‘Tis the season for making tax decisions and this year is a real cliffhanger. Investors and their advisors are trying to anticipate what Washington will or won’t do about the coming budget deadline known as the fiscal cliff. Take profits now to avoid higher taxes later? Dump those dividend-paying stocks and buy municipal bonds? Hold your loss positions over until next year? Delay that extra IRA contribution?
This frenzy is making people anxious, goading some into making decisions that require guesswork about a host of interconnected events over which they have no control. Yes, you might benefit from timing your gains, especially if you’ve just won a couple hundred million in the Powerball and a tax increase could take a $10 million bite out of your winnings.
Ordinary investors who let themselves be spooked into action overlook a fundamental flaw when they do so—just like you can’t time the markets, you can’t game government tax and economic policies.
The economic issues of the day—tax rates, inflation, interest rates and so on—are always going to be with us, year in and year out. There is, in effect, always going to be a fiscal cliff over which none of us has any control and which we cannot anticipate reliably enough to use as a basis for our long-term investment decisions.
The public debate that’s taking place now—whether to raise, lower, or keep our current tax rates—is an opportunity to stop and think about how tax rules in general govern your financial life and what you can do to get some of that control back.
The average investor and saver who is trying to build a nest egg for retirement should not be worrying about what Congress is up to, or which political party controls which branch of government, or whether there will be another stimulus.
In fact, most investors have already given up control of their portfolios and their liquidity—the flexibility to get access to their money at any time—in exchange for tax breaks that may, and frequently do, come back to haunt them. Attractive capital gains or dividend tax rates save cash today but there is always a bill to be paid when we want our investment money back.
One example that’s hitting more baby boomers every day are the rules governing the sale of principal homes, second homes and vacation homes that have been rented out. When they were enjoying the depreciation deductions on their tax returns, those owners never considered what effect it would have decades later when it came time to downsize and sell. And they certainly couldn’t have anticipated rule changes in 2008 that make it possible to sell a home or condo at a loss but end up with a big tax bill.
If you want to profit from any fiscal cliff, conduct your financial life with the understanding that what the government gives, the government takes away. Federal tax policy creates the incentive through IRAs for people to put their retirement money at risk in stocks and bonds in the expectation they will earn higher returns than they could elsewhere.
Very few people I meet ever think about what the tax rate and tax policies will be when they’re going to need that money. Very few people truly grasp the possibility that when they reach retirement, the assumptions they made about gains may not have materialized. Global economic conditions, inflation, interest rates, tax rates, and so on are all wild cards in retirement plans if they rely on mutual funds and equivalent vehicles.
If you really want to profit from this fiscal cliff, learn the lesson that by the time you reach retirement age, the money you’ll need for the rest of your life probably shouldn’t be tied up in assets subject to risk and to changes in tax policies.
But that’s what government policies encourage, and with good reason—economists understand that a dollar of tax revenue the government defers today will be worth many times that when the taxpayer retires and starts drawing on his or her IRA, when you add in inflation, gains, and possibly tax increases.
Investors should be talking with their advisors about the control they’ll have and the liquidity of their retirement plans. They should be asking how they can be sure to end up their working lives with the money they’ll need in cash or cash-equivalent vehicles, not subject to market risk or cumbersome, fluid tax rules.
It may be that a business owner or professional might put the money they’d ordinarily put into an IRA into growing his or her business, over which they have control and flexibility. Cash-value life insurance is another vehicle that gives you control and access to your money when you need it.
One of the most common mistakes people make is accelerating principal payments on their mortgages. That, like mutual-fund IRAs, means losing control and liquidity of your money. Once it’s in the house, the only way to get it out is to take out another mortgage (expensive and not guaranteed), or sell the house (slow, expensive, and not guaranteed). Money that could be used to pay down a mortgage might instead be used to build up a liquid reserve of funds for emergencies. You’d have control and liquidity—if you were to have a crisis that interrupted your income, you’d have the cash to continue making those mortgage payments.
Life is one fiscal crisis after another. Those who get through them with portfolio and sanity intact tend to be those who limit the degree of control taxes and other factors have over them by balancing their assets between those that offer the possibility of gains with funds that are safe, liquid, and in their control.