How to Prepare for the Fiscal Cliff

Fiscal cliff negotiations continued Thursday, but with Republicans not budging on their staunch opposition to raising taxes, and Democrats refusing any deal that doesn't include higher taxes, hopes for a compromise by year's end have waned.

Investors are worried, and rightly so.

In fact, the Wells Fargo/Gallup Investor and Retirement Optimism Index turned in a score of -8 in November, down from double-digit positive readings in early 2012. That means investors polled are back to being as pessimistic about the investing climate as they were a year ago when Washington was battling over the debt ceiling.

About 70% of investors polled said the fiscal cliff was already slowing the economy, and feared a deep recession would hit in 2013 if the economy fell off the cliff.

With no deal in sight, here's how investors can prepare for falling off the fiscal cliff.

How to Prepare for the Fiscal Cliff: Five Steps to Take

  • Take Capital Gains At Current Low Rates

The maximum tax rate on long-term investment earnings, if no deal is inked, would increase to 21.2% from the present 15%. That is on top of a new 3.8% surcharge on investment income to help pay for Obamacare.

With the impending threat of capital gains rates to rise in 2013, possibly on par with the ordinary income tax rate, consider fast-tracking income into 2012.

That means considering selling your gainers in 2012, whether they are equities, investment properties, or vacation homes.

  • Evaluate Your Estate

It is looking highly likely that the level at which estates go untaxed, currently set at $5.12 million, will fall - possibly to $1 million. Now might be a good time to shuffle assets so as to take advantage of the current estate tax code.

Under the current code, estates worth more than $5.12 million are taxed at a rate of 35%. Any part of an estate's assets, such as stocks, bonds, and real estate, are taxed on the current market value at the time of the original owner's death - not when an heir sells it.

Also, consider gifting assets to your children or heirs before the end of the year. With the estate tax threshold expected to decrease, it's a good bet the gift tax exemption level will follow suit.

  • Take Your Deductions

There is a good possibility that any tax reform completed in 2013 could limit the value of deductions.

Pay property taxes, don't defer your mortgage payments, and make those charitable contributions you have been considering.

  • Consider IRA Conversions

With the prospect of higher tax rates coming in 2013, discuss with your accountant if it would be beneficial to make future contributions to a tradition IRA or a Roth IRA.

Contributions to a Roth are not deductible, but qualified withdrawals are. Meanwhile, contributions to an IRA are deductible when they are made.

With the federal deficit at a record $16.4 trillion, and lawmakers scrambling to bring it down, taxes are bound to go up to help pay for our swollen debt, whether or not we go over the fiscal cliff. So it might make sense to pay taxes at current rates than the elevated ones in the future.

  • Don't Panic

The worst thing you can do is panic, and take your money on a downward spiral with you.

Don't make drastic changes to your long-term financial plans, but make sure you have down your research as to what's ahead.

Save more, minimize risk, diversify and take advantage of tax savings now.

Once you've prepared, check out this analysis of the investing opportunities associated with the fiscal cliff, by Money Morning Chief Investment Strategist Keith Fitz-Gerald.

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