A Farewell to 2012 - and a Look Ahead


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A Farewell to 2012—and a Look Ahead

Last year served as yet another useful reminder that the economy and the market are two very different things. We continued to experience uncertainty in the domestic economy and saw a particularly turbulent presidential election, and yet the S&P 500 index ended the year up 16 percent. In the fixed-income markets, analysts continued to worry about the potential of a bond bubble, but the Barclays US Aggregate bond index earned 4.21 percent, and the Barclays Municipal index gained 6.78 percent.

Overseas, euro zone worries continued to plague the global outlook, and financial experts doubted the continued growth of emerging market economies; however, the MSCI EAFE (Europe, Australasia, and the Far East) index closed the year up 17.32 percent, and the MSCI Emerging Markets index gained 18.22 percent in 2012. Investors who tuned out the pessimistic news reports were rewarded for their perseverance.

But if there was one thing in 2012 that seemed to blot out almost everything else, especially late in the year, it was the seemingly endless stop-start negotiations surrounding the so-called fiscal cliff. In the end, although technically the nation did go over the cliff briefly, on January 1, 2013, the retroactively effective American Taxpayer Relief Act of 2012 was passed by both the Senate and House of Representatives.

While the agreement reached between Congress and the White House allowed everyone to finally exhale, the legislation isn’t a panacea. On the one hand, it avoids the automatic tax hikes many experts speculated would lead to a recession if we were to go over the cliff. And it does represent progress toward budget stabilization, with the Congressional Budget Office estimating that we should continue to see the deficit drop over each of the next five years. But on the other hand, economists expect the economic recovery of the past year or so to slow as a result of the legislation’s mix of higher taxes and spending cuts.

What’s more, the act doesn’t address the issue of raising the US debt ceiling—by the end of February, we’ll be in for a second standoff on this issue, with Republicans demanding the spending cuts they originally sought as part of the fiscal cliff legislation. While it was a relief to get a deal passed and it has provided a respite for many weary investors, our budget struggles are by no means resolved.

Indeed, there’s every expectation that 2013’s political battles—between the Republican-controlled House and the Democratic-controlled Senate and between the House and President Obama—will unfold in much the same hyperpartisan manner they did in 2012. Given the absence of a shift in the balance of power after the November election, it will be business as usual in Washington, DC.

Nonetheless, the act contains several key provisions worth highlighting here. Let’s take a brief look at each.

Tax Rates
The act permanently extends the lower federal income tax rates that have been in place for the past decade for individuals earning under $400,000 annually (or $450,000 for married couples filing jointly). Taxpayers above those income levels will see their marginal tax rate increase from 35 percent to 39.6 percent and their long-term capital gains and qualified dividend tax rate increase from 15 percent to 20 percent.

All investors with modified adjusted gross income over $200,000 (individuals) and $250,000 (married filing jointly) will be subject to an additional 3.8 percent tax on net investment income. While a total increase of 8.8 percent on the capital gains tax rate may seem high, the resulting 23.8 percent rate is close to the historical average.

Estate and Gift Taxes
Although the top estate tax rate will increase from 35 percent to 40 percent, the current $5 million exemption amount will be permanently locked in and indexed for inflation going forward. This exemption will cover transfers made both during life and at death.

Alternative Minimum Tax
The act permanently extends AMT relief, avoiding a dramatic increase in the number of households subject to AMT.

Social Security Payroll Tax
While the legislation preserves the tax status quo for many individuals, it also eliminates the 2 percent reduction in Social Security payroll tax that was part of the stimulus measure in 2010, resulting in smaller paychecks for all wage earners.

You can find additional information about the new tax rates and other provisions in the act here.

What Can Investors Do?

Regardless of whether you’ll be paying more in taxes this year, there are a few tax-saving techniques you should discuss with your wealth advisor. This list is just a sampling of possible strategies that may or may not be appropriate for you. As always, you should consult with your accountant for professional tax advice.


Take Advantage of Employer Retirement Plans
By maximizing your retirement contributions to tax-deferred employer retirement plans, you can lower your taxable income. This year the maximum annual contribution limit to a 401(k) plan has increased from $17,000 to $17,500. The additional annual catch-up contribution for those over age 50 remains $5,500.

Revisit Withholding Amounts
A simple way to address your tax liability is to change your tax withholding amounts. Consider speaking with your accountant to discuss whether this year may be a good time to adjust these amounts.

Consider Municipal Bonds
Fixed income investors may want to consider the addition of municipal bonds to their portfolio. The income from municipal bonds is often exempt from federal tax and from state tax in the state in which the bond was issued.

Select the Appropriate Cost Basis Method
You’re required to pay tax on any capital gains resulting from the sale of investments. An important component used in the capital gain equation is the cost basis of the investment. There are many methods of measuring cost basis, including first-in-first-out, last-in-first-out, average cost, high cost, low cost, and lot specific. Your wealth advisor can help determine which method is most advantageous for you.

Location Optimization
Where it makes sense to do so, consider placing high-income investments—bonds, REITs, high-dividend-paying equities—in tax-deferred investment accounts, such as IRAs and 401(k)s.

Revisit your Financial Plan and Estate Plan
Your financial plan and estate plan will incorporate your appropriate income and estate tax assumptions. The peace of mind and security you can achieve through a stress-tested personal financial plan will make 2013 a truly happy new year.

We're Here to Help

Despite the efforts made to resolve the fiscal cliff, we’ll likely continue to see volatility in the domestic and global markets in 2013. Investors should continue to stand by the same tenets that served them well in 2012: Coordinate your investment portfolio with your personal financial plan, diversify your investments, rebalance regularly, and tune out the media noise. For help with this and more, contact your Moss Adams wealth advisor.

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