The United States is heading towards what is being called a “Fiscal Cliff” that could potentially damper stock market returns and plummet the U.S. back into a recession. In order to avoid this outcome, Congress must act by January 1st to come up with a solution.
What is the Fiscal Cliff
The Fiscal Cliff refers to a series of tax increases and spending cuts that will take place if Congress fails to pass legislation to avoid them. The Bush tax cuts enacted by President Bush back in 2001 and 2003 will expire and tax rate will revert back to rates before his cuts. This means that marginal tax rates will go up slightly on US income taxpayers. The worry is that with the costs of increased taxes and with the decreased government spending, the US economy will plunge into another recession.
What is more concerning for investors is the fact that tax rates on capital gains and dividends will also increase. Long term capital gains tax rates will increase from 0% to 10% for the lowest income bracket, from 0% to 20% for the second lowest income bracket and from 15% to 20% or 23.8% for higher income earners depending on your income bracket. For dividends, the tax rate paid will increase from 15% to equal your new marginal tax rate. This means dividend income will now be taxed just like ordinary income.
Currently US elected officials are fighting over the different tax increases and spending cuts that are going to take place. Democrats want to extend the tax cuts for lower income earners while letting the cuts expire for those who earn over $250,000 a year. Republicans do not want to allow any tax increases and want to focus on more cuts in spending. The reason something needs to happen is because the US has an increasing federal budget deficit needing to be balanced and a growing federal debt that needs to be got back under control.
Why I’m not Worried About the Fiscal Cliff
Personally I am not too concerned about the Fiscal Cliff for a few reasons.
- I don’t believe Congress will allow it to happen. This is my personal opinion. I believe Congress will fight about this issue up until the very last minute coming to a final hour solution. My skepticism in our politicians leads me to believe that most likely they will extend everything for another year or two basically just kicking the can down the road. The media will be worrying everyone about this issue in another year or two again as Congress once again will have to address it.
- What else would you invest in? There is worry that the Fiscal Cliff will negatively affect the stock market. A recession will lead to stagnant returns or more likely losses. Many are selling stocks because they believe they will under-perform due to higher capital gains and dividend tax rates. However, I don’t see this as a reason not to be invested in stocks. What other investment asset class can you be invested in and do well? Bonds are already priced at all time highs with very low yields. Real estate may be ok with passive rental income. Some will favor gold but over the long term gold merely performs in line with inflation. When looking at the long term markets, the best returns come from the stock market. We may not have the greatest year or two but this will merely be a great buying opportunity if it occurs.
- I believe the companies I own will continue to make profits as people will continue to buy their products and services. They types of companies I own shares in are industry leaders. They will continue to make profits. People will continue to drink Cokes, eat at McDonald’s, shop at Wal-Mart and purchase the goods and services of many fine dividend growth companies. These companies stayed strong through the last recession and I believe if there is another they will still continue to perform.
A Little Tax Strategy if the Fiscal Cliff Concerns You
If you are concerned that Congress will fail to act causing tax rates to increase, you might want to consider selling some of your stocks that have significant gains now to lock in your capital gains and pay the current lower tax rate. You can then buy back in and retain your position if you like. Obviously if you hold your stocks in a non taxable account then you don’t need to worry. Make sure it is worth the commission costs you will be incurring while you are trying to lock in capital gains at the lower tax rate.
Personally I am doing nothing because my gains are relatively small and I don’t plan on selling for a very very long time. Hard telling what the rates will be if and when I ever do want to sell my stocks.
What do you think? Are you worried about the Fiscal Cliff? Are you making any changes to your portfolio in preparation for financial Armageddon? Or are you staying the course, using this as a possible buying opportunity and keeping your eye on your long term investing goals?