American Taxpayer Relief Act (ATRA) a.k.a. Fiscal Cliff Deal

I’ve parsed through the legislation (which can be found here if you want to check it out for yourself), as well as a ton of analysis, and to the best of my ability, here’s a quick summary of the relevant portions of the new law that averted the tax portion of the fiscal cliff. Note that while $400k/450k are getting all the press for paying higher taxes, there are a number of provisions which impact $200k(single)/$250k(married), and one really big one that impacts everyone (Payroll Tax Holiday Ended):

· Income Tax Rates: All existing rates remain the same with brackets increased for inflation (10%, 15%, 25%, 28%, 33%, 35%) and a new 39.6% bracket begins at taxable income over $400k for singles and $450k for joint filers.

· Long-Term Capital Gains: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to 20% for everyone. The legislation keeps the 0% and 15% rates for everyone except those in the new 39.6% tax bracket. They’ll pay 20% (not including the new Obamacare Medicare Surtax, see below).

· Dividend Rates: These were set to move from 0% for the bottom two tax brackets and 15% for everyone else to ordinary income rates for everyone. The legislation keeps this rate tied to the long-term capital gains rate with the same rules as above.

· Estate Tax Rates & Exemption: Retained the $5M per person exemption (was set to reset to $1M) and kept it portable (each spouse gets $5M instead of the couple getting $10M which forces complicated bypass trusts to be set up to try to use the $5M from the first to die spouse). Set the top tax rate at 40% (up from 2012’s 35%, but down from the 55% to which 2013 was due to revert).

· AMT Exemption: Patched the AMT exemption amount to the 2011 amount, increased for inflation. This was a big one since it was 2012 they were fixing, not 2013. Even better, they permanently fixed this so that each year’s exemption will be indexed to inflation going forward. This means no end of year scramble to get an AMT patched passed each year.

· Phaseout of Itemized Deductions: this was due to happen in 2013 without any new law, but ATRA tweaked the thresholds. If you are Single with AGI over $250k or married with AGI over $300k, your itemized deductions will be reduced by 3% of the amount that your AGI exceeds the threshold, up to a maximum reduction of 80% of your itemized deductions. To simplify, if you’re over the threshold by $10k, you lose $300 of itemized deductions. If you’re over by $100k, you lose $3k.

· Phaseout of Exemptions: this was also due to happen in 2013, but ATRA unified the phaseout level with the Itemized deduction phaseout. If you are Single with AGI over $250k or married with AGI over $300k, your exemptions ($3800 per family member) are reduced by 2% for every $2500 that you’re over the threshold. To simplify, if you’re over by $10k, you lose 8% of your exemptions. If you’re over by $100k, you lose 80% of your exemptions. This can be a pretty big bite.

· Payroll Tax Holiday Ended: this was due to happen in 2011, but was extended for two years and now is finally gone. It impacts everyone with income from work (employment or self-employment) by restoring the employee portion of Social Security (FICA) tax to 6.2% from 4.2%. This means everyone will pay 2% more tax in getting this level back to its pre-2011 setting (which still grossly underfunds Social Security over the long-term).

· Marriage Penalty: The standard deduction for married filers and the 15% tax brackets were due to revert to 1.67x the single amounts. ATRA kept them at 2x the single amount and made that change permanent. There is still a very large marriage penalty in the code anyway, as described here.

· Bonus Depreciation & Higher 1st Year Expensing: For business owners, 50% bonus depreciation on new purchases is extended into 2013 as is the higher limit for immediate expensing of certain purchases (Section 179).

· Misc. Permanent Extensions: Child Tax Credit ($1k per child subject to limits), Exclusion for Employer Provided Tuition Assistance ($5250 tax free reimbursement).

· Misc. Temporary Extensions: American Opportunity Tax Credit (college), teacher’s deduction ($250), exclusion from discharge of debt on primary residence (no income on short-sale or foreclosure), deduction for Mortgage Insurance Premiums, Deduction for State and Local Sales Tax paid (big in no income tax states), Tuition Deduction.

While not included in the ATRA legislation, it’s important to remember that two new fairly large changes also being in 2013 as Obamacare is rolled out. They are:

1) 0.9% Medicare Surtax on earned income (income from work) that exceeds $200k (single) or $250k (married). It’s important to note here that this will cause underwithholding from your employer if you have multiple jobs or are marred and both spouses have income since payroll systems will not realize that your earned income will exceed $200k/250k until you exceed that amount from a single employer.

2) 3.8% Medicare Surtax on investment income (interest, dividends, capital gains, rents collected, passive business income) if your Adjusted Gross Income exceeds $200k (single) or $250k (married). While there is no withholding on most investment income and you’re used to paying tax when filing or making estimated tax payments on that income through the year, the 3.8% additional tax effectively raises the tax rates on interest, dividends, gains, etc., even if you don’t meet the now well-publicized $400k (single) / $450k (married) income from the fiscal cliff deal.

I have no doubt that more tax changes will come in 2013 and/or 2014 since ATRA only reduces the > $1 trillion deficit by ~$60 billion per year, so it’s hard to count on anything above as permanent even where legislation made it permanent. The next major debate, likely to be more focused on spending than taxes will be in February as the Debt Ceiling will need to be raised again at that time. It’s quite possible that taxes, especially beyond 2013, become part of that negotiation as well.

Fiscal Cliff Deal Update 12/31

At the 11th hour, as expected, here comes the mini-deal. All speculation so far, but here’s what it’s looking like:

· Threshold for income tax rate increase would be $400k for individuals or $450k for families. Top rate on these taxpayers would increase from 35% to 39.6% though the marginal rates below that level will remain the same as they are now.

· Long-Term Capital Gains rates AND dividend rates go to 20% from 15% (but not 39.6%) for those above the $400k/450k income level. 15% would be maintained for those below.

· Extension of unemployment benefits for ??? time

· AMT Patch for 2012

· Deferral of sequestration-related spending cuts for a limited amount of time

· 40% top tax rate on estates over $5M (per individual??), up slightly from current 35%

Details still to be worked out. Votes in both the Senate and House required to pass. Not a given by any means. This would also do nothing for the debt ceiling (which needs to be raised sometime around late Feb / early Mar) and does VERY little to close the $1 Trillion per year deficit at the heart of the matter.

Fiscal Cliff Update

Reporters are already beating this story to death, but I wanted to provide a quick update from my perspective. Going over the Fiscal Cliff means higher taxes for all via the expiration of the 2001 and 2003 tax cuts, and forced spending cuts via the sequestration that was agreed upon during the debt ceiling debacle last year. We will technically go over the cliff on Jan 1 if Congress and the President don’t pass a law to extend the tax cuts and/or modify the sequestration. By now, everyone knows that. Ultimately, the “answer” is not to perpetually extend tax cuts and keep spending more than we can afford. But, the idea is to extend some of the tax cuts and some of the spending until the economy is back on its feet while setting the stage for major tax and entitlement reform in 2013/2014.

What isn’t as readily apparent is that virtually everything that changes if we go over the cliff can be modified retroactive to Jan 1. I hate to get into politics on this blog, but there seems to be a substantial incentive to go over the cliff, or come as close to it as possible, and then to place blame on the other party for doing so while each party is able to appeal to its base for sticking to its guns. Speaker Boehner’s re-election vote is on Jan 3 and the odds of re-election are thought to be higher if he stands his ground, consistent with the motivation for each party to obstruct progress and issue blame. Then, post Jan 1, after payroll systems are at the deadline for change to charge higher taxes, markets are on edge, constituents are threating to stop funding Congressional election campaigns, etc., a deal can be reached without losing face.

Whether a minor deal is passed on 12/31 or in early January is not relevant (2012 AMT exemption aside – this will almost certainly get passed). What is relevant is avoiding a traumatic shock to the economy and laying the groundwork for long-term reform, at least far enough to prevent another debt downgrade, and prevent the market from demanding higher interest rates in order to lend money to the US government. It’s hard to have faith in government at this point. But, as Winston Churchill supposedly once pointed out, you can always trust Americans to do the right thing once all other possibilities have been exhausted. I believe we’re getting close to that exhaustion.

One more thing… a CNBC commentator recently drew a parallel between Congress’s fiscal cliff actions and term paper deadlines saying, “Did you ever turned in a term paper ahead of its deadline?” Of course the answer for virtually everyone is a resounding “No”. Congress acts similarly. However, I think this is a little different. This is like a term paper where you’re penalized one point for every day late. If the deadline is 12/31, you would be tempted to miss the deadline by a few days, but would be unlikely to never turn in the paper. Even though the incentive to turn it in on any particular day is fairly low and you might be ok with losing a few points, there comes a time where you start to add up the damage, sit down at your computer, and just get it done. Damage will be done to the economy and to confidence each day that passes beyond 12/31, but it’s important to note that we’re not going to immediately get an “F” or fall off a cliff into the abyss, despite claims from ratings-hungry reporters. Markets will get antsy, reporting will get ugly, and the political blame game will be enhanced to its highest level yet. But, as long the short-term is handled in the next few weeks and the long-term is handled in the next few years, this crisis will pass like all others before it.

Have a Happy New Year. The Mayan’s couldn’t take it away and neither will the Politicians.

2013 Tax Changes & “The Fiscal Cliff”

By now everyone has heard of the tax increases and spending cuts that will take effect in 2013 under current law, not-so-affectionately-called “The Fiscal Cliff”. This post takes a look at many of the tax changes which will have a broad impact on individuals and joint filers regardless of income. While the list is not all-inclusive, it covers most of the changes that would affect individuals and couples (leaving out some of the business tax impacts). Some of these may come as a surprise since they don’t get much attention in the press. The chart below shows the changes as they are currently on the books, the impact of each change if left as is, and the probable outcome of efforts to avoid the Fiscal Cliff.

The probable outcomes on the changes above are not likely to close the deficit enough to prevent another rating downgrade of U.S. debt, especially if the proposed spending cuts are also scaled back to avert the fiscal cliff. To close the deficit, a broader “grand bargain” will be necessary to cut spending on entitlements and discretionary items while raising tax revenue through a major tax revamp. There is no time for this to be negotiated in late 2012 / early 2013, but I think it’s on the table toward the end of 2013 / beginning of 2014, especially if motivated by the debt rating agencies and/or market-based increases in long-term interest rates as the U.S. loses credibility as a borrower. The solution needs to be a balance of higher taxes and reduced government spending, but most of it needs to be focused on long-term changes, rather than sudden short-term shocks to the economy. I suspect this will include pushing out the SS retirement age for those currently below age 50, greater Medicare limitations and/or higher Medicare premiums for those currently below age 50 when they reach Medicare age, an increase in the SS wage base, means testing of both Social Security and Medicare (i.e. if you have high income from other sources in retirement, you’ll receive less from these programs), a slight reduction in marginal tax brackets, a large reduction in items that are excluded from income or deductible (especially for mid-high incomers), and a modified AMT that will impose a minimum effective tax rate on all income for those earning $1M or more. It’s too early to know specifics, but I’ll continue to post about these items as ideas run through Congress and become more than just speculation.

Market Update 7/5/2012

*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients just after the start of Q3 2012 as part of that communication effort***

Q2 2012 proved to be yet another roller coaster quarter in the financial markets led mostly by continuing debt problems plaguing European governments & banks, and the economic slowdown driven in part by fear and in part by the austerity measures that are being put in place to try to rectify the debt overhang. After losing much of the Q1 gains through the month of May, markets rallied back in June on hopes of progress in Europe following the latest Greek elections (a win for the party that wants to stay in the Euro), a hint that Germany may be willing to concede to a cross-country banking union of some sort, and the extension of Operation Twist by the U.S. Federal Reserve (thereby also extending hope of more easing in the future). US stocks a whole lost just over 3% for the quarter, with international stocks losing just over 7%. U.S. interest rates continued to fall with short-term rates pinned near zero and long-term rates plunging to historic lows (U.S. 10-year yields just under 1.6% as I type this note). This helped bond funds to perform fairly well in aggregate, up about 2% for the quarter. Commodities fell on global growth concerns, down 4.5% for the quarter with energy components leading the way down. While investments in commodities lost value, the economy as a whole likely felt some relief from declining energy prices which helps consumer confidence and more importantly, consumer budgets. As we noted in our Q1 update, we expect risk assets like stocks and commodities to continue to remain volatile, both up and down, for the short-term, with bonds in aggregate generating fairly constant, albeit low returns. Interestingly, the national average rate on a savings account is now 0.12%. While it doesn’t get much safer than an FDIC-insured savings account, with year over year inflation running close to 2%, that’s a guaranteed loss of almost 2% per year by keeping money in cash.

While much has been blamed on Europe over the last two years, the U.S. faces its own issues heading into 2013. At current pace, we borrow approximately fifty cents of every dollar we spend as a government. This completely unsustainable way of running of the country will take its toll at some point in the future. The good news is that we seem to know that we have a problem. The bad news is that the method by which we fix it is heavily debated by our two political parties, each seeming to move toward a more extreme position as time goes by. It would be difficult to call them deadlines, but at least strong milestones loom in the not too distant future with the major credit ratings agencies noting that if the U.S. doesn’t come up with a credible plan for reducing the deficit by the start of 2013, another rating downgrade will follow. As current law stands, three dramatic changes are scheduled to be implemented in 2013. These have become known in aggregate as “The Fiscal Cliff”. They include the sequestration of defense spending budgets, the repeal of the 2001 & 2003 tax cuts which will increase tax rates on everyone who pays U.S. taxes, and the next steps in the implementation of the new healthcare laws which will institute a new Medicare surtax on certain individuals. If these changes go into effect, they combine spending cuts with tax increases in a slowing economy that is plagued by high unemployment already. This dramatically increases the possibility of another sharp recession. If the changes don’t go into effect and no other credible plan is put into place to balance the budget over time, the credit worthiness of the U.S. will come into question. If/when that happens, borrowing costs will start rise, putting more pressure on the budget (higher interest payments) and that spiral of debt that is all too familiar in southern Europe could attack the U.S. in much the same way. The answer to this problem in our opinion is one that Congress will get to eventually. That is, easing the Fiscal Cliff for the short-term and simultaneously publishing a credible plan for the long-term, likely through an overhaul of the tax system and a review of programs like Social Security and Medicare that are growing to levels we can’t support over the long-term. What’s not clear is whether the will exists to accomplish this before sharp and severe economic realities hit.

Led by the election in November, we believe the issues in the U.S. will come to the forefront over the next few months. It is likely that the stock market will gyrate, perhaps wildly at times, as solutions are brought forward and political power for the next 2-4 years is revealed. Further stimulus by the Federal Reserve, possibly in a coordinated effort with central banks around the world, will become more likely if economic conditions deteriorate. Monetary stimulus would continue to provide a temporary floor to the economy and to asset prices by simply pumping more money into the banking system. If the Fed does this, cash is one of the worst places to be as interest rates will continue to near zero while inflation would likely pick up as more money enters the financial system.

What all of this means is that we’re unfortunately stuck in the middle of a potentially deflationary bout of economic deterioration (where we’d want to hold cash and bonds and avoid stocks and commodities) and a potentially inflationary move by the Federal Reserve and other central banks to offset that economic deterioration (where we’d want to avoid cash and bonds and own stocks and commodities). The market in aggregate continues to do a very good job of pricing the risks to both sides. The current best course of action is to maintain asset allocation targets and continue to take advantage of volatility through portfolio rebalancing. We are monitoring the economic landscape closely and are prepared to take action if risk/reward does come out of balance in the coming months. If the market rally significantly from here on a perception that the world’s problems are solved, we will likely move toward more conservative portfolios by adjusting all models and using hedging positions where appropriate. For now though, we believe the inflation/deflation scenario is well-balanced and that stocks, especially in comparison to other asset classes, remain well-priced.

More on the fiscal cliff, stock valuations, Europe, and a host of investment and other personal finance topics will be presented on the new PWA blog which is officially live as of today ( In future quarters, rather than sending you emails like this, we’ll be posting shorter, more easily digested ruminations on the blog. You can subscribe to receive emails on new blog posts if you prefer to receive the content in your inbox rather than on the sites. Our Facebook and Twitter pages are also live, though with each still under construction and notably light on content (as is the case for all new pages). We’ll rectify that shortly. Feel free to provide encouragement by “Liking” & “Following” us. You can find links to all the pages via the icons in the signature below. For those of you who have made it this far into reading this email, you’ll be receiving a second notice about the blog, Facebook, and twitter pages in the coming days specifically because I’m guessing only a few of you made it this far (which I find as solid confirmation that a blog will be more useful than long emails each quarter). You have my apologies in advance for the double notice. As a reward however, reply to this message with a suggestion for a future blog post topic and you’ll be entered into a drawing to receive a gift card at the end of the quarter. As always, if you have any questions or comments about this message or anything else, please don’t hesitate to ask. Thanks for reading and enjoy the rest of the summer.