She Moves in Mysterious Ways: Our Year-End Super-Duper Fiscal Cliff Spectacular

December 18, 2012

The so-called fiscal cliff is just a couple of weeks away, and while the fiscal cliff is certainly real, the ultimate size of the drop-off is unknown. There are many complex financial happenings at the end of 2012. Some have to do with estate taxes, some with ordinary income, and some with investment income. We can’t speak to all of the strategies available to those with different financial issues; moreover, non-investment tax issues would require the advice of estate attorneys and accountants. That doesn't mean, however, that everyone needs to seek such professionals or make any changes.

From our perspective, there are two issues to address: 

1) Will tax increases and government spending cuts cause another recession and/or significant stock slide?

2) Market moves aside, should the tax tail wag the investment dog this time around?

On the first issue, we may see a recession, one that has more to do with fear and panic of an economic slowdown than the actual effect of higher taxes and reduced government spending. The actual tax increases and spending cuts by themselves won't be implemented at levels that would grind our economy to a halt. Not even a so-so economy. 

And that's the worst-case tax situation. In all likelihood, we'll eventually see a tax deal that will, for the short run at least, leave tax rates slightly lower for most Americans than they were during the 1990s, but slightly higher than they were during the 2000s. 

Could this by itself cause a slide in stocks? Yes. Could it also lead to a fairly dramatic rise in stocks if we get something better than a somewhat arbitrary fiscal cliff? Yes.

Significant stock market slides usually occur following big rises in asset prices, during periods of investor optimism, and in areas in which no one expects them. Well-known fears that the majority of people expect to cause major problems, including war, oil price spikes, the collapse of Europe, and tax cliffs - either don’t do much damage or are already baked into prices. If everyone sees it, it's not a black swan. It’s just a swan.

An example of markets doing the unexpected would be France, now near and dear to us with our relatively recent additions of funds with European stock exposure, like Vanguard Euro Pacific ETF (VEA).

French voters decided to solve their ongoing serious budget and economic problems by electing Socialist François Hollande this year, because apparently the last government, with its roughly 50% tax rates, wealth taxes, and spending at more than 50% of GDP didn’t tax enough. 

In September, France's  new government announced its own budget solution, which includes  some cuts, but is largely composed of tax increases. They raised the top rate to 75% (Gerard Depardieu is apparently considering a move to Belgium). The result? A strong move UP in French stocks. Are tax increases good for stocks? Probably not. But failing to  solve a budget problem might be worse. Who would have thunk buying French stocks after the election would be a good idea?

Conclusion #1: Sitting out the fiscal cliff could help you avoid some losses, but it could just as easily make you miss out on gains. This strategy does not compare favorably to, say, six years ago, when we decided being a little light on stocks was a good idea, since downside from a collapsing housing market exceeded the risk of missing upside.

As for taxes, the Powerfunds strategy tends to be as tax-favorable as a non-buy-and-hold index-style investment strategy can be. That's because we usually buy funds and categories that have been weak, minimizing fund-level year-end tax distributions. We also try to hold most positions longer than a year in order to convert any gains into long-term gains that are taxed at a lower rate. That said, we’re still realizing gains (and losses) from time to time unlike a buy and hold index strategy.

While we're aware of tax issues, we generally don’t feel tax minimization is the main goal of investing. Although it's true that after-tax returns are all that matter, you can’t always increase your after-tax return by worrying about the tax implications of your investment. In fact, you risk lowering your pre-tax return more than any benefit you'd realize by paying lower taxes on the gains. We're trying to maximize returns for each client's risk level. Booking mostly long-term taxable gains along the way is a necessary result of this strategy. Is it better to pay 15% on gains after a big multiyear run up in a fund, or hold on longer for an eventual slide?

Conclusion #2: In general, you shouldn’t push off realizing a gain at a 15% rate if, tax considerations aside, you'd want to sell anyway. Chances are you won’t get a better rate on gains down the road than you will this year. 

The question for us is whether we advance a sale that might have taken place in 2013 or later in order to prepay the gains. The answer is maybe. The risk here is that rates won’t change or the stock market slides. In that case, you'll have booked gains that would have diminished. Only those investors that want to essentially make a bet on future tax rates and estimate when they'll have to realize gains should advance those gains to the here and now. This could work for both investors in the current 0% capital gains bracket and those going into the top capital gains bracket next year, which will include an additional Affordable Care Act tax. The zero percent capital gains rate is generally for those under $35,350 individual / $70,700 joint return. The additional 3.8% capital gains tax for 2013 on for those earning over $200,000 individual / $250,000 joint return as part of Affordable Care Act. Check with your accountant for your specific situation.

The bottom line is this: investment income is likely going to become less special and more ordinary, like ordinary income (the taxes of which are also going up). Although the increase may not be that drastic for all investors next year or the year after, in the long-term I doubt we'll get back down to lower levels on capital gains or dividend income than we have today, due to our huge budget problems. Our golden era for investing tax rates is ending. On a positive note, our golden eras for investing RETURNs did not occur during periods of such low investing taxes.

Wherever tax rates end up in 2013 and beyond, it would be in the economy’s best interest if the variety of tax rates, schemes, deductions, IRAs, etc. could at least stabilize, if not consolidate, into fewer rates that remain predictable. That way, we could all spend less time focusing on taxes and more on making money. A good tax code shouldn’t throw these kinds of curveballs.