Some sort of compromise was likely. Congress now acts only when there is a “forcing event”—a circumstance where the consequences of inaction are intolerable. The fiscal cliff was such a forcing event. What is worrisome is how much closer to the forcing event we got before a compromise was reached, and how, with each forcing event, Congress kicks an ever-larger can a shorter distance down the road.
Discussed below are the elements of the compromise, a discussion of what we might expect from Washington as 2013 begins, and steps investors might consider in light of these developments.
The Fiscal Cliff Compromise The compromise reached on New Year’s Eve:
• Permanently extends the current $5.12M estate, gift and generation-skipping tax exemptions, and
indexes the exemption amounts for inflation. The estate tax rate is increased to 40% (from 35%).
• Permanently “patches” the alternative minimum tax (AMT) to keep it from affecting more taxpayers in later years.
• Extends unemployment benefits through 2013.
• Extends through 2013 the provision permitting tax-free distributions of up to $100K from an IRA to a charity. This extension provides two favorable transition rules:
• An individual who took an IRA distribution in December 2012 may now contribute that amount to a charity and treat it as an eligible charitable distribution.
• An individual may make a tax-free charitable IRA distribution during January 2013 and treat it as made in 2012. At the same time, there were a number of things the compromise did not do:
• Extend the lower payroll tax rate in effect in 2011 and 2012. Thus, the payroll tax rate reverts to 6.2% (from 4.2%).
• Reduce government spending. The compromise delays for two months the implementation of the
“sequester” government spending cuts that were slated to begin in January 2013.
• Reduce the percentage of American families who pay no federal income tax (currently close to 50%).
• Prevent the implementation of the new 3.8% health care reform surtax on investment income for families with adjusted gross income over $250K ($200K for individuals).1 Because the health care reform surtax applies to families with income over $250,000, but the higher tax rates under the fiscal cliff compromise apply to families with income over $450,000, there are now three tax rates on investment income where before there was one:
Thus, the compromise added to, rather than reduced, the complexity of the tax code. Imminent 2013 Deadlines Finally, the compromise failed to reduce uncertainty and the need for short-term Congressional action.
To the contrary, the compromise leaves the country with three new “forcing events” in the first quarter
2013:
• On December 31, the United States hit its debt limit. The Treasury Department has said it can keep the government running without additional borrowing through the middle to the end of February. If Congress does not raise the debt limit by then the United States will be unable to pay interest on existing debt and will default on its obligations.
• The fiscal cliff compromise delayed the implementation of the sequestration cuts in discretionary federal spending only until March 1. If Congress does not act by then, government spending will be reduced by about two billion dollars over ten years. About half of those cuts will be reductions in defense spending.
• Congress has appropriated funds to run the government only through March 27. If Congress does not appropriate additional funds by that time, the federal government will shut down. As a practical matter, Congress is likely to address these three events together in seeking to craft legislation. A compromise will not be straightforward, however.
The Republicans—stung by the fiscal cliff deal that raised taxes without reducing government spending—will likely demand significant cuts in spending. And it is no longer possible to meet those demands simply by cutting discretionary spending. Only about a third of total government spending is discretionary (defense spending and domestic spending that funds the government agencies). Even if enough discretionary spending
could be cut to make a difference, the parties cannot agree on where the cuts should come.
In general, the Republicans want reductions in social programs, while the Democrats want cuts in defense. Thus, any reduction in spending must be found in the entitlement programs—Social Security and Medicare—that make up the bulk of federal expenditures.
The Democrats will likely demand that any spending cuts be “balanced” with new tax revenues. After the hard-fought compromise in December, another increase in tax rates does not appear to be in the cards. Thus, to satisfy the Democrats, tax revenue must be raised in another manner, such as by curtailing exemptions and deductions.
The home field advantage in this debate appears to shift to the Republicans. Obama held the leverage in the fiscal cliff battle—if Republicans did not meet his demand for higher tax rates, then taxes would go up on everyone. Now the Republicans can threaten to permit a default on government debt and to shutter the government if their demand for spending cuts is not met.
But the Republicans cannot negotiate with complete abandon. If Congress does not act, one trillion dollars of defense cuts will go into effect—cuts that are anathema to the Republicans. And, in reality, no one wants the U.S. to default on its debt, causing a likely breakdown in the world financial system.
Possible Changes
With discretionary spending and tax rates off the table, the discussion around the debt limit and the other upcoming forcing events is likely to involve possible changes to Social Security, Medicare and
the tax code.
The debate over Social Security is likely to focus on the rate of growth of Social Security benefits. Currently, benefits increase each year based on the consumer price index (CPI). The Republicans would like to replace CPI with “chained CPI.”
Chained CPI acknowledges that when the price of an item gets too high, people do not simply pay that higher price, they substitute something cheaper. If the price of beef gets too high, people buy more chicken. Chained CPI does not grow as quickly as conventional CPI. Thus, using chained CPI would slow the rate of growth of Social Security payments. Obama appeared to accept chained CPI in a compromise to raise the debt ceiling in 2011, although that compromise fell apart.
The Republicans might also insist on an increase in the eligibility ages for Social Security and Medicare. And they might propose “means testing” benefits, so that affluent recipients do not get all of their Social Security payments and pay more for Medicare coverage.3 None of these changes likely would apply to individuals currently over the age of 55.
On the tax side, both parties would like to implement comprehensive tax reform to simplify the tax code (although their definitions of “reform” might differ). But comprehensive reform—which requires reconsideration of each tax exemption and deduction currently available—is not possible in the short time available. Instead, Democrats are likely to seek an overall cap on tax exemptions and deductions claimed by affluent individuals and families. Obama and Mitt Romney suggested differing versions of such a cap during the presidential campaign.
A limitation on exemptions and deductions could have far-reaching consequences, including curtailment of the:
• Tax exemption for employer-paid health insurance premiums
• Exemption for interest paid on municipal bonds
• Deduction for pension plan contributions
• Charitable contribution deduction
• Mortgage interest deduction
Although the Republicans will object vigorously to such a cap, curtailment of at least some of these exemptions and deductions is likely to be included in a final plan. The plan also could include a number of “loophole closers,” perhaps directed at the tax treatment of master limited partnerships, carried interests in hedge funds and investment partnerships, and sophisticated wealth transfer techniques such as family limited partnerships, intentionally defective grantor trusts and grantor retained annuity trusts. None of these changes, however, are likely to apply retroactively (although this result cannot be assured).
What should investors do?
Given the higher tax rates implemented by the fiscal cliff compromise and the possibility of even higher taxes through the curtailment of exemptions and deductions, affluent taxpayers should consider the following:
• Give increased attention to harvesting losses and to buy-and-hold investment strategies.
• Consider tax-efficient mutual funds and other professionally managed tax-advantaged investment strategies.
• Prepay charitable contributions in the next few months.
• Pay down mortgage debt.
• Take advantage of sophisticated gifting techniques.
• Consider investing in annuities and life insurance, which offer tax deferral and provide for investors and their heirs.
1The 3.8% surtax applies only to taxable investment income. Thus, the tax does not apply to nontaxable income such as tax-exempt municipal bond interest or to life insurance death proceeds. Also, the tax does not apply to amounts withdrawn from qualified pension plans and IRAs. The 3.8% tax applies to taxable
investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual). For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income. Total adjusted gross income of $280,000 exceeds $250,000 by $30,000. Thus the 3.8% tax would apply to $30,000 of the dividend income. 2“Ordinary income” is income that is taxed at an unreduced rate. Types of investment income taxed as ordinary income include interest (other than tax-exempt interest), rents and royalties. Dividends, capital gains, and tax-exempt interest are not ordinary income, as they are taxed at lower rates (or not at all). Compensation income (income from a job) also is “ordinary income” because it is taxed at an unreduced rate. The 3.8% does not apply to compensation income. Instead, compensation income is subject to a new 0.9% surtax. The chart addresses only the taxation of investment income.
Family income Ordinary income Tax Rate2 Capital Gains/ Dividend Tax Rate
< $250K 35% max 15% max $250K – $450K 38.8% 18.8% > $450K 43.4% 23.8%
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3Affluent Medicare recipients already pay higher premiums for regular care (Part B) coverage. The proposal would require them to pay for catastrophic care (Part A) as well.
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About Eaton Vance
Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance and retirement products. He may be reached at www.TheWashingtonUpdate.com.
Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
Copyright Andrew H. Friedman 2013. Reprinted by permission. All rights reserved.
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