Jan. 4, 2013, 7:00 a.m. EST
After the cliff: Roths, munis, diversification
How to prepare your nest egg for a new tax reality
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BOSTON (MarketWatch)—Most retirees and those saving for
retirement can relax slightly now that Congress has passed the American Taxpayer
Relief Act of 2012 or ATRA—the compromise bill designed to avert the fiscal
cliff.
Discussion of that law, which President Obama signed late Wednesday, has
focused mostly on taxes, many of which will rise for the wealthiest 1% of
Americans. But while 99% of taxpayers have avoided the worst of the fiscal-cliff scenarios, it doesn’t mean they won’t still have work to do to adjust their portfolios and saving strategies to the new reality. The possibility of slower economic growth, reduced entitlement benefits and higher expenses remains a looming challenge for future retirees.
How to protect your retirement in 2013
2013 brings new factors to consider for your retirement portfolio, including tax liabilities, the impact of the fiscal cliff and global equities.
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To understand the broader impact of the deal on their portfolios, taxpayers first have to grapple with the tax implications. On this front, most retirees and would-be retirees have less reason to worry than they did at the end of 2012, at least in the short term.“It’s status quo for the vast majority of taxpayers,” said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research. “The highest earners will pay additional taxes, but likely won’t have their retirement prospects materially impacted. The lowest level will likely still enjoy the government entitlements they’ve come to expect.”
ATRA raises taxes on income, dividends and long-term capital gains for households that make more than $450,000 a year and individuals who make more than $400,000. For the wealthiest, dividend income and capital gains will be taxed at a 20% rate, up from 15%, and the true rate will be 23.8% as a new Medicare surcharge on the wealthiest takes effect. (See related story.)
Under the bill, Americans at all income levels would see a two-percentage-point jump in the employee portion of the Social Security payroll tax.
But for income earned below the $400,000/$450,000 threshold, the 2012 rates would be permanently extended. All told, the income and investment tax hikes in 2013 could affect fewer than two million households.
Recession avoided?
Some experts also predicted that the economy would not fall back into a recession in the wake of ATRA, as some feared would happen if there were no deal. “This compromise will not solve the longer-term debt and deficit problems facing the United States,” wrote Gary Thayer, the chief macro strategist at Wells Fargo Advisors. “However, it will prevent major tax increases on most Americans, and will, therefore, likely keep the economy from falling into recession. Continued modest economic growth should give lawmakers more time to address the longer-term issues.”But just because the short-term outlook seems rosier doesn’t mean that people saving for or living in retirement should rest easy. Here’s some advice experts offered recently in this column, “Retiring on the edge of the fiscal cliff: 10 ways to protect your retirement savings.”
Income tax diversification is key
At a minimum, experts say, retirees and investors will need income-tax diversification. In the face of the continued possibility of rising tax rates, it is going to be more important than ever to have some sources of future income that are not subject to income tax, such as Roth accounts. Having a Roth IRA will let retirees and others shift back and forth between taxable and nontaxable income from year to year, depending on one’s circumstances.One bit of good news on this front: ATRA features a new rule that will allow 401(k) participants to complete intra-plan Roth conversions. (See related story.)
Spiegelman recommended that taxpayers, and especially the middle class, follow the advice he’s been giving for years now. “Save as much as possible in tax-advantaged accounts—especially if they expect higher taxes and reduced government benefits via means testing and increased retirement age down the road,” he said.
Read related story: Why most taxpayers can cheer the fiscal-cliff deal.
And: Cracking the 2013 tax code changes.
Prepare for reforms
Diane Boyle, the vice president of federal government relations for the National Association of Insurance and Financial Advisors, also said retirees and would-be retirees need to prepare for all sorts of future tax reform, including the potential for limits on tax-favored contributions to retirement savings.In addition, Boyle said, retirees and those saving for retirement need to prepare for entitlement reform that could include, potentially, greater Medicare means-testing, an increase in the Medicare eligibility age (phased in over a long time, perhaps 20 years), and a change in the way cost-of-living adjustments are calculated for Social Security benefits (for inflation-adjusted tax rules, too)—the use of the so-called chained CPI. Read Jason Fichtner’s piece on chained CPI. Chained CPI: Diet COLA for Social Security.
Boyle said retirees and would-be retirees need to “prepare for another enormous struggle over the debt ceiling, continuing uncertainty and thus a potential slow-down in economic recovery if not an actual fallback into recession.”
Also of note, for those retirees thinking about how to pay for long-term care: Boyle said the bill repeals the CLASS Act, the moribund new federal program that aimed to provide long-term care/disability insurance through an employer-based automatic deduction system. The bill does, however, set up a new commission that would study and then recommend to Congress ways to address Americans’ long-term care needs.
And Boyle noted that the bill includes a rule that allows a direct tax-free gift from an IRA to a charity.
What to do now
“The fiscal cliff is a big deal, but there will always be big deals,” said Craig Israelsen, a professor who teaches personal and family finance at Brigham Young University. “Portfolios that are well diversified will weather the storms.”For those contemplating what to do with their investment portfolios, Israelsen offered this advice
- Build a diversified portfolio. In Israelsen’s world, that would be his so-called 7Twelve portfolio, a multi-asset balanced portfolio. Unlike a traditional two-asset balanced fund with a 60/40 ratio of stocks to bonds, the 7Twelve balanced strategy uses multiple asset classes to increase returns and reduce risk. Learn more at his website.
- Save at least 10% to 15% of your income each year, or at least as much as feasible.
- Don’t bail out of your portfolio based on external events, such as the fiscal cliff or whatever comes next.
- Check your investments less often; that will take volatility out of your portfolio. Instead, focus your time and energy on more important matters such as children, grandchildren, service to community, religious activities and travel/adventure.
- Do you need to reassess your goals and time horizon? A tax rate increase could change your cash flow needs.
- Do you have enough cash available to handle expenses for the next two years so that you can sleep at night during volatile times and avoid having to liquidate your investments when the markets are down?
- Is there an opportunity or need to rebalance? Volatile markets can create asset allocation imbalances. Rebalancing back to your target allocation may assist you in staying on track with your long term plan.
Where to invest
In his review of ATRA, Well’s Fargo’s Thayer noted that the increase in payroll taxes on all workers and income taxes on wealthy Americans will be a drag on economic activity. He’s predicting that the U.S. economy is likely to grow at only a modest rate of 2.5% in 2013, instead of a normal healthy rate of 3% or more. He’s expecting the Standard & Poor’s 500-stock index to end the year in the 1525-1575 range.Thayer recommends that investors be positioned more cyclically and less defensively, overweighting the following S&P 500 sectors: consumer discretionary, technology, and materials, as well as telecommunication services for some dividend yield. “We expect stocks to outperform bonds in 2013 and expect the cyclical sectors of the stock market to outperform the defensive sectors of the market,” he wrote. What’s more, Thayer wrote, taxpayers will continue to have an incentive to invest, because in most cases, their investment income will be taxed at a lower rate than ordinary income.
Robert Powell is editor of Retirement Weekly,
published by MarketWatch. Learn
more about Retirement Weekly . Follow
his tweets @RJPIII .
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