Fears over the euro-zone debt crisis have become second fiddle to growing concerns over the upcoming fiscal cliff, which threatens to increase taxes and create substantial government spending cuts, both of which may push the country back into a recession. For financial advisors, however, helping individuals develop strategies to lessen tax pain in 2013 can be a powerful prospecting and client retention tool.
The fiscal cliff typically refers to a combination of government spending cuts and the expiration of numerous tax cuts at the start of 2013. For taxpayers, the impact could be substantial. The nonpartisan Tax Policy Center says the average tax increase would be $3,446. For the top 1% of Americans, the change would be the most drastic, with the tax rate climbing to 40.50%, up 7.2 percentage points.
While Congress and the White House may act to eliminate some tax increases, most Beltway observers predict that political gridlock may hinder meaningful intervention prior to next year and even then policy change could be disappointing. Also next year, estate taxes are expected to increase and the amount of an estate that can pass to beneficiaries is slated to decrease. Those changes are also creating opportunity for advisors who can encourage their clients to engage in legacy planning.
Opportunities for advisors to help clients with the Fiscal Cliff aren’t limited to legacy planning. Simply put, advisors can use the expected tax increases as an opportunity to illustrate how they can deliver value to clients by suggesting strategies to lesson Uncle Sam’s sting next year. Here is a hypothetical example that illustrates how an advisor can help clients substantially cut their tax burdens.
An investor with a marginal tax rate of 35% can expect to see their top rate increase to 39.6% next year. By increasing salary deferrals to qualified retirement programs, such as 401(k) plans, an investor can partially offset the impact of the tax increase.
For 2012, if an investor is currently deferring $10,000 a year into a qualified plan, he or she would have reduced their tax burden by $3,500. With the higher tax rate expected next year, the same deferral will result in $3,960 in savings.
Yet, the higher tax rate makes increasing the deferral amount next year more appealing. In 2013, 401(k) deferrals are capped at $17,500, although individuals age 50 or older can defer an additional $5,500 into their plans. So, if the hypothetical investor increases their deferral rate to $17,500, he or she would save $6,930 in taxes, which is nearly double the amount that individual would have saved in 2012 taxes with a $10,000 deferral. Advisors can also explain to clients how the increased deferrals can increase the size of retirement savings over time.
Sheltering income through Flexible Spending Accounts, which allow individuals to pay for out-pocket health care costs with pre-tax money, should also be evaluated. If an investor allocates $1000 in 2012 to an FSA and believes that their 2013 out-of-pocket expenses will exceed that amount, they can consider increasing their allocation to the program, further sheltering income from the higher tax rates. In a similar manner, parents can assess if allocating money to pre-tax childcare accounts is appropriate.
Advisors’ potential for helping clients manage increasing taxes isn’t limited to employee benefit plans, however. Indeed, advisors can evaluate if tax-efficient investment strategies may be appropriate. Some tax-efficient strategies seek to minimize the realization of capital gains by limiting portfolio turnover. They may be appropriate when considering that the long-term capital gains tax rate, currently at 15% for many investors, would increase to 20%.
Some tax-efficient funds also seek to limit taxable income by avoiding stocks with high yielding dividends. With the current dividend tax rate of 15% for most investors resorting to individuals’ ordinary income tax rates next year, the strategies may be appealing for investors seeking to limit how much they fork over to Uncle Sam each year.
It’s likely, of course, that Congress and the White House may avert at least some of the tax increases. Yet, for advisors, taking time to help clients create a Fiscal Cliff contingency plan is still prudent. First, it’s unlikely that all of the expected tax increases will be avoided. Second, many of the strategies for minimizing taxes, such as increased retirement plan deferrals, may still be appropriate even if taxes don’t increase next year. Either way, the Fiscal Cliff is an attractive opportunity for advisors to illustrate that they have their clients’ best interests in mind.