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Craig Allen: Financial Planning Complicated by Possible Expiration of Bush Tax Cuts

Regardless of your position on the politics, you'd better make sure you're prepared for the fallout

The phrase “Bush tax cuts” refers to changes to the U.S. tax code passed originally during the presidency of George W. Bush through the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Frequently, the key aspects and implications of these two acts are spoken of collectively as the Bush tax cuts.

The Bush tax cuts had sunset provisions that made them expire at the end of 2010. Whether to renew the lowered rates, and how, became the subject of extended political debate. These tax cuts were extended for two years during the presidency of Barack Obama as part of a larger tax and economic package — the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.

“Taxmageddon” is a term coined by congressional aides to refer to the Dec. 31, 2012, expected implementation of government spending reductions and the expiration of a large number of tax cuts, including the Bush tax cuts. In a report released in May, the Congressional Budget Office predicted that these policy changes could lead to reduced economic growth, significant enough to be considered a recession. In fact, many economists are predicting a second, or double-dip, recession some time in the first half of 2013, largely as a result of the expiration of the Bush tax cuts.

The increase in taxes that is due to occur when the Bush tax cuts expire at the end of 2012 has been described by Republicans as the largest tax hike in U.S. history, (although the United States would be returning to Bill Clinton-era tax levels). According to The Associated Press, the increase would be the second largest after the tax increase of 1942, if population growth, increased pay and the size of the economy are taken into account.

Based on figures from the CBO and the Joint Committee on Taxation, federal taxes would increase by a total of $423 billion in 2013, if the tax cuts are allowed to expire. The nonpartisan Tax Policy Center has estimated that for 83 percent of households in the United States there would be an average tax increase of $3,701. The Heritage Foundation, however, said that those affected by the tax cuts’ expiration would be primarily in the middle- and low-income groups, with its research finding that families would experience an average tax increase of $4,138.

According to the Center on Budget and Policy Priorities, the expiration of the Bush income tax rates (i.e., returning to Clinton-era rates) would affect higher income families more than lower income families. The Bush tax cuts reduced income taxes for those earning more than $1 million by $110,000 per year on average during the 2004-2012 period. The tax cuts made the tax system less progressive. From 2004 through 2012, the tax cuts increased the after-tax income of the highest-income taxpayers by a far larger percentage than they did for middle- and low-income taxpayers. During 2010 for example, the tax cuts increased the after-tax income of people making more than $1 million by more than 7.3 percent, but increased the after-tax income of the middle 20 percent of households by just 2.8 percent. Keep in mind, though, that the percentages are not as important as the dollar amounts paid in as taxes.

In general, Republicans want to extend the Bush tax cuts, or to put it another way, they do not want to increase taxes, while Democrats want to allow the Bush tax cuts to expire on everyone making more than $250,000 per year. Regardless of where we stand as individuals on these tax issues, from a financial planning perspective, the uncertainty surrounding the scheduled expiration and the contentious debate on whether to extend the cuts makes planning a huge challenge.

While it is certainly possible, especially if the Republicans win the White House and control Congress, that the Bush tax cuts could be extended, there can be no doubt that taxes will have to increase at some point in the near future. The national debt is above $16 trillion now, and is rising at an increasing rate. This is occurring when interest rates are at all-time lows. Once interest rates begin to rise, the cost of financing our debt will skyrocket, forcing us to borrow even more money to “pay” the interest. This is, quite simply, unsustainable. We will be forced to raise taxes and cut spending to balance our budget each year, and to eventually generate a budget surplus so we can begin to repay our massive national debt. This means that taxes will go up for just about everyone, eventually.

It is highly likely that those earning more will be forced to pay more. We already have a progressive tax system, meaning that, as income increases, the percentage tax charged on that incremental income also goes up. It is likely that our tax system will become even more progressive, meaning that higher income earners will be forced to shoulder an even larger percentage of the total tax burden each year. Today, the top 1 percent of income earners pay 36.73 percent of total personal income taxes; the top 5 percent pay 58.66 percent while the top 10 percent pay 70.47 percent. From this data, it is clear that the top income earners, despite how the Democrats spin it, are paying the bulk of taxes. However, these percentages will no doubt increase even further, especially if the Bush tax cuts expire, and I believe in the future, even if the Bush tax cuts are extended for a time.

From a financial planning perspective, those with incomes above $250,000 per year who have opportunities to recognize income in the 2012 calendar year will want to consider doing so. Business owners with cash sitting in their companies that is untaxed may want to go ahead and take that income as a dividend if possible. Those who plan to take income in this way who also have unrealized losses may want to combine those losses with recognizing income to minimize their tax burden. If tax rates rise in 2013 as a result of the Bush tax cuts expiring, it will be cheaper from a tax perspective to recognize this income for the 2012 tax year, unless there are planned losses or other income offsets that could reduce taxes in 2013 or subsequent years. (Anyone considering any change that will have tax implications are strongly advised to consult with a tax expert before making any changes.)

Another consideration for investors with incomes above $250,000 who have significant unrealized capital gains. Both short-term and long-term capital gains rates are set to increase if the Bush tax cuts expire. Additionally, the dividend tax rates will increase. These possible changes have significant implications for portfolios. In the big picture, we may see disruptions in securities markets as those with capital gains realize profits to reduce their tax burdens. Investors wanting to take advantage of the current tax rates for capital gains may decide to sell positions, thus driving markets down. On an individual basis, investors may benefit from these sales by reducing their tax burden, and also possibly avoiding a significant correction in the market. Dividend-paying stocks may lose a bit of their luster if the tax advantage associated with those dividends in diminished when tax rates rise.

Investors should carefully review and evaluate their portfolios in the context of the possible expiration of a portion or all of the Bush tax cuts to understand the implications and risks these cuts will cause for their investments. From a financial planning viewpoint, everyone should have a comprehensive plan in place that includes an analysis of the possible direct and indirect impacts the expiration of the Bush tax cuts may have on each person’s financial situation. My best advice is not to wait until the end of the year to begin analyzing and evaluating these important financial issues. Now is the time to address it, and those who do not have a plan in place should take this opportunity to formulate a solid financial plan.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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