Retirement Prepping for the Fiscal Cliff

Christine Benz: Hi, I am Christine Benz from Morningstar.com. To talk about the fiscal cliff hasn't worried the markets too much recently, but investors may still be wondering what it means for their retirements. Joining me to discuss that topic is syndicated columnist Gail MarksJarvis. She is also the author of Saving for Retirement (without living like a pauper or winning the lottery).

Gail, thank you so much for being here.

Gail MarksJarvis: Oh, it's my pleasure. Thanks for having me.

Benz: First of all, congratulations on the second edition of your book.

MarksJarvis: Thank you. It's really an exciting time.

Benz: One topic I'd like to discuss with you, Gail that is top-of-mind with everyone these days is this fiscal cliff. Let's first outline what are the expected tax changes that are part of the so-called fiscal cliff, and how do they intersect with investors' investments?

MarksJarvis: If we go over the fiscal cliff at the end of this year, it means that virtually every taxpayer is going to face higher taxes next year. So, even people at really low incomes, we are talking about people earning maybe $12,000, they are going to go into a higher tax bracket next year. So, whether you are making $12,000 or $12 million, you are going to have higher taxes next year, and it's about $500 billion.

And the real risk there is that if that happens, if people are faced with higher taxes, that means they have less money to spend. And the economy is expected to slow so much that Ben Bernanke, the Federal Reserve chairman, says we'll go into a recession. So, everyone will have higher taxes.

Now, it's possible that Congress will stop this from happening at the end of the year, or they'll let us go over the fiscal cliff. And they'll use the frantic people as they open their paychecks and they say, "Oh no, I have less money. Where did it go?" The politicians then will say, "We'll fix it." And they'll come back at the beginning of the year, and those higher tax rates will go back to the taxes that people are paying now. So, that's the biggest impact. Then, of course, there are impacts for investors, too.

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Benz: That's what I'd like to focus on. So, we've been hearing from a lot of investors saying "One strategy I might consider given that capital gains rates are set to go up is maybe preemptively sell some securities in my portfolio that have appreciated whether stocks or funds or whatever it might be. Lock in today's relatively low capital gains rates, and then I can even rebuy the thing down the line." What do you say to a strategy like that?

MarksJarvis: Absolutely. It's something everyone should be considering right now. Now, of course, you know the caveat says, make sure you don't do something for taxes that would be bad for you as an investor or hurt this year's taxes too much. But as a rule of thumb, I would say people should look at taking capital gains this year. And you know that some people--and this is really almost a no-brainer for people who are now in the 10% tax rate--have no capital gains taxes now. So they can sell something that's appreciated--a stock, a mutual fund, a bond, some real estate--they could sell it right now and owe no taxes on it. Then they could buy it right back. And then next year if indeed the capital gains tax goes up, they'll have a lower tax than they would have if they sold it later or at retirement. So, that makes a lot of sense.

Then there are also the dividend questions, and dividend taxes might be going up as well for the highest-income-level people. People are going to perhaps owe taxes all the way over 40%, which is a high rate.

So, there again what you could do is if you have a dividend-paying stock, and it's sitting in a taxable account, you could sell it. And then you could buy it back; if you really like that stock and want the dividends, you could buy it back in an IRA, if you have an IRA.

Benz: So, if it is taxable money where you are holding the dividend payers, relocate it to an IRA where it will be safe from those potentially higher tax rates down the line?

MarksJarvis: That's right. You are still going to get income from your dividends. Just if you pay higher taxes, you'll have less income than you once thought.

Benz: We are hearing a lot about Roth IRA conversions right now, too. I think some investors think "Well, if tax rates will be higher in the future, am I maybe better off taking that tax hit on my investment now and then be able to take tax-free withdrawals?" What's your advice to people who have big traditional IRA kitties that they are looking at wondering, "Is that a good strategy for me?"

MarksJarvis: This is a little more complicated because it depends on a situation a lot. I think it's definitely worth trying to look at converting some IRA money to a Roth IRA, especially if you have years to go before you are going to need that money. If you are already in retirement, then you have to think twice about that.

The other thing you might have to think twice about is if that's money that you are planning to give to a charity there is no reason why you want to convert it to Roth and pay taxes on it now when you know that charity is not going to have to pay taxes later.

So, there are some things to think about, but I think it makes sense to look at the IRA. Maybe convert some of it to a Roth because it could bump you if it's a large IRA and you convert it, you could have a very high tax bite this year. You also want to look [at whether] you are going to be subject to the alternative minimum tax. If that's the case, you want to be very careful about what you do with your taxes this year, but that doesn't mean not to consider it. I think that if you have a very large IRA before converting it to a Roth IRA, you should definitely talk to a certified public accountant about it.

Benz: Get some tax advice. Last thing I’d like to cover with you, Gail, is entitlements. They have certainly been part of this fiscal cliff discussion as well with talks about possible changes to Medicare, as well as Social Security, let's talk about maybe two constituencies. Let's start with younger folks who are, say, under 40 for example. What should they be thinking about when they hear that there could be prospective changes to these entitlements?

MarksJarvis: I think that if you're under 40, you should assume that even if it doesn't happen this year, later you're probably going to end up with a less attractive Social Security or Medicare than your parents had. That's because the government, We the People, cannot afford to be paying as much as we once did given the amount of debt that the country has and the amount of debt that the country has to take on in order to pay huge Social Security benefits and Medicare benefits for a giant population. We have 77 million baby boomers about to retire, and they're just going to place demands on the system. So, cutbacks will have to happen.

If you're in your 40s, I don't think you should assume there will be no Social Security or Medicare for you, but I think perhaps there is a Social Security website you can go to and you can do a quick calculation with very little information and find out how much Social Security you're about to get some day. And people should figure that into their retirement plans.

So, I encourage everyone to say, "Am I saving enough for retirement?" You can do that very easily by going to website called choosetosave.org and running a ballpark estimate calculation. It will show you right away, are you saving enough or do you have to save more. But they figure full Social Security benefits into that, and I suggest that if you're in your 40s, maybe you do the calculation but assume you get 25% less Social Security than you're assuming. And if you're getting less Social Security than you assume, then that means you need to save more for the future.

Benz: How about folks who are in a slightly higher age band, let's say people 50-plus? What should they be thinking about? This is the real deal for them now; some of them are already receiving some of these benefits. What is the likelihood that there will be cutbacks there that will affect them?

MarksJarvis: The discussion that's taking place, a lot of that discussion has centered around leaving people 55 and over alone, letting them have the same system that exists now. But I think even there, there could be possible changes.

Some of the things that have been talked about are perhaps having lesser cost-of-living increases. Again if that's going to happen, then you need save more because if your cost-of-living increases from Social Security are not great, then you're going to need more from your own savings.

In addition, another thing that's been talked about it is means testing, both Social Security and Medicare. If that happens, you're going to need a lot more savings. And health-care costs are a huge expense, and a lot of people who are not yet retired don't realize Medicare doesn’t pay all of your health-care costs. So, if you're going to be faced with paying more health-care costs, you are going to need to save a lot more.

Benz: Gail, thank you for this very helpful recap. I guess time will tell what will actually happen with the cliff, but these are some helpful guideposts.

MarksJarvis: I hope it helps.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.