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Weekend Investor

Investors may be headed toward 'fiscal cliff'

5/25/12 5:52 PM ET (MarketWatch)Print

SAN FRANCISCO (MarketWatch)--Investors are reeling from Europe's deepening economic crisis, but they may soon find themselves battered closer to home as the U.S. economy closes in on another debt-ceiling debate and teeters toward the edge of a "fiscal cliff."

Come 2013, tax rates are slated to skyrocket and mandated cuts will slash defense and other federal spending. Higher revenues and lower government spending might suggest good news for our grandchildren, but that cliff could represent bad news for today's investors.

Some prognosticators see the stock market falling as much as 30% if lawmakers don't grab the steering wheel and pull hard. That may be overstating the danger presented by higher tax rates (), but the Congressional Budget Office said Tuesday that if the scheduled tax increases and spending cuts occur, the economy will fall back into a recession.

On Friday, European leaders urged the U.S. to put fiscal reforms in place to avoid the "fiscal cliff."

Still, Congress is widely expected to extend at least some of the tax cuts in the postelection lame-duck session or early in the new year. Though, given today's political climate, you can't be sure of that.

Meanwhile, the prospect of another debt-ceiling debate looms, similar to the one that hammered stocks in the summer of 2011.

Earlier in May, Speaker of the House John Boehner said he wouldn't accept a debt-ceiling increase unless spending cuts were part of the deal, suggesting another down-and-dirty congressional battle. Still, it's possible the debt ceiling won't be hit until the end of the year or even early 2013, thus delaying that fight.

In 2011, lawmakers' impasse on raising the debt ceiling, followed by ratings agency Standard & Poor's downgrade of U.S. government bonds on Aug. 5--helped drive the S&P 500 (SPX) down 17% from about mid-July to mid-August.

But where there's stock-smashing crisis, some see opportunity.

In the event of a debt-ceiling debate, "We anticipate there could be some very interesting buying opportunities, given the historic volatility from last year."said Louie Nguyen, chief investment officer at Soledad Investment Management.

Steady your portfolio

Nguyen said he's likely to buy in the utilities and consumer-staples sectors if they get hammered along with everything else, as happened in 2011. "When there is crisis, correlation goes to one," he said. "It's a matter of what recovered and what did not," he said.

"Going into this next debate, [we] would start building up our cash hoard and start looking at specific utilities, consumer staples, some telecom, some pharma, where we think it would do well coming out of such a crisis."

Others take a longer view. A debt-ceiling standoff in Congress is likely to "create some volatility and some turbulence in the market," said Erik Davidson, Wells Fargo Private Bank's deputy chief investment officer.

But, he said, "We can't just give into this primal urge to run to the sidelines. Most of our clients have goals that are measured in years and decades," he said. "You're not going to get there by earning five basis points a year" in a money-market fund.

Along with a debt-ceiling debate, cue up one "fiscal cliff"--a recession-driving combination of tax increases and spending cuts, according to the CBO, that would slash the federal budget deficit by $607 billion, or 4% of gross domestic product.

That prospect likely will prompt lawmakers to extend some of the expiring tax breaks. There's no telling which ones.

Up for grabs are the Bush-era income-tax rates, plus breaks on capital gains and qualified dividends. There's the payroll-tax cut most workers enjoy right now, and a patch for the alternative minimum tax. Certainly, wealthier taxpayers appear likelier to face higher tax rates going forward. As one example, starting in 2013, there's a new 3.8% tax on investment income for higher-income taxpayers, thanks to the health-care law. Read: Tax planning? Good luck with that.

For investors, the prospect of market volatility plus potentially higher tax rates on long-term capital gains--slated to rise to 20% (23.8% for high-income taxpayers) from 15% now for most investors--means investors might consider selling some winners, said Rob Gaan, an investor, manager and adviser at Christopher Weil & Co. Inc. (Nguyen's firm is subadviser to Christopher Weil & Co.).

"This is an opportunity for [investors] to thin down or sell a position that's done well, realize that preferential tax treatment, and build up a little cash to maybe take advantage of opportunities."

But, Gaan and others warned, taxes alone shouldn't drive investing decisions.

"Taxes can be a tipping point but not the driving point," said Tim Steffen, director of financial planning at Robert W. Baird & Co.

"If you're going to buy back in and hold it for three or four years, all you've done is accelerated an income tax that you could have pushed off," Steffen said. "The farther out in the future you're looking, the less value there is in paying it early because of the time value of money."

That said, the outlook for higher taxes ahead means now's a good time to rebalance your portfolio, sell positions you were planning to sell in 2013, and diversify out of concentrated positions.

Will tax outlook hit dividend-paying stocks?

Without congressional action, the tax rate on qualified dividends will jump to as high as 43.4% for some taxpayers next year, from 15% now.

That's because the expiration of the Bush-era tax cuts causes dividends to be taxed at ordinary income-tax rates, and pushes the top marginal income-tax rate to 39.6% from 35% now. Plus the new health-care law triggers a 3.8% tax on investment income for high-income taxpayers. Read: Health law's demise would save big bucks for some.

Watching the tax hit on dividends jump that high could cause some to flee dividend-paying stocks--despite the fact that most taxpayers won't face that highest rate, alternatives for income-generating investments are few these days, and even at that higher rate, the tax simply matches the rate owed on taxable-bond income.

Still, if Congress allows tax rates to rise, "Dividend-paying stocks [could] go down for a while," said Josh Peters, director of equity-income strategy at Morningstar, an investment-research firm.

"You could see people sour on them," said Peters, who edits Morningstar DividendInvestor. "Taxes are such an emotional topic. People make decisions that don't necessarily make the most sense."

That could present opportunities for bargain-hunters. And, given the tax outlook, it may make sense for investors to start purchasing dividend-paying stocks through tax-deferred accounts such as IRAs.

"If dividend-paying stocks go down a little bit and yields go up, then you take your IRA and shift into those stocks," Peters said.

Municipal bonds

The prospect of higher tax rates suggests that tax-exempt municipal bonds, which traditionally have been more appealing to higher-income taxpayers, may attract a broader swath of investors.

"It's quite possible that that tipping point between buying taxable bonds and tax-free bonds becomes more appealing to even more investors," Wells Fargo's Davidson said. "That creates a bullish case for muni bonds, which have been performing relatively well but still do offer attractive yields versus taxable bonds on an historical basis."

If muni bonds make sense for your portfolio, you might want to make the move before the rush. "If an investor wants to shift toward tax-exempt bonds, they'll want to do so before demand raises prices, effectively negating the better yield," Steffen wrote in a recent paper.

Another positive: Muni-bond income isn't counted in investors' net investment income for purposes of the new 3.8% tax hit for high-income taxpayers.

Still, do your research before you buy. One concern: Certain regions may get hit if spending cuts go through, potentially affecting muni bonds. For instance, defense cuts may drive up unemployment in Maryland and Virginia, said Peter Hayes, head of BlackRock's municipal bond group. "There would be some implications," from spending cuts, he said. "Not broad-based, but for certain areas of the market."

Also, there's tax uncertainty: the alternative-minimum-tax patch--a higher exemption amount that prevents about 27 million additional U.S. taxpayers falling prey to this parallel tax--is currently not in effect for 2012. If lawmakers fail to enact the patch for this year, many more taxpayers will owe AMT. Private-activity muni bonds aren't tax-exempt for purposes of the AMT.

Tax adjustments

The tax picture likely won't become clearer until after the election, but now's the time to assess whether your portfolio will need tax-related adjustments.

Some say investors should assume rates will be higher.

In that case, "You want to push off losses into the future"--to use them to offset higher-taxed gains--"and you want to accelerate and recognize gains," Davidson said. "We will look back nostalgically to the days when we were able to pay only 15% capital-gains tax."

One option is to sell your winners, pay your long-term capital-gains tax now before rates rise, and then buy back in (the wash-sale rule doesn't apply to gains). But financial advisers aren't keen on that idea.

"I would be hard-pressed to trigger my entire gain to take advantage of a slightly better tax rate," Gaan said. He said he'd base that decision on "more fundamental reasons, such as does it represent too big a position in my portfolio, or do I have some fundamental concerns that the company may have reached its peak?"

Others say it's too early to make tax-based decisions.

"Should Congress not extend the Bush-era tax cuts--if we do lose these benefits for capital gains and qualified dividends--maybe at the end of the year it might be a time to take gains and accelerate them into this year, but we're not shifting portfolios and asset allocation because of taxes," said Anna Pfaehler, a fee-only financial planner in Scarsdale, N.Y.

Said Morningstar's Peters: "Taxes are only one of thousands of factors affecting stock prices. I don't think it's the one item you want to pull out and say, 'This is the end-all and be-all of the fate of my portfolio' and plan on that. That would be quite a mistake."