On January 1, if Congress hasn't gotten its act together, the talk of the “fiscal cliff” becomes reality. It won't be pretty as federal spending falls and federal taxes rise. The impact will be gigantic – enough to send the country back intro recession so the thinking goes among many economists.
“The looming fiscal cliff would strain already-tight government revenues. In the long-run, this means that federal, state and local governments will need to find more ways to fund themselves. We all know what that means: increasing taxes and reducing benefits that will place a larger financial burden on working families, and particularly on retirees and those nearing retirement,” says Mitch Adel, a lawyer specializing in elder law and financial planner with Cooper Adel & Associates.
No doubt this will be bad news for everyone, it is especially so for those nearing retirement or already retired. What are smart moves they should be making “just in case”?
Keep your cool
For those nearing retirement and/or in retirement, do not make dramatic changes to investment assets and move to cash out of fear, cautions certified financial planner Roy Larsen of Larsen Wealth Management. “Any short term market reaction caused by Congress will be trumped by long term corporate earnings. Trying to time this next possible event's impact on the market will likely do more harm than good,” he says.
That said, that doesn't mean you should close your eyes, cross your fingers and hope for the best. Tweaks may be required.
Be realistic. “Whether it's January 1, or some time down the road, the financial problems in the U.S. today will need to be fixed, and the solution will have a negative impact on our economy. Retirees and those facing retirement need to invest with this mindset. They can't expect the markets to head upward indefinitely,” says Dan White, founder and president of Daniel A. White & Associates.
Ask your financial advisor what the prognosis is for your investments if there is another recession. “With the potential for a wider Eurozone crisis and a slowdown of the Chinese economy, the U.S. may find itself at a fiscal cliff, even if it's not of our own making,” says White.
Assess the safety of your investments. “Even bonds, for example, are often touted as a very conservative choice, but if interest rates rise, there may be many investors left holding bonds with less principal and extremely low rates. Often index annuities are a better fit,” says White.
Consider making some changes to portfolios based on what is doing well in this environment and what will likely do well if tax rates are increased. “Pre-retirees and retirees alike should consider from the traditional pool: tax free bonds, emerging market bonds, defensive equity sectors,” says Larsen.
Focus on reducing volatility. “This can be achieved in many cases with asset classes that have lower correlations to equities. Many alternative assets and strategies should be considered such as absolute return strategies, long/short funds, managed futures, non traded REITs and tactical or opportunistic allocation strategies,” says Larsen.
Furthermore, says Brenda Wenning, principal of Wenning Investments, “I recommend shifting stock holdings to more defensive positions such as money market or short term bond funds until the fiscal cliff outcome is know.”
While there is talk about recovery in the real estate market, another negative economic cycle may restrict the rebound. “Seniors should be very careful in thinking about real estate as an investment as they approach retirement, if the economy takes another negative turn,” says White.
Minimize your tax burden
“Take inventory of your overall situation and figure out what tax-efficient strategies you might be able to put in place if things play out worse vs. better,” says Simon Roy, president of Jemstep, a personal online investment guidance and management service.
For people looking to hedge against tax risk, one option they have is to maximize contributions to their Roth IRA. Even if tax rates were to drop slightly, the Roth IRA shines over the long term, says Tom Hegna, author of Paychecks and Playchecks: Retirement Solutions for Life. “Roth IRAs have no required minimum distributions and can allow the children and grandchildren to receive tax free income for life as well.”
Those with estates larger than $5 million should consider gifting and the possible benefits of doing it this year prior to the top estate tax rate increasing to 55% and the exemption reverting back to $1 million, points out Larsen.
Realize long term capital gains before the end of the year, while they are still taxed at 15%. In 2013 the rate could jump to 20%.
Health care is an area of significant concern – a fast-growing part of the federal deficit – and seniors must be prepared for the rising costs of long-term care, says Adel. “The individual burden may become worse in the face of a fiscal cliff, so investigating long-term care insurance or using legal tools and strategies to protect assets from these costs is critical,” says Adel.
For investors still in the income taking stage, but close to retirement, reallocate your portfolio and increase your cash position. “You want 12 months of income in reserve,” says Steve Kolinsky of Kolinsky Wealth Management.
Lastly, says John Holodinski, a senior vice president with PNC Investments, “The most common mistake is panicking and making a quick decision. Always create a plan, understand where you want to go and understand the current financial landscape.”