Archives for December 2012

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Fiscal Cliff Investment and Tax Planning

I’ve gotten a number of emails from readers over the last week asking for my thoughts about the “fiscal cliff.” Typically these have fallen into one of two categories:

  1. Should I get out of the market (or lighten up on stocks) in case the market crashes, and
  2. Are there any year-end tax planning moves I should be making with my portfolio?

Should You Get Out of the Market?

In order to make a successful fiscal-cliff-related market timing move, (aside from simply getting lucky) you would not only have to be able to successfully predict what our lawmakers are going to do, you’d have to be able to make that prediction before the rest of the market can make it. (And this is assuming that no other unpredictable factors will play a significant role in what the market does this month.)

I can’t speak for you, but I know I have no idea how to do such things.

That said, if you’re particularly worried about what the market’s going to do, perhaps you should reduce your stock allocation. Permanently. As a general rule, your stock allocation should not be causing you any significant amount of anxiety. The idea is to pick an allocation where you can hold on even when the news is bad and the market is falling.

Year-End Tax Moves

As things stand right now, beginning next year:

  • Income tax rates are scheduled to increase across the board,
  • The special tax treatment for dividends is scheduled to expire, and
  • The special 0% and 15% tax rates for long-term capital gains are scheduled to increase to 10% and 20% (or 8% and 18% for property that’s been held for at least 5 years).*

In addition, the new 3.8% Medicare tax on unearned income (including dividends, interest, capital gains, rents, royalties, and annuity income, but not including distributions from tax-deferred accounts such as traditional IRAs) for people with modified adjusted gross income in excess of $200,000 ($250,000 if married filing jointly) is scheduled to go into effect.

As a result of these scheduled changes, there are a few actions you might want to consider taking. (Please note that it’s possible that a new law will be passed preventing any combination of those scheduled changes from actually occurring. So for the moment, I think it might be prudent to make a plan, but to hold off on any actual actions for a couple of weeks to see if we get any more information about what agreement our lawmakers are reaching — or not reaching.)

First, for investors with unrealized long-term capital gains, there’s a good chance it makes sense to engage in tax-gain harvesting. That is, it may be advantageous to sell the securities with the unrealized gains and pay tax on the gain now, at either 0% or 15%, rather than paying higher tax rates down the road.

Second, when possible, it may be advantageous to accelerate taxable income into this year rather than next year. For example, retirees currently taking distributions from tax-deferred retirement accounts may want to take out extra this year (enough to fill up their current tax bracket, for instance) so that they can take out less next year when rates are higher.

Third, for investors with holdings in taxable accounts, it’s likely time to rethink the asset location strategies that have been recommended for the last several years. With dividends being taxed like other ordinary income and tax rates increasing for long-term capital gains, there’s no longer as compelling a reason to make a point of tax-sheltering bonds before tax-sheltering stocks.

Instead, depending on circumstances, it could make a lot of sense to switch things around so that you’re holding tax-exempt muni bonds in taxable accounts and keeping your stocks in retirement accounts. (Please note, however, that this isn’t a must-get-it-done-before-year-end sort of thing.)

*This is not an exhaustive list of tax changes scheduled to go into effect in 2013. This is simply a handful of the changes most applicable to managing an investment portfolio.

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Should I Have More Than One Asset Allocation?

A reader writes in, asking:

“I have always had an asset allocation of 50-50 stocks and bonds and have been happy with that. But I am having trouble framing my current AA. I’m retired but not yet collecting Social Security, so I have now set aside some of my retirement money in cash to use over the next few years to get me to my planned Social Security claiming age (in this case, FRA).

Do I consider the cash as part of our allocation? My question isn’t about what allocation to choose, but about how to frame the allocation so that I can monitor it for rebalancing etc. I feel that if I don’t have a specific plan here, I might be tempted to drift around too much because I don’t have a set AA.”

I don’t think there’s a right or wrong answer here. But my personal preference is to have a separate mental pot of money for each major financial goal and to then choose an asset allocation that’s specific to that goal.

For example, I have one allocation for my emergency fund (i.e., 100% cash or short-term bonds).

Then I have another asset allocation for my primary retirement savings — that is, the money that I expect to be drawing on, at a roughly steady rate, throughout my entire retirement.

Then I would have a separate (low-risk) allocation for any money that was designated for a short-term goal — such as a few years of needing to satisfy a higher level of spending from savings prior to Social Security kicking in.

And if there were other major goals for which I was saving (e.g., saving for children or grandchildren’s college), I’d have a separate allocation for that money as well.

Just to be clear, the point here is not that the total portfolio is in some way superior as a result of this mental partitioning. The point is simply that I find it more intuitive to separate things by goal. For me, picking sub-allocations on a goal-by-goal basis is the easiest way to see how much money to have in each asset class at any given time.

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