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Fiscal Cliff or Not, Higher Taxes Are Coming

13 December 2012 in Trading Ideas

There’s nothing like a little end-of-year fiscal uncertainty, and the White House and Congress have done their best to continue delivering it in spades.

Recent news reports suggest no compromise is imminent on the so-called fiscal cliff – a combination of tax hikes and spending cuts that will go into effect in 2013 if no other agreement is reached. And so investors are left to contemplate the prospects of how a post-fiscal cliff world will affect performance, profits – and taxes on those profits.

For starters, without an agreement the return to a pre-Bush tax system would see the top tax rate jump to 39.6% from 35%, dividends being taxed at ordinary rates and taxes on long-term capital gains rising to 20% from 15%.

In addition, itemized deductions would take a hit for those making over about $170,000, while the lifetime gift-tax exemption is set to fall to $1 million from $5.1 million.

It’s reasonable to assume that the compromises to come could leave some of the above intact, but let’s not forget the tax boost coming to pay for healthcare legislation, or Obamacare. Under that law, earned income above $200,000 ($250,000 if married filing joint) will be taxed an additional 0.9% and unearned income above the same thresholds an additional 3.8%.

In other words, higher taxes are on the way for most, it’s just a matter of how much.

While the upcoming possibilities have spurred many investors to sell parts of their portfolio – as well as the slew of companies enlisting special dividend payouts before year end — a seemingly useful piece of advice came from Tim Steffen, director of financial planning for Robert W. Baird, in a recent article on CNBC.com.

“The thing to keep in mind is they should all be investment decisions first, and not tax decisions,” said Baird. “If you have a strong investment that can outperform a tax increase, then there shouldn’t be any urgency to sell to lock in today’s rates.”

Regardless, the relatively flat performance of stocks over the past nine months and the imminent tax changes has been a big reason that investors have been seeking bonds, and specifically municipal bonds, which can offer an ability to generate income and their tax-exempt status.

Of course, as CNBC.com pointed out, stripping munis of their tax treatment is on the table and could be a significant casualty of an agreement to end the cliff. One proposal considered most likely would tax munis at a 28% cap for top earners, meaning muni holders would pay their normal income tax rate minus 28% on their holdings.

And that’s not to mention the very creditworthiness of municipal bonds themselves. As the Financial Times reported on Monday, credit rating firm Fitch warned that investors who piled into US municipal debt could face rating downgrades on their bonds next year. The agency said local government is still far from recovering from the effects of financial crisis and the last recession, and it expects to downgrade “dozens or hundreds” of issuers in 2013.

Muni-hungry investors have pushed yields on the bonds to their lowest levels in 45 years, the FT said.