Almost immediately after the election, the national conversation turned to what is widely seen as an impending financial crisis known as the fiscal cliff. A dramatic term, for sure, but what does it mean for the economy, investment advisors and their clients?

The term "fiscal cliff" refers to a set of tax increases and spending cuts that will automatically take effect in January if Congress does not take action. On the tax side, the Bush-era cuts of 2001 and 2003, and their renewal in 2010, are scheduled to expire at the end of the year, while a number of other tax issues are in play, including an expiration of a temporary payroll tax holiday and the question of whether lawmakers will restore an elevated exemption level in the Alternative Minimum Tax. The expiration of the Bush-era cuts would increase rates on a broad measure of tax classes, including ordinary income, capital gains and dividends. Going over the fiscal cliff would increase federal tax collections by more than 20% next year, or more than $500 billion, according to the Tax Policy Center, a nonpartisan think tank. That would drive up taxes on nearly 90% of households by an average of $3,500.

The spending cuts stem from the 2011 Budget Control Act, the deal lawmakers reached to raise the borrowing limit for the federal government, which included a provision for cuts to lower the deficit by $2.1 trillion. With the failure of a bipartisan joint select committee to reach a deal on deficit reduction, $1.2 trillion in cuts would begin to take effect on Jan. 1, 2013, a prospect both parties are eager to avoid.

"The specter of harmful across-the-board cuts to defense and nondefense programs was intended to drive both sides to compromise. The sequestration itself was never intended to be implemented," the Office of Management and Budget wrote in a report outlining the impact of the cuts. "The administration strongly believes that sequestration is bad policy, and that Congress can and should take action to avoid it by passing a comprehensive and balanced deficit reduction package."

Where Are the Political Fault Lines?

On Friday, President Obama met with Republican congressional leaders for the first time since winning reelection to begin the negotiations. Leaders of both parties expressed confidence that they could reach a deal, though compromise on tax issues has been in short supply of late. Obama has held firm that taxes must increase for top earners, setting the threshold of $250,000 in household income. Congressional Republicans have signaled their willingness to negotiate on revenue increases, though it remains unclear whether they will be amenable to rate increases, as the president has proposed, or hold firm in their insistence that any increases come in the form of closing exemptions and deductions.

What's at Stake: Recession Looming?

Anxiety over the fiscal cliff has been fueled by dire projections from economists who forecast a return to recession if Congress and the White House can't reach a deal to avert the across-the-board tax increases and spending cuts. The nonpartisan Congressional Budget Office has projected that "if all of that fiscal tightening occurs," GDP will drop 0.5% in 2013, weighed down by a particularly sluggish first half of the year, before economic activity begins to revive in the third and fourth quarter. Unemployment, however, would remain a lagging indicator.

"That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1% in the fourth quarter of 2013," the CBO projects.

But it's important to remember that economists at the CBO and elsewhere are working with a set of hypotheticals that assume that lawmakers and the president will fail to reach a deal. And their warnings, with the attendant effects on markets and business investment, are contributing to a sense of urgency that could spur policymakers to compromise, according to Neil Simon, vice president for government relations with the Investment Adviser Association, who says he is "cautiously optimistic" that Congress and the president will strike a deal to avert the fiscal cliff before year's end.

"I think the concerns about a double-dip recession are real. And I think there is very, very high awareness on Capitol Hill, and that's one of the reasons congressional leaders are likely to resolve it," Simon said "I think there's an increasing likelihood that there will be a deal before the holidays."

What's at Stake: Market Volatility?

Without a doubt, the days following the election have not been kind to the markets, as uncertainty over the government's ability to deal with the fiscal cliff have contributed to several hundred-plus point selloffs. As of Friday afternoon, the Dow Jones industrial average was down more than 600 points in the month of November.

Some of that uncertainty can likely be attributed to investors' concerns that capital-gains rates and dividends could be in flux, as discussed below.

"I think we're going to see a lot of money in motion in the next couple months," said Andrew Friedman, principal at the policy-analysis group Washington Update.

But there could be an upside. Just as the chorus of recession warnings from economists could spur policymakers to action, the market fluctuations might also prove a catalyst for compromise.

"Ideally, what does not happen is a repeat of August 2011, when markets went into riot mode during the debt-ceiling debacle and subsequent downgrade of U.S. debt by Standard & Poor's. Unfortunately, it is a distinct possibility," Liz Ann Sonders, senior vice president and chief investment strategist with Charles Schwab, wrote in a blog post on the fiscal cliff. "I do expect the markets -- more likely on the stock side -- to play an important role as a messenger to our politicians."

Simon, who like Friedman is optimistic that a deal will be struck to avoid the worst fallout of the fiscal cliff, suggested that the current period of market turmoil will be shortlived.

"I think it's critical to take the long view right now," he said. "To the extent the volatility is based on uncertainty about the fiscal cliff, I think that will be resolved shortly."

Is it Really a Cliff?

While it is true that lawmakers face a hard year-end deadline to preserve the current low tax rates and avert automatic spending cuts, a more apt metaphor might be a slope, rather than a cliff. If Congress and the White House can't reach a deal of any kind, tax rates for all Americans will increase, as detailed below, but lawmakers could return to session in January and pass a bill that would retroactively restore the prior rates, preserving the current tax picture for some -- or even all -- Americans. In that scenario, the markets could still experience a jolt, but the tax situation for investors would ultimately remain unchanged.

Similarly, there is broad agreement that the automatic cuts entailed in the sequester would have a harmful effect on the economy and undermine critical government programs -- national defense chief among them. In that light, many observers expect that lawmakers will strike a deal -- sometimes referred to as a "bridge" -- to postpone the cuts into 2013 when Congress will have more time to hash out a larger bargain that includes broad tax reforms and spending reductions.

"It's really less of a cliff than it is a descent," Simon said. "I think it's very, very likely that sequestration, if not repealed, would be pushed back. I don't see it happening."

If Obama holds to his oft-repeated assertion that he will accept no deal that does not include higher taxes on top earners -- whether that comes in the form of rate increases or closures of loopholes and deductions -- it seems clear that in the end, at least some investors will see their tax situation change. In gaming out the scenarios, observers have suggested that congressional Republicans, many bound by a pledge they have signed vowing not to support any form of tax increase, could withhold support for any measure that would come up this year allowing any portion of the Bush-era tax cuts to expire. Then, with the new higher rates taking effect in January by default, they could come back to the table to support a package reducing rates for all but the top earners that the White House would accept. In that scenario, what Friedman calls political "sleight of hand," they would be casting a vote for a tax cut, and thereby not violating the letter of the Americans for Tax Reform pledge, even if the net result saw taxes increase for wealthy Americans.

Medicare Surcharge on Investment Income

Even if Congress and the administration agree to extend the current rates on dividends and capital gains, it's important to recognize that taxes on investment income for the wealthy will still increase next year. That's because of one of the funding mechanisms included in Obama's health care law, which adds a Medicare surcharge of 3.8% on investment income -- capital gains, dividends and interest -- above a threshold of $250,000 for married couples and $200,000 for others.

As a result, reports describing the impact that going over the fiscal cliff would have on top rates can be confusing, because they often include the Medicare surcharge, which will take effect regardless of how lawmakers address the Bush-era tax cuts.

With the debate over health care effectively settled, high-end investors can expect to pay the 3.8% surcharge on investment income realized in 2013 no matter what happens with the fiscal cliff. But the surcharge doesn't apply to certain types of income, including tax-exempt interest from municipal bonds, rental income (from actively managed real estate) and Roth IRA distributions, a condition that could tax-conscious investors may want to consider.

Capital Gains Tax Rates

The top tax rate for income from capital gains is currently 15%. If policymakers can't reach a deal, that rate will jump to 20% in the New Year, making for a top effective rate of 23.8% when adding the Medicare surcharge for top earners.

Absent congressional action, the marginal tax rate on long-term capital gains would increase by about seven percentage points. "If investors believe it will actually happen, the pending increase in the capital gains tax rate could induce them to sell appreciated stocks, bonds and other assets before the end of 2012," analysts at the Tax Policy Center wrote in a policy paper on the fiscal cliff. "That would create a temporary spike in realizations, much as happened in 1986," the last time Congress enacted comprehensive tax reform.

Dividend Tax Rates

The top tax rate for dividend income is currently 15%. With no action from Congress, that cap would expire at the end of the year and dividend tax rates would align with tax rates on investors' ordinary income, with a top rate of 39.6%, or 43.4% when considering the Medicare surcharge.

Friedman anticipates that any deal lawmakers can reach would prevent dividend rates from spiking to the ordinary-income rate, likely keeping dividends in line with capital gains.

The prospect of an increase on dividend tax rates is significant because it naturally suggests that dividend-paying stocks would become a less attractive investment. That's why organizations such as the Edison Electric Institute, a group representing shareholder-owned utilities, are calling on Congress to preserve the current rates, warning that a sell-off of utility stocks would sap their share prices, affecting the financial plans of investors who count on those holdings as a source of income or as part of their retirement strategy.

"Companies and shareholders make their investment decisions with an eye toward the long-term future. They know that Congress has acted in recent years to keep the tax rates on dividends low for all investors, so a future tax increase may not be reflected in current stock valuations," according to the institute. "This raises the likelihood that financial markets and our nation's economy will suffer further if Congress and the president do not act to extend the current dividend tax rates for all taxpayers."

Alternative Minimum Tax (AMT)

The last time Congress addressed the AMT, it was with a so-called patch that shielded millions of Americans from additional tax burdens. That patch expired in 2011, and lawmakers on both sides of the aisle are eager to extend it retroactively to keep taxes low for the 2012 filing year.

"If the AMT is not 'patched' before the end of the year, an estimated 25-30 million Americans will pay higher taxes for 2012 -- meaning on the returns they file this coming February, March and April," explained Michael Townsend, Schwab's vice president of legislative and regulatory affairs. "Neither party wants this to happen."

The 2011 patch increased the exemption level to $74,450 for couples and $48,450 for other filers.

Estate and Gift Taxes

If no action is taken, the maximum exemption under the estate and gifts taxes would revert from the current level of slightly more than $5 million to $1 million, with the top rate jumping from 35% to 55%. As a result of changes to the estate tax alone, more than 10 times as many estates would be subject to the tax in 2013 as they were this year, according to the Tax Policy Center.

Friedman expects that members from both parties will agree that the $1 million exemption is too low, and might find a compromise in the range of $3.5 million up to the current $5 million mark. He expects that the gift tax could be handled differently, and that the exemption level that policymakers ultimately settle on will be lower than the estate tax, suggesting that investors planning a sizable wealth transfer consider acting soon to take advantage of "historically low" rates.

Payroll Tax

A two percentage-point cut in the payroll tax, always intended as temporary, is also scheduled to expire at the end of the year, meaning that households with employees would see their expenditures rise. Taken together, the payroll tax increases would affect some 120 million households, the Tax Policy Center estimates.

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