What Lies Ahead Doesn’t Look Promising

by Bryan Perry | August 27, 2012 1:30 pm

What Lies Ahead Doesn’t Look Promising

dangerous cliff edge 630 Flickr 150x150 What Lies Ahead Doesn't Look PromisingIf you blink, you’ll miss the change in market sentiment. As of this Monday, the bulls were in control on the heels of stronger industrial production, retail sales, employment and housing data. But then on Tuesday, the bears took over, blaming further contraction in China, all talk and no action from the ECB and the Congressional Budget Office’s memo saying that the U.S. economy will fall back into recession if the fiscal cliff issues aren’t resolved by year end. We live in trigger-happy times, that’s for sure.

What does the now popularized phrase “fiscal cliff” mean to income investors as the end of the year approaches? A lot. It involves $1.6 trillion in spending cuts and tax increases, namely $500 billion in cuts and $1.1 trillion in new taxes. Through 2012, the Bush tax cuts are safely in place. However, if Congress doesn’t act with the blessing of President Obama, those breaks will expire and individual income tax rates on investment income will increase for all income levels—but especially for higher-income households.

Now that the Supreme Court has upheld Obamacare, a new 3.8% tax on investment income collected by households earning over $250,000 will be collected starting next year. And that’s just the tip of the tax iceberg. Beginning in 2013, the maximum federal rate on long-term capital gains will increase to 20% from 15%, with an 18% maximum rate being applied to those assets acquired after December 31, 2000 and held for five years.

Here’s where it could get tough. For 2013 and beyond, dividends will be taxed at regular rates, which could be as high as 39.6%. That’s up dramatically from the current 15% for qualified dividends, so it’s alarming to say the least—and again, is designed to tag the higher-income households most.

But that’s not the only trouble ahead along the road to investing. For 2013 and beyond, the top rate on short-term capital gains, interest, rental income, royalties and annuities will rise to 39.6% from the current 35% maximum rate as applied to these categories.

And there’s even more pain coming. For 2013 and beyond, the ominous phase-out rules for personal and dependent deductions and itemized deductions are scheduled to be put back into force, raising the effective tax rate on higher income earners even more. Not a good scenario if investment tax rates line up with ordinary income tax brackets. It really is hard to imagine Congress letting this come to pass, given that the lion’s share of their campaign donations come from the very people that will be hit the hardest by these draconian changes in the code. Talk of something more like a 5% hike from 15% to 20% seems to be in the works from different sources of Congressional notes.

It’s my take (and that of most financial editors) that Congress will vote to extend all the year-end deadlines and grapple with this wide-ranging set of measures well into the spring of 2013. At least, that’s the tone of any Congressional feedback that can be mustered as of this writing.

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