Retiring on the edge of the fiscal cliff

One of the biggest risks retirees and soon-to-be retirees face is that of taxes. Not only will paying taxes be a challenge but the risk that tax policy will change and throw a big wrench into one's plans is also a concern. With the fiscal cliff around the corner, these individuals must develop a plan of action for their portfolio.

By Robert Powell
Nov. 13, 2012, 7:01 p.m. EST
Market Watch

One of the biggest risks that retirees and pre-retirees face is that of taxes; not just paying them but the risk that tax policy will change and throw a big wrench into one’s plans.

Well, that risk—in the form of the fiscal cliff—is now upon us and retirees and pre-retirees must now develop a plan of action for their portfolio should all, some, or none of the scheduled tax changes and spending cuts become a reality on Jan. 1.

“The ‘fiscal cliff’ may affect retirees, pre-retirees and the economy as a whole unless Congress acts,” said Thomas DiLorenzo, manager in the Employee Financial Services group at Ernst & Young LLP.

According DiLorenzo, increased taxes—higher income, higher dividend, and capital gains tax rates—are the primary personal finance concern as the Bush-era tax cuts are set to expire for all individuals. Among the changes:

  • Marginal tax rates will rise from 10%, 15%, 25%, 28%, 33% and 35% in 2012 to 15%, 28%, 31%, 36% and 39.6% in 2013.
  • The 15% maximum long -term capital gains rates will revert to 20% and qualified dividend rates will increase from 15% to being taxed at an individual’s marginal tax rate.
  • Earned income tax credit, child tax credit, and the American Opportunity credits will all be reduced.
  • Itemized deductions and personal exemptions will become subject to phaseout.
  • Estate and gift tax exemption will drop from $5.12 million to $1 million and the top estate tax rate will go from 35% to 55%.
  • And while not part of the Bush tax cuts, the 2% FICA tax reduction that has been in place for the past two years would also expire at the end of this year.

In addition, the lower Alternative Minimum Tax (AMT) exemption that is currently in place for 2012 would result in many more individuals being subject to the AMT if the exemption amount is not increased as it has been in previous years..

While there is still time for Congress to take action and every individual’s situation will be different depending upon their facts and circumstances, experts including DiLorenzo said retirees and pre-retirees ought to consider the following given that the fiscal cliff might become a reality.

Set aside 12 months of living expenses

Things might get a little bumpy as we approach the fiscal cliff. So, Stephen Smith, a vice president at Noesis Capital Management, recommends that retirees and pre-retirees set aside 10 to 12 months of living expenses in a money-market fund. “That should provide a cushion so that their investment portfolio can be managed according to their respective time frame and circumstances, with less regard for volatility over a six-month period,” he said.

Rebalance assets

In the event that we do go over the fiscal cliff for more than just a few weeks of 2013, “the ramifications could be quite significant,” according to a UBS Wealth Management Report.

So retirees and pre-retirees might consider how they will allocate their assets given any number of scenarios that could play out as we near the fiscal cliff.

In a worst-case scenario, for instance, UBS reports that there will be severe double-digit losses for U.S. and cyclical non-U.S. equities; U.S. Treasuries and highly-rated non-U.S.-government bonds will rally and credit spreads will spike across the board; the U.S. dollar and other safe-haven currencies will rally; and there will be severe double-digit declines in the broad commodity indexes, with energy and base metals being the most affected.

In its report, UBS outlined four other possible scenarios, including a scenario where lawmakers design a best-case grand bargain that avoids the fiscal cliff. In this scenario, UBS predicts that there will be a rally in stocks, fueled by multiple expansion and stronger earnings growth; Treasury yields will rise modestly, but remain low; the U.S. dollar will rise; and commodities won’t fall.

Others, however, have a different point of view. “Although tax policy for 2013 remains highly contingent on the outcome of U.S. Presidential elections—we think that most likely scenarios continue to favor our themes of preferring large cap over small cap and dividend payers/growers over non-payers,” said Lisa Shalett, CIO and head of Investment Management and Guidance for Merrill Lynch Wealth Management.

Strategic asset allocation

While many agree that you need to develop a plan for the best- and worst-case scenarios, some suggest that you consider what’s called strategic asset allocation.

“Investors should, in my view, one, have a plan for what to do if valuation levels in the current stock market go up or go down substantially; and two, adhere to that plan—strictly,” said Ron Rhoades, assistant professor at Alfred State College and the president of ScholarFi Inc.

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