can gamble on the VIX using call options or ETFs and exchange-traded notes which track it. This is not for the faint of heart. During the first 11 months of this year, with volatility in check, the iPath S&P 500 VIX ST Futures Exchange Traded Note (VXX) lost 79%.
Be aware, too, that some smart advisors consider the current worries overdone. “The hype surrounding the fiscal cliff reminds me of the Y2K hype,” says Rick Ferri, a Forbes contributor and the founder of Portfolio Solutions, which allocates$1 million plus portfolios into index funds. “At 0:01 AM Eastern Time on January 1, 2013, 99% of Americans will see no difference. The stock market will not crash, interest rates will not soar, unemployment will not insanely increase, and the economy will not tumble into a black hole.’’
8. Ignore the noise. If gambling on volatility isn’t your speed, tune out all the Washington sniping and take the dog for a walk, read a good book, or go to the movies. After all, once you’ve liquidated enough stock to cover short term needs and settled on a reasonable asset allocation, you don’t want to be panicked into a knee-jerk decision to dump your stocks —or renounce your U.S. citizenship.