After the Election

• CIO Update
• November 2012

With the 2012 election over and President Barack Obama and a divided Congress reelected for another term, U.S. investors must now focus on what the next four years will mean for their financial lives. Even before the inauguration, the president's agenda will be focused on the deficit and, specifically, what combination of taxes and spending cuts will be used to reduce it.

It will be the president's first task, even before he takes the oath of office, to work out a compromise in Congress that will help prevent the nation from going over the cliff.

Could We Fall Off the "Fiscal Cliff"? Due to a confluence of forces, including the upshot of the 2011 debt ceiling impasse, a series of mandatory spending cuts and expiring tax breaks are slated to take effect in January. It will be the president's first task, even before he takes the oath of office a second time, to work out a compromise in Congress that will help prevent the nation from going over what Federal Reserve Chairman Ben Bernanke and other economists have described as the "fiscal cliff."

In October, the Tax Policy Center, a joint project of the Brookings Institution and Urban Institute, issued a report called "Toppling off the Fiscal Cliff: Whose Taxes Rise and How Much?" It concluded that tax revenue could rise as much as $500 billion, or $3,500 per household, if the tax cuts from 2001-2002 and other sources are allowed to expire. This would be on top of the $1.2 trillion in mandated spending cuts (half of which would come out of the defense spending), for a combined $1.7 trillion negative drain on the economy.

Two Parties, Two Economic Plans. President Obama's 2013 budget, submitted several weeks prior to the election, offers the most complete picture of the plan favored by the President and Congressional Democrats. It calls for allowing the 2001-2002 tax cuts to expire for individuals with above $200,000 in adjusted gross income (or married couples filing jointly with above $250,000 in AGI), but extending them for those making less. Under this plan, among other changes, the top marginal income tax rate would rise to 39.6%, the long-term capital gains rate would rise to 20%, qualified dividends would be taxed as regular income (read: 39.6%), personal exemptions and itemized deductions would be phased out above certain income thresholds, current reductions in the Alternative Minimum Tax (AMT) would be allowed to expire, and gift and tax exemptions would roll back to 2009 levels. Separately, the President and his party support an extension of the 2 percent point cut in the payroll tax also set to expire on January 1. They would moderate the mandated defense and other spending cuts, and keep the extension in unemployment assistance.

Republicans oppose any direct tax increases. Instead, they would raise federal revenue through the reduction of exemptions and deductions. Since they advocate trimming the size of the federal government, they would probably support most of the Democrats' planned cuts, but oppose cuts to defense spending (although that remains one of the most likely areas of compromise).

Meanwhile, President Obama's plan for a 3.8 percent surcharge on Medicare is currently scheduled to go into effect on January 1st. It too will affect individual taxpayers with more than $200,000 in AGI (or married couples with more than $250,000). This surcharge, which is intended to help pay for the Patient Protection and Affordable Care Act of 2010, will apply to capital gains and other investment income.

Together, the proposed changes could serve to push the effective tax rates paid by any high Income earners to more than 30%.

What a Stalemate Will Mean for Higher Income Tax Payers. If no compromise is reached by the end of this year, the bipartisan Committee for a Responsible Federal Budget predicts that the nation could face a second recession from the combined spending cuts and tax increases. Federal Reserve Chairman Ben Bernanke warned Congress in September that the tools at the central bank's disposal may not be "strong enough to offset" the effects of such a combination. The combined effects of these tax changes on upper income earners could be substantial. The expiration of the payroll-tax holiday, and the introduction of the Medicare surcharge could increase tax rates by 5.8%. Moreover, for earners in the highest tax brackets, the limited deductions that were allowed even under the AMT (including credits for child care and higher education) will expire. Together, these changes could serve to push the effective tax rates paid by many high-income earners to more than 30%

What a Compromise Might Look Like. There are seven weeks from the time Congress reconvenes in mid-November until the end of the year. However, the House only has 16 days before its scheduled year-end recess. So, time will be a major driver in whatever gets done — and not.

The most likely scenario is another "AMT patch," temporary stopgap legislation that Congress has repeatedly employed since 2001. The patch is designed to keep the limited deductions in place and to increase the income levels exempt from the AMT — in effect, an attempt to make sure that the AMT keeps up with inflation and doesn't end up penalizing middle-class taxpayers.

For upper income earners, any “reprieve” they see over the next several weeks may not be much of a reprieve at all.

Beyond that, though, we believe the odds are rising that some sort of "kick the can down the road" compromise will emerge, in which President Obama and Congress agree to extend all the tax cuts and spending cuts — but for just a very limited period. Several Democratic Senators, for example, have already called for a six month extension to give tax-writing committees enough time to develop a more global deficit reduction plan, and that sounds about right. The debt ceiling is another factor that will come into play here. Although the ceiling will be breached again before the end of the year, the Treasury has indicated there are measures it can take to extend the limit into the early part of next year. But starting early next year the ceiling will once again become an issue. At that point fiscal hawks in the House will likely insist on some tangible progress on deficit reduction before voting to reraise the ceiling. Combined with the threat of government shutdown and another credit downgrade, this should be enough in our view to keep everyone's feet to the fire and force some sort of resolution by mid-year in time to affect 2013 rates.

For upper income earners, what that means is any "reprieve" they see over the next several weeks may not be much of a reprieve at all, especially since we believe the ultimate compromise will likely skew closer to Democratic terms. Some of the elements of such a plan might include:

• Qualified dividends potentially moving in lock step with long-term capital gains, likely at 20%, instead of reverting to being taxed as ordinary income.
• The marginal income tax rate rising to 39.6% on the highest earners.
• Estate and gift tax exemptions reverting perhaps to $3.5 million (a possible compromise figure), instead of falling to $1 million under the scheduled expiration, with a 45% tax rate for each. (Although it's possible the two parties could split the difference and hold the estate tax exemption at $3.5 million and allow the gift exemption to fall back to $1 million.)
• The phase-outs of deductions and exemptions moving ahead as planned.
• Extending the so-called estate tax portability provisions, which allow a surviving spouse to use the unused tax exemption of a predeceased spouse.

What It Means For Investors. For anyone who has not yet formulated their year-end tax strategy, the time is now to take action with their tax professionals, looking closely at their portfolios to offset the risk that comes with higher taxes and less federal spending.

First on the priority list for many private clients will be using what time is left on the calendar to shore up their estate planning. To avoid losing the benefit of current exemptions, they should consider accelerating gifts to move taxable assets out of their estates and take advantage of current gift and estate exemption levels. Significant flexibility can still be maintained by using trusts and other vehicles that allow for continued control over the assets should the tax picture change.

One of the many benefits of a 2012 Roth conversion is that it can be reversed as late as October 12, 2013.

In terms of income tax planning, it may be time for investors to consider moving money into investments that offset rising tax rates, like selected tax-free municipal bonds. They'll want to max out their contributions to tax-deferred accounts like 401(k)s and IRAs, and also consider converting traditional IRAs to Roth IRAs—paying the tax on the converted amounts at today's lower income rates in order to create a source of tax-free income down the road. (One of the many benefits of a 2012 Roth conversion is that it can be reversed as late as October 12, 2013.) Some clients may want to explore setting up annuities or defined benefit plans (if they're business owners), both of which can be used to provide income in the future while serving as a tax shield for the growth of capital.

Other ideas to consider include selling certain appreciated assets and holding off on taking investment losses until 2013 to offset gains and soften the blow from a potential rise in the capital gains tax, and exercising stock options before year-end. For a more complete discussion of all these strategies see our recent Investing in a Time of Higher Taxes.

The economy has and will continue to grind along, improving, but slowly.

Finally, working with their advisor, investors should review how the individual companies in their portfolios may be affected by the potential for rising tax and interest rates and cuts in federal spending. With the changes in Medicare in mind, it's prudent to keep an eye on health care sector companies—particularly those offering Medicaid managed care plans, pharmaceutical companies and pharmacy benefits managers — which are expected to continue to prosper under this Democratic president.

Finally, working with their advisor, investors should review how the individual companies in their portfolios may be affected by the potential for rising tax and interest rates and cuts in federal spending. With the changes in Medicare in mind, it's prudent to keep an eye on health care sector companies—particularly those offering Medicaid managed care plans, pharmaceutical companies and pharmacy benefits managers — which are expected to continue to prosper under this Democratic president.

Other sectors could also be influenced by the changes in Washington. Defense companies, for instance, are likely to see cuts in revenue if the Pentagon's budget is sliced significantly, as the automatic cuts mandate. Even with a compromise, the Pentagon's budget is likely to be lower.

ASK YOUR ADVISOR
As you talk with your Private Wealth Advisor and, when needed, your tax professional about adjusting your portfolio to fit the new political landscape, consider the following steps:

• Review your portfolio to make sure it is diversified, and consult with your tax advisor about what potential tax hikes could mean for your finances. You want to be well-positioned to protect your investment returns in a rising tax environment for both individuals and corporations.
• Consider the location of your wealth and whether a shift needs to occur in the structures being used to deal with a higher-tax environment, whether it's IRAs, Roth IRAs, annuities, defined-benefit plans (again, for business owners), or other tax-shielding vehicles.
• We don't believe the election presages the need for substantial changes to portfolio-management strategy. The overall environment has not changed dramatically: The economy has and will continue to grind along, improving, but slowly. Further political gridlock is likely even as the financial regulatory environment remains murky. While markets may appreciate the added clarity that the election results bring, the ongoing divide between business confidence and consumer confidence could dampen the upside. For investors, then, the best course of action is to stay the course.