A frightful scenario could play out in a couple months unless a lame-duck Congress and the White House are able to resolve their differences on taxes and spending.
If they don't, Bush-era tax cuts will expire Jan. 1, and automatic federal spending cuts will be phased in. Such a combination could doom the fragile economic recovery and send the stock market into a tailspin.
What's more, tax rates on investment income would rise, a particularly scary prospect for investors in the upper tax brackets.
Investors may be inclined to sell some investments to take advantage of today's historically low rates. While acknowledging that could be sensible, John Sweeney of Fidelity Investments urges investors to heed the adage, "Don't let the tax tail wag the investment dog." In other words, consider whether you're becoming preoccupied with tax issues at the expense of long-term investing objectives.
"Building a well-constructed portfolio will give you the confidence to weather any number of geopolitical or economic crises," says Sweeney, an executive vice president with Boston-based Fidelity.
In an interview this week, Sweeney discussed how to take a big-picture approach to the short-term risks from any fall over the fiscal cliff.
But first, here's a look at the tax consequences if that happens. The maximum rate of 15 percent on long-term capital gains — the profits from selling such investments as stocks or mutual funds held for at least a year — would increase to 20 percent.
The tax on dividend income that now tops out at a 15 percent rate could rise more sharply. For those in the top income bracket, the rate would rise to more than 43 percent, with smaller increases for those making less.
Those rates may not take effect if Congress delays or otherwise averts tax increases. But it could be just a matter of time before rates rise, given the extent of the nation's debt problem.
There are relatively simple steps investors can take to minimize tax bills. For example, they can keep investments that are likely to generate a tax bill in tax-sheltered accounts like IRAs or 401(k)s, where only withdrawals are taxed.
Here are excerpts from the interview with Sweeney:
Q: What are you advising clients to do with the fiscal cliff looming?
A: It's the same advice we would offer in any given situation. Remember, presidential elections occur every four years. There are always economic cycles, debt crises, and various crises in other parts of the globe. We try to help folks come back to a place of confidence and comfort, where they understand the importance of constructing their portfolio to meet their specific objectives. We emphasize finding the right balance between stocks, bonds and short-term cash investments.
When folks say, "I'm planning for a retirement that's 20 years away," we want to make sure they have enough exposure to stocks so they can continue to grow their portfolio over that time frame. We remind them that historically stocks have outperformed bonds, and that bonds have outperformed cash investments. Recognizing how long it will be before an investor needs to draw from savings is very important.
Q: Does the potential for higher taxes on investment income affect how to allocate between different investment accounts?
A: Many investors have a 401(k) or IRA, so taxes are deferred until you begin to draw down from savings. So the main impact from any short-term rise in tax rates would involve taxable accounts, and those who are in the high tax brackets. But you have tax liability, whether it's a taxable account or one that's tax-deferred. You'll have to pay taxes at some point.
Q: For investors with taxable accounts, what steps are worth considering now?
A: You want to make the right investment decision first. But it might make sense to sell a particular stock if it has appreciated in value, and your portfolio might be out of balance as result. Stocks are up about 13 percent this year, so your stocks might have appreciated to the point that they're a bigger component of the portfolio than you want. Finding an appropriate balance is the first thing to think about. Then, if you decide you should reduce exposure to stocks, look at the particular holdings where you may want to sell or cut back. Then think about the tax consequences.
Ideally, as you rebalance your portfolio, you want to minimize your tax bill by booking some losses to offset the gains. But hold onto an investment if you really like that particular security or fund.
Q: With the fiscal cliff looming, is it a good time for retirees, or those close to retirement, to consider cutting back on their stock holdings?
A: Even if they're already retired, I'd caution against any 65-year-old saying, "I need to lock in whatever market gains I have now, to avoid potential short-term losses." A 65-year-old needs to plan for a retirement that could last 30 years or longer. With a couple aged 65, there's a 25 percent probability that one of those two will live to age 92. The risk of inflation reducing the purchasing power of your investment portfolio is significant over such a long time. So you want to make sure you have meaningful exposure to stocks, even in retirement.
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