While talking with a client yesterday, we learned that several of his colleagues were moving all of their assets to cash in preparation for the coming “fiscal cliff”. Although it was the first we had heard of this extreme measure, we believe it’s not likely an isolated incident. Therefore, we wanted to send a out a quick note regarding the topic.
What is the “Fiscal Cliff”?
We like to think of it as a great media term made up to describe several tax increases and budget cuts taking place January 1st, unless Congress comes to a quick resolution.
Have we been here before?
Yes! We were in very similar circumstances at the end of 2010. What amazes us is that no one was calling it the “fiscal cliff” nor did it create a media frenzy like it has today. In that instance, Congress met December 17th and put in place a two year temporary patch that had extended the Bush tax cuts until the end of 2012.
What impact will this have on physicians if we “go over the cliff”?
Several aspects come into play that have a direct impact on many physicians:
- Federal income tax rates increase by approximately 5% for most physicians
- There is not yet a patch for the AMT adjustment to help offset inflation
- Medicare income taxes go up by .9% for income in excess of $200k-$250k
- Social security taxes will increase by 2% on the first $110,000 of income
- A new Medicare tax of 3.8% is put in place as an additional tax on investment gains
- And most importantly for physicians (although ignored by many media outlets), Medicare reimbursements will be reduced unless a new patch is put in place
Key items to remember:
- There are several different items in action, but they do not all need to be solved together. Congress has often tackled the patch for AMT and Medicare reimbursements independently of income tax items.
- Previously Congress has gone back retroactively after the beginning of the year to solve challenges like this. In other words, year-end doesn’t mean much outside of public confidence in our leadership. We don’t mean to minimize that aspect; we are just stating that there is nothing stopping Congress from fixing these issues in January.
What can you do to protect yourself?
- First, we offer a reminder that for younger investors, who are consistently adding large sums of money to the market each year, the best thing that can happen is for the market to go down while you continue to buy.
- Second, for clients within 10 years of retirement, they should already be taking several steps to protect themselves, including any number of the following:
- Reducing equity exposure as a strategic move – not just to time the potential market impact of the “cliff”
- Utilizing annuity safety net strategies to allow some peace of mind that income potential will not be reduced regardless of market outcomes
- More broadly diversifying across the international spectrum in order to reduce currency risks
- Third, being prepared to re-balance your equity/bond exposure should the market make any major shifts. Studies show that if your exposure to any major asset class moves more than 20-30% off of its target, re-balancing should occur. This is something we monitor closely for our clients on a weekly basis, but during this time of uncertainty, we are stepping this up to a daily review. In essence, if the equity market does take a nose-dive, you should be prepared to dump some of your bonds in order to buy more equities at a lower price. Although this feels counter-intuitive, re-balancing to maintain proper risk exposure has been shown to reduce risk and increase the speed of recovery in an account after a market declines.
- Fourth, if you are within 10 years of retirement and have not taken the precautions indicated above, then this may be a prudent time to move to cash temporarily until you can put a game plan in place to eliminate some of this worry from your plan.
Why we don’t forecast:
- We don’t find any evidence supporting the validity of economic predictions, market forecasts, or analyst recommendations. Wall Street suggests these things matter, but academic studies have debunked these myths repeatedly.
- Over the past four decades, almost ½ of the market growth has occurred during 25 days. In other words, the market growth occurs in approximately ½ day per year. Missing these important days means giving up more than ½ of your growth. In order to benefit from the market you need to be invested on the days that matter and there is no evidence-based method of predicting in advance when those days will be.
The big unknown:
- Academic studies aside, the biggest unknown is what people’s emotions will do to their investment strategy. Remember though, that individual investors make up less than 30% of the large cap U.S. Market – meaning that it is large institutional investors who own the majority of the market. Institutional investors tend to be much less emotion-based in their decision making.
- Emotion does make a big impact on the market and we don’t want to ignore this.
Our bottom line:
- For most investors, we are not encouraging any major moves at this time for the reasons stated above.
- We are however, stepping up our re-balancing monitoring on a temporary basis and will contact clients on an as-needed basis if individual adjustments need to be made.
- For investors within 10 years of retirement, it is important that you are utilizing strategies to protect yourself, but those should be in place regardless of the “fiscal cliff”.
The article is for informational purposes only. It is not intended to be specific investment or tax advice and is not a recommendation, as everyone’s financial situation is unique. You should contact your financial, tax, and legal advisor to discuss your specific financial situation before taking any action.
Larson Financial Group, LLC, Larson Financial Securities, LLC and their representatives do not provide tax advice or services. Please consult the appropriate professional regarding your tax planning needs.