With the fiscal cliff avoided and U.S. tax rates rising for higher income households, financial advisers have gone into overdrive to help their clients mitigate the negative effects while trying to benefit from the greater clarity.
That means in some cases finding ways to defer income and in others, working on ways to curb spending. It can also mean being more aggressive about investing in equities rather than bonds or holding cash.
While people at many income levels are going to face higher taxes because a payroll tax cut that was brought in to stimulate the economy has been allowed to expire, it is individuals earning more than $400,000 of taxable income a year, or $450,000 for households, who are going to face the biggest increased burden. Those are thresholds where the personal income tax rate rises to 39.6 percent from 35 percent, and where the capital gains tax goes to 20 percent from 15 percent.
Households earning between $500,000 and $1 million would see an average annual tax increase of $14,812, according to the nonpartisan Tax Policy Center. That includes an income tax rate increase, the end of the payroll tax reduction, and a 3.8 percent tax on investment income for couples earning $250,000 or more - a surcharge resulting from President Barack Obama's health care reform law.
While these people may be very well-off by any standard, it does not mean that some are not overstretching their budgets. Many are likely to have bigger mortgages and outsized expenses like private school tuition or multiple homes.
For those living beyond their means or close to it, such a tax rise could force them to cut spending by selling a holiday home or a yacht or curb dining out at expensive restaurants.
Azim Nakhooda, chief executive of Cleveland-based Cedar Brook Financial Partners LLC, said he will be telling many of his high-earning clients, they have to reprioritize.
"For every dollar you had coming in, you now have 95 cents," said Nakhooda, whose firm manages $1.6 billion in assets. "How do you want to divvy that up?"
Alan Haft, a financial adviser with California-based Kings Point Capital LLC, has been fielding concerns from a semi-retired client with $2 million invested, who was worried about the impact of the changes on his and his wife's income.
To feel comfortable, they may need to trim spending, alter investments or, in the worst case, sell one of two properties they own on Nantucket island in Massachusetts, Haft said.
Some wealth advisers like Michael Conway, a New Jersey-based adviser with Summit Financial Resources are recommending that clients on the cusp of the higher tax rates try to defer income into future years in case there are adjustments that might benefit them tax-wise later.
There is a potential downside to such a strategy. Given the United States has massive budget deficit and debt problems, it is unlikely that personal income taxes will go down anytime soon - they are, if anything more likely to rise further.
PUT OFF TO TOMORROW
Still, the capital gains increase could spark more interest in deferral strategies, such as like-kind real estate exchanges, a method that allows an investor to defer gains on the sale of a property by purchasing a similar property in a certain amount of time, said Matt Hilbert, senior tax manager at Pitcairn, a family office in Jenkintown, Pennsylvania, that caters to clients with $25 million or more to invest.
Some insurance products, such as private placement insurance, can also be used to defer gains for high-net worth clients, Hilbert said. The policies are a type of variable life insurance whose cash value is tied to how investments in the policy perform - with any gains not taxable because they are not a straightforward investment.
Those products are far from being for everyone. Purchasers must meet hefty thresholds for assets including income and investments. Premiums can start at $1 million for a $10 million policy and the policy holder gives up liquidity and control over investment choices.
Tax-deferring moves may be especially appealing to wealthy, elderly clients. Deferring capital gains often helps heirs since the gain is calculated based on market value when the grantor dies, not when it was acquired. Beneficiaries can then sell the asset at little to no gain.
The need to minimize potential estate taxes is no longer as pressing for many families, since the exemption on the tax for estates remains at just over $5 million.
PREPARING FOR VOLATILITY
Financial advisers say last week's tax deal doesn't mean they are only suggesting defensive strategies - as it has also created some opportunities for more aggressive investing. It has removed an immediate uncertainty from the financial markets as shown by the rally in equities. At the same time, the U.S. Treasury debt market has been weakening.
In the final months of last year, Robert Fross, co-owner of Fross & Fross Wealth Management in The Villages, Florida, had several clients insist on moving all of their investments into cash for fear that lawmakers' inability to come to a budget deal would cause a "financial Armageddon." The firm manages $350 million in client assets, mostly for retirees.
Fross said he had no trouble Wednesday coaxing those clients back into equities. But, he and other advisers say they are cautioning clients to expect volatility - including big market swings during what are likely to be contentious debates in Congress over spending cuts and the debt limit.
The last time the debt ceiling was debated, in the summer of 2011, the Dow Jones industrial average saw several days in a row of 400-plus point swings.
"I am telling (clients) it's still going to be very volatile given the uncertainty around the debt ceiling," said Michael Pomerantz, president of Pomerantz Financial Associates, a Cherry Hill, New Jersey-based financial adviser with $80 million in assets under management. His clients now investing in the markets, do so over a period of time rather than all at once, to protect against market swings.
Municipal bonds, which retained their tax-exempt status during the fiscal showdown, are also something advisers and strategists are recommending. Alan Dalewitz, a senior vice president with Herbert J. Sims & Co, a Connecticut-based firm focused on fixed income, said munis are one of his favorite investments for clients right now, both because of their tax status and because their valuations are attractive. But he is also cautious - the tax exempt status may not make it through upcoming budget negotiations, he noted.
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