Advisors, Beware of Sharp Tax Increase in 2013, Expert Says

Andrew Friedman offers measures advisors should look at now to protect their clients against the coming tax hikes

Andrew Friedman, the former Covington & Burling attorney. Andrew Friedman, the former Covington & Burling attorney.

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Government affairs expert Andrew Friedman offered a warning to financial advisors to prepare for a steep rise in taxes likely to take effect just one year from now.

In a just-released whitepaper, Friedman, a principal in the Washington Update and a fixture on the financial advisory lecture circuit, outlined a number of scenarios that could take place following the congressional supercommittee’s failure to meet its deficit-cutting deadline last week. Friedman also offered financial planning ideas that advisors and investors could undertake to prepare for rising taxes, in a separate interview with AdvisorOne.

Friedman’s white paper argues that the supercommittee’s failure to reach an agreement was hardly surprising in the absence of a “forcing event” that in recent times has been necessary to break the political impasse in Washington. It was the imminence of a government shutdown in April that forced a congressional deal last April and the risk of a default on the national debt that prompted the August budget agreement (under which the supercommittee was created).

But, since that August deal included automatic (“sequestration”) budget cuts if the supercommittee failed to meet its deadline, there was no forcing event strong enough to induce the parties to make decisions their core constituencies would find unacceptable at this time.

Friedman underscores just how strong a forcing event must be, noting earlier errant forecasts about a downgrade in the U.S. credit rating and ensuing severe decline in equity markets: “Both of those events happened, yet Congress did not act. I obviously underestimated Congress’s tenacity to do nothing,” he writes.

Post-supercommittee, the  next battle over the budget will center on three major issues that must be resolved before the end of this year. First is the payroll tax, which will return to the usual 6.2% rate if Congress does not renew a temporary reduced rate of 4.2% set to expire at year end; the president wants to further reduce the rate to 3.1%.

A provision allowing investors to move up to $100,000 from an IRA to a charity to satisfy the required minimum distribution without incurring tax, and a “doc fix” that will avoid a 30% cut in Medicare reimbursements must also be addressed in the remaining weeks of the year.

Says Friedman: “If Congress passes these measures, the lost revenue in 2012 will exceed the entire 2012 cost savings achieved from the debt limit deal that consumed Washington this summer. In other words, after all the rhetoric, drama, and focus, the deficit actually would be slated to increase in 2012.”

Because of the politics of the presidential race, little is likely to occur in 2012 before the election, though Friedman outlines some disturbing potential scenarios in his white paper. But it is again the expiration of significant tax legislation at the end of next year that could force the hand of a lame-duck Congress with surprising and far-reaching results, Friedman says.

Forcing events at that time include the sunsetting of the Bush-era tax cuts on Dec. 31, 2012, and the draconian defense cuts that go into effect under sequestration the very next day. President Barack Obama has said he would veto any extension of the Bush tax cuts for families earning more than $250,000. Even if Obama is not re-elected, and even if a new, more Republican Congress is voted into office, it is the present Congress that must decide this question in a lame-duck session this time next year.

Friedman writes: “But President Obama cannot simply veto the extension of the Bush tax cuts for families with income over $250,000. If the cuts are not extended, taxes

increase across the board in 2013.” That would raise $3.5 trillion in additional revenue that will be necessary to override the then looming defense cuts most everyone will want to avoid. Ironically, it will also virtually erase the budget deficit, though at a cost of massive tax increases “which virtually everyone (including Democrats) agrees is counterproductive,” Friedman writes.

Given how unlikely any other deal between the president and the current Congress will be at that time, Friedman foresees sharply higher taxes taking effect in 2013. His advice to financial advisors:

“Investors looking to sell businesses or who have concentrated stock positions that they need to dissolve,” should begin preparations now. He expects the current 15% capital gains rate to be in the low 20s in 2013.

Also, he recommends aggressive gifting now. The current $5 million gift tax and estate tax exemptions ($10 million for married couples) will likely revert to $1 million in 2013.

Also, “I’d look at municipal bonds,” Friedman adds. “As tax rates go up, muni rates go up.” He advises investors to keep durations short since interest rates may rise as creditors like China demand higher returns on their bond investments.

Friedman concludes: “As it starts dawning on people that taxes can go up in 2013, selling pressure could affect the market. That could depress the market toward the end of next year,” he tells AdvisorOne.

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