If you're pondering how to position your portfolio for the fiscal cliff, you might consider doing something more useful with your time, like teaching the national anthem to a washtub full of bees.
Frankly, no one knows what those wacky folks in Congress will do. So why not take some time and work on things you can control: minimize your expenses, reduce your taxes, and increase your savings.
The fiscal cliff is a combination of congressionally self-inflicted problems. The first part is the end of the tax cuts enacted under president George W. Bush. In order to bypass a rule forbidding laws that would significantly increase the federal deficit over a 10-year period, Congress mandated that the tax cuts would lapse after 10 years. Congress passed a two-year extension in 2010. If Congress does nothing by Dec. 31, tax rates will return to 2000 levels.
In case you don't remember the 2000 tax code: The maximum tax rate was 39.6%, vs. 35% now. Dividends were taxed at your maximum income tax rate, vs. 15% now. Long-term capital gains were taxed at 20%, vs. 15% now.
Congress also has to fix the alternative minimum tax levels, which will kick in at 2000 levels if no action is taken. About 30 million more people would have to pay AMT for the 2012 tax year than for 2011 if the fix isn't made.
Then there's sequestration, which would mean $110 billion in mandatory cuts in defense and other government spending, excluding Medicare and Social Security.
The effect of the cuts and the tax increases would cut the 2013 deficit in half, which is good if you hate the deficit. But the cost is high: The non-partisan Congressional Budget Office estimates it would push the nation into recession and send the unemployment rate up to 9.1%.
Will Republicans and Democrats hammer out a last-minute agreement? Will the nation fly over the fiscal cliff? Who knows?
Actually, nobody does. It's simply not something you can control. So rather than spending your time seething -- or, worse, shuffling your investments back and forth in fits of pique -- try to concentrate on the things you really can control.
Minimize your expenses. All other things being equal, a fund that takes more in expenses than another will earn less over time. For a stark contrast, consider the difference between Rydex Series Trust S&P 500 fund class C and Schwab S&P 500 Index fund. Both are unmanaged funds that track the Standard & Poor's 500-stock index. The Rydex fund carries a mind-melting 2.26% expense ratio, which obliterates much of the rationale for buying an index fund. The Schwab fund charges 0.09%. Over 10 years, assuming a 5% average annual return and a $10,000 initial investment, you'd pay a total of $115.45 for the Schwab fund. You'd pay $2,584 for the Rydex fund. A broker who sells you the Rydex fund clearly values the relationship with you, but not in a good way.
To see what you're paying for your funds, go to www.finra.org and look for their mutual fund comparison tool. If you're shocked, consider one of the low-cost funds in the chart.
Reduce your taxes. If you're investing in a taxable account, you can use your losses to reduce any amount of capital gains. If you have more losses than gains, you can deduct $3,000 of your losses from your income, and carry forward any remaining losses into the next tax year.
If you're considering opening an individual retirement account, make a Roth IRA your choice over a traditional IRA. In a Roth, you invest after-tax money; when you withdraw, you pay no taxes on your earnings. Given that federal income tax rates are historically low and the deficit is historically high, it's a good bet that taxes will rise eventually. Fiscal cliff or no, it's probably better to pay taxes at current rates than at higher rates in the future.
Increase your savings. True, that's easier said than done. But the single most important determinant of the size of your account is the amount you save. And it's also something you can control.
For example, suppose you save $2,000 a year and earn 5%. After 30 years, you'll have about $133,000. If you earn 7% a year on that amount, you'll have $189,000. But it's much harder to earn 7% a year than 5%.
If you increase your savings to $3,000 a year and earn 5%, you'll have about $199,000 after 30 years. Should you manage to earn 7%, you'll not only have bragging rights, but you'll have about $283,000 in the bank. But it's always better to lower your earnings expectations and increase your savings rate.
If you shift your portfolio around as a bet on the outcome of the fiscal cliff, bear in mind that you're betting, not investing. It's far more reasonable to invest based on corporate earnings or compound interest than on the whims of Congress. Really, you'd be better off trying to teach bees to sing. Or at least hum.
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