Possible Investment Strategies for the Coming Fiscal Cliff

One of my very smart clients called me last  Friday.

He wanted to make sure that I had seen an editorial in that morning's Wall Street Journal that highlighted some of the potential changes in tax rates that could occur in 2013 if Congress does not act.

The piece - titled "Bernanke's Cliffhanger" - was accompanied by a table that summarized some of the different scenarios:




These changes, of course, are the result of the expiration of the Bush tax cuts, originally implemented in 2001.  Most observers are calling the event a "a fiscal cliff", although opinions vary widely as to the actual economic impact that will be felt.

The Journal, naturally, sees higher taxes as a road to economic ruin:

Meanwhile, the cliff that could break the economy's neck is the scheduled tax hikes. These include a tripling of the tax on dividends, a near 60% increase in the capital gains rate, a 20% increase in personal income-tax rates that will hit small businesses, and the repeal of tax breaks allowing businesses to write-off capital purchases. (See the nearby table for the comparisons.) 

Even if the lower rates for those earning less than $200,000 are extended, the rise in rates for high-earners will hurt the incentive to invest or take risks—and may already be doing so. As Mr. Bernanke put it, "Uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence." 

http://online.wsj.com/article/SB10001424052702303753904577452674278573122.html?KEYWORDS=Bernanke%27s+Cliffhanger

I am in the process of trying to gather more information and thoughts from various sources as to what changes, if any, should be made in my current investment thinking.

However, here are a few initial thoughts:

1. Dividend-paying stocks could be hit fairly significantly. Tripling the tax rate on qualified dividends obviously reduces the after-tax yield;
2. On the other hand, my client pointed out dividends from non-qualified sources (e.g., REITs, or MLPs) could be helped, since they tend to offer higher yields;
3. My client also questioned whether it might make sense to realize any long-term capital gains in 2012.  The idea here is that it is unlikely that capital gains rates will ever be as low as they are currently, and next year's increase only represents the start of future rate increases;
4. On the other hand, loss-harvesting strategies probably should be delayed until next year.  At higher tax rates, realized losses have more economic value;
5. Estate planning, however, will be essentially impossible until after the election, given the wide differences in estate taxes from Obama and Romney.

It doesn't seem likely that we will get any clarity on next year's tax policy until the last few weeks of this year.

One final cynical observation: 

The fact that dividend rates will be much higher than capital gains tax rates is a wise move; after all, most would agree that we should encourage long-term investing strategies.

On the other hand, most hedge fund managers are paid via a so-called "carried interest" method, which is taxed at capital gains rates. 

No matter what happens, then, the managers of hedge funds and private equity companies (such as Romney's old firm Bain Capital) will continue to enjoy historically low tax rates on their income.