As an investor, you can sometimes still feel you’re at the mercy of forces beyond your control. This may be especially true today, when the Federal Reserve has warned of an approaching “fiscal cliff.” What can you do in the face of such a dire prediction?
First of all, you need to understand what led to the Fed’s remarks. Here’s the story: Some $1.2 trillion in spending cuts are scheduled to begin in 2013 while, simultaneously, the Bush-era tax cuts - including the reduction in capital gains and dividend taxes - are set to expire. This combination of spending cuts and higher taxes could take some $600 billion out of the economy, leading to a possible recession - and maybe something much worse, at least in the eyes of the Fed.
Still, there’s no need for panic. Despite its political infighting, Congress is likely to reduce the “cliff” to a smaller bump, though it probably won’t happen until after the election. But as an investor, you may need to be prepared for two significant events: Market volatility, at least in the short term, and higher taxes, probably for the foreseeable future.
To combat market volatility, you need to own a broadly diversified portfolio that can handle “bumps,” “cliffs” and other rugged investment terrain. This means you’ll need a mix of stocks, bonds and other securities that are suitable for your needs. (Keep in mind, though, that while diversification can reduce the impact of market volatility, it cannot guarantee profits or protect against losses.) You may also need to “rebalance” your portfolio to ensure that it’s still aligned with your goals, risk tolerance and time horizon, despite the impact of volatility.
Now, let’s turn to taxes. Even if taxes on income, capital gains and dividends do rise, they will still, in all likelihood, be much lower than they’ve been at various points in the past. Nonetheless, you may want to consider a variety of steps, including the following:
Take advantage of tax-deferred vehicles. Contribute as much as possible to your traditional IRA, your 401(k) or other employer-sponsored retirement plan, and any education savings accounts you may have, such as a 529 plan.
Consider converting your traditional IRA to a Roth IRA. A Roth IRA provides tax-free earnings, provided you don’t start taking withdrawals until you’re 59½ and you’ve had your account for at least five years. (Be aware, though, that this conversion is taxable and may not be appropriate if you don’t have money readily available to pay the taxes.)
Consider municipal bonds. If you’re in one of the upper tax brackets, you may benefit from investing in “munis,” which pay interest that’s free of federal taxes, and possibly state and local taxes as well.
Not all these choices will be suitable for your situation, of course. Before taking action on these items, you may want to consult with your tax and financial advisors. But give these options some thought because they may prove helpful in keeping your financial goals from going “over a cliff.”
Brian Humphrey is a financial consultant and investment advisor.