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Fiscal cliff: crisis averted

What the deal to avoid the "fiscal cliff" may mean for you.

Fiscal cliff: crisis averted

In early January, the House and Senate took action to avert the so-called fiscal cliff, and making most of the 2001 and 2003 tax cuts permanent.

As the fiscal debate moves on to the debt ceiling, it may be worth taking a moment to look at the tax changes in the deal, officially called the American Taxpayer Relief Act, to find out what they will mean for you as a taxpayer, and investor.

So what does this deal mean for you? A few key takeaways:

  • FOCUS ON THE LONG TERM. Make sure that you develop or update your retirement plan. Check that your asset allocation is in line with your long-term goals. And make sure that you have an emergency fund or, if you are retired or approaching retirement, a base of guaranteed income in place so you won’t be tempted to make emotional moves during volatile market times.
  • RECONSIDER STOCKS. If you are a long-term investor and have fled the stock market for fear of the fiscal cliff and other market risks, it may be time to revisit your asset allocation, and to reconsider stocks. The S&P 500 Index was up 13.4% in 2012, and risk assets like stocks, commodities and high yield bonds could do relatively well if long-term deficit reduction proves credible and growth picks up.
  • GET TAX SMART. With taxes rising—particularly for high-income earners—it will become all the more important to have a tax-efficient savings, investment, and retirement income plan. Remember, it’s not just what you earn that counts, but what you keep.
  • BUMP UP YOUR SAVINGS. Restoring the solvency of Social Security and Medicare may be part of the fiscal debate in 2013. Changes to these programs could mean smaller benefits during your retirement. So you may want to consider increasing your savings, and maximizing tax-advantaged accounts including traditional and Roth IRAs, 401(k)s and other workplace savings plans, Health Savings Accounts (HSAs), nonqualified executive compensation plans, and annuities.

Breaking down the deal

Taxes are going up for many Americans this year, but not nearly as much as they might have. The deal prevented the expiration of the 2001 and 2003 tax cuts for the vast majority of people, and maintained preferential tax treatment for qualified dividends and municipal bond income. There may still be more tax reform to come, but for now, here are the highlights.

Tax changes

  • Income tax rates. Permanently extends the lower tax rates and other tax cuts enacted in 2001 and 2003 for single filers with taxable incomes below $400,000 and joint filers with taxable incomes below $450,000. The top income tax rate will permanently increase from 35% to 39.6% (as scheduled under current law) for single filers with taxable incomes above $400,000 and joint filers with taxable incomes above $450,000.
  • Limits on exemptions and deductions for higher wage earners. Permanently reinstates the phase-out of personal exemptions (PEPs) and the limitation on itemized deductions (Pease) for single filers with adjusted gross income (AGI) above $250,000 and joint filers with AGI above $300,000.
  • Payroll tax. Restores the employee Social Security payroll tax contribution to 6.2% on income up to $113,700 in 2013. This payroll tax contribution had been temporarily reduced to 4.2%.
  • AMT (alternative minimum tax) patch. Permanently extends the AMT patch with annual inflation adjustments.
  • Estate and gift tax. Permanently extends the lifetime estate and gift tax exemption of $5.12 million (with annual inflation adjustments), but increases the top tax rate from 35% to 40%. Provisions for spousal portability and reunification of the estate and gift tax are also permanently extended.
  • Capital gains and dividends. Permanently extends the 0% and 15% tax rates for long-term capital gains and qualified dividends for single filers with taxable incomes below $400,000 and joint filers with taxable incomes below $450,000. The top rate will permanently increase to 20% for filers with taxable incomes above these thresholds.

The new 3.8% Medicare tax enacted under the healthcare law is not repealed and takes effect as scheduled in 2013. The new 3.8% tax applies to single filers with modified AGI above $200,000 and joint filers with modified AGI above $250,000. As a result, the tax law will include four different rates for long-term capital gains and qualified dividends depending on the investor’s modified AGI and taxable income: 0%, 15%, 18.8%, and 23.8%.

  • Annual expiring provisions. Two-year extension (for tax years 2012 and 2013) of dozens of tax provisions, including the ability to make tax-free rollovers from an IRA to a qualified charity. The charitable rollover provision includes two transition rules. The first would allow individuals who make qualified charitable rollover distributions in January 2013 to count the rollover as if it were made in 2012. The second would allow individuals who took a distribution in December 2012 to contribute that amount to a charity and count it as an eligible charitable rollover.
  • 2009 stimulus-related tax relief. Five-year extension of certain tax credits enacted in the 2009 stimulus bill (e.g., the American Opportunity Tax Credit and enhancements to the refundability of the child and earned income credits).

Spending

  • Unemployment benefits. One-year extension (through 2013) of emergency unemployment benefits for the long-term unemployed.
  • "Doc fix." One-year extension (through 2013) of the current Medicare reimbursement formula for doctors, preventing a cut in Medicare payments to medical service providers.
  • Budget sequester. Delays for two months the automatic spending cuts that are scheduled to take effect under the budget sequester.

Retirement plans

  • Roth conversions. The new law paves the way for participants in 401(k), 403(b), and 457 plans to make Roth conversions, and pay the applicable tax bill, if their plan includes a Roth account option. This new option is still being explored by companies and financial services providers, but may become available in some plans later this year.

For investors: a potential plus for risk assets

For months, fiscal cliff fears have been weighing on the markets. A November Fidelity survey found that 63% of investors had lost confidence in the markets due to the issue, and of those making changes to their portfolios as a result—more than 70% were decreasing their allocation to stocks.1

"I think that had we gone fully over the cliff it would have led to more market volatility and lower Treasury yields," says Bill Irving, manager of Fidelity Government Income Fund. "On the other hand a grand bargain would have been very good for stocks and other risk assets and would have led to higher Treasury yields. But what we have here is a deal does not stabilize the debt-to-GDP ratio, and kicks the can down the road regarding the debt ceiling and the sequestration spending cuts. I think there will be temporary relief that the cliff has passed, but the markets will still want to see meaningful deficit reduction plans down the road."

If you moved into more defensive positions, you may want to reconsider. Bonds have had a strong three decade run, but from today’s interest rate levels, it may be hard for them to continue to provide above-average returns. Make sure your asset mix is in line with your personal goals, and with the amount of time you expect to be invested.

"Investors should be careful that their loss aversion hasn’t pushed them so far away from their neutral mix that they are under-investing in equities, because it may not be a bad environment over the next several years," says Dirk Hofschire, senior vice president of Asset Allocation Research. "This isn’t a blanket statement for everyone, but I think when you look at the one-sided nature of the big shift in investor sentiment into bonds in recent years, one does have to ask, 'Am I extrapolating these above-average bond returns and below-average equity returns off infinitely into the future?', because that might not be the case going forward."

Stocks. Within your equity allocation, you want to be diversified with exposure to all styles, caps and sectors. But several of our seasoned fund managers are considering taking on a little more risk if a credible long-term deficit reduction deal is reached.

Jurrien Timmer, co-manager of the Fidelity Global Strategies Fund, believes a fiscal deal would be bullish for risk assets generally. Says Timmer: "With the fiscal cliff resolved, I expect risk assets such as stocks, corporate bonds and commodities to perform reasonably well into the first quarter and perhaps beyond. Treasury yields could rise modestly and the dollar could edge lower as risk appetites return."

Fixed income. Most investors should have some allocation to bonds in their portfolio, but this doesn’t mean that bonds will generate the strong returns investors have seen in recent years. Today many types of fixed income are near decade-low yields, and the short-end of the Treasury curve is actually offering negative real returns. Still, fixed income has a place as a diversifier in many portfolios.

For taxpayers: time for tax-efficient strategies

For taxpayers making less than $400,000 a year, or $450,000 for married couples filing jointly, your income tax rates won’t go up in 2013. But other taxes very well could. The payroll tax will return to its pre-2011 levels—a 2% increase in most cases. And a range of other tax rates will be going up for high income earners including dividend taxes, capital gains, and estate taxes. These come on top of a new 3.8% Medicare surtax and net investment tax that affects taxpayers with modified adjusted gross income of more than $200,000 (single) and $250,000 (joint).

"Rising rates and reduced deductions will impact investors’ bottom line," says Executive Vice President John Sweeney. "These changes magnify the importance of having a tax sensitive strategy—which starts with making the most of tax-advantaged retirement accounts, and includes a strategy for which type of assets to keep in those accounts, which type of investments to choose, and how you structure and time your withdrawals in retirement."

Here are some of the key changes—and potential implications. Keep in mind that you should view any tax strategy in light of your overall financial plans, and consult a tax advisor.

Capital gains and dividends. For investors with modified adjusted gross income greater than $200,000 (single filers) or $250,000 (married filing jointly) the new 3.8% Medicare surtax on net investment income is going to impact capital gains and dividends. Earners with taxable income greater than $400,000 (single), or $450,000 (married filing jointly), will pay a top rate of 20%—23.8% including the Medicare surtax.

  • What to consider: Investors should consider tactics for minimizing taxable gains, such as tax-loss harvesting or holding tax inefficient assets like taxable bonds, dividend-paying stocks, or high-turnover equity funds in tax-deferred accounts such as a 401(k), IRA, or tax-deferred annuity.

Estate tax. Taxpayers should always revisit their estate plans in light of tax changes or life changes. In the fiscal cliff deal, the estate tax exemption stays at the 2012 levels of $5,120,000 per person (subject to inflation adjustments), but the top tax rate was raised from 35% to 40%.

  • What to consider: If your estate may be taxed at the federal or state level, you may want to consult with an estate planning attorney to look into charitable giving, trust, or ownership structures that allow you to transfer wealth outside your estate.

Income taxes. If you are in the top tax bracket, you can expect your income tax rate to go up next year to 39.6% for tax year 2013. When you consider the potential impact of the phase-outs of personal exemptions and itemized deductions, and the new Medicare surtax—the impact could be even greater.

  • What to consider: As tax rates climb, the relative benefit of tax-advantaged accounts increases, so if you are not already maximizing 401(k), IRA, and HSA savings, you may want to consider doing so. If your employer offers you one, a nonqualified deferred compensation plan might also be worth considering. If you are maxing out these savings options, a deferred annuity may provide additional tax benefits. Because bond income is taxed at ordinary income rates, it may be worth looking at municipal bonds, which provide federal-tax-free income, although they typically offer lower yields than similar taxable bonds.

For savers: save more, save smarter

This budget deal did nothing to trim Social Security or Medicare benefits. However, reforms to help restore the solvency of those programs figure to be a major part of the debate over deficit reduction. For retirement planners, that means it may make sense to increase your personal savings rate.

So, think about taking advantage of your tax-deferred savings through a 401(k), HSA, or other workplace savings plans. The bill also allows participants in 401(k), 403(b) and 457 plans to convert to a Roth 401(k) account, if the plan offers one. And because taxes may continue to rise, consider converting your traditional IRA, where withdrawals are subject to income tax, to a Roth, where they are not.

The bottom line

The fiscal cliff deal helped to avoid the immediate impact of tax hikes and spending cuts, but it did little to answer the long-term deficit reduction, tax reform, and spending questions. There is much work ahead in Washington. But in the meantime, you can take stock of your own portfolio, and make sure it’s positioned to meet your personal goals—after taxes.

Learn more


Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Past performance is no guarantee of future results.

1. Source: Online survey of Fidelity Retail Customers (random sample; all ages<80 years with $2K of Fidelity retail assets), fielded November 14-29, 2012; 40% response rate.

Views expressed are as of January 2, 2013, and may change based on market and other conditions. The opinions provided are those of the speakers and not necessarily those of Fidelity Investments. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and your evaluation of the security. Fidelity is not recommending or endorsing these investments by making them available to its customers. Consult your tax or financial advisor for information concerning your specific situation.

The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice.

Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change.

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