We at Paragon Financial Advisors are not accountants and urge you to verify any items we discuss with your tax professional to determine its implications in your particular situation. We also do not believe you should “let the tax tail wag the investment dog.” That is, your investing should not be dependent solely on tax considerations. However, tax consequences certainly should be considered when all other things are equal. Taxes can have a significant impact on your total economic well-being. It is in that spirit that we discuss the Congressional resolution (enacted at the last minute) to the fiscal cliff.

There are many items available for discussion in our current fiscal situation. However, there are two specific facts that cannot be ignored: 1) 2012 marked the fourth consecutive year that our federal budget deficit exceeded $1 trillion, and 2) the majority of our federal spending as currently structured is non-discretionary. In fact, our spending (by type as a percent of total spending) for 2012 is estimated as follows (source: Congressional Budget Office, Monthly Budget Review, September 2012):

Mandatory: 65%

  • Social Security-21%
  • Medicare-13%
  • Medicaid-7%
  • Interest on the national debt-6%
  • Other (veteran’s benefits, retirement benefits for gov’t employees, unemployment compensation, etc.)-18%

Discretionary: 35%

  • Defense-19%
  • Non-Defense-16%

The most widely discussed solutions to our deficit problem seem to be centered around either, or a combination of, tax increases (reform) and/or spending reductions. The spending reductions could involve cuts in discretionary spending or entitlement reform. Since social security is the largest component of spending, potential reform in that area could include (but is not limited to) the following:

  • Increase the taxable wage base (i.e. the amount on which social security taxes are collected—a maximum of $113,700 for 2013).
  • Increase the retirement age eligibility for younger workers.
  • Make changes in the cost of living adjustment (COLA) formula for benefit increases.
  • Means testing—i.e. reduce the benefits for higher income recipients.

Tax reform could include such items as follows:

  • Changing tax brackets (perhaps fewer) with elimination of tax deductible items.
  • Taxing newly issued municipal securities.
  • Capital gains and dividend income being taxed at ordinary income rates.
  • Elimination or reduction in tax preference items or deductible items. Listed below—in order of impact– are the items that would have the greatest impact on tax revenues in the 2011-2015 time frame (source: Joint Committee on Taxation, January, 2012):
  1. Taxing employer provided health care plans. 
  2. Taxing contributions to defined contribution (DC- i.e. 401(k), 403(b), etc.) plans and IRA’s. 
  3. Eliminating the mortgage interest deductions.
  4. Eliminating the lower tax rates on dividends and capital gains. 
  5. Eliminating the earned income tax credit (EITC).
  6. Taxing contributions to defined benefit (DB) pension plans. 
  7. Eliminating the step up in basis allowed on assets for capital gains taxation. 
  8. Eliminating the deduction for state/local income tax or state sales tax.
  9. Eliminate the deductibility of charitable contributions. 
  10. Tax interest income from municipal bonds.

By examining the above list, you can begin to see where legislators might begin to look in terms of adding additional tax revenue. With that in mind, you, the investor, can begin to take steps that would benefit your economic well-being in the future. As always, we here at Paragon Financial Advisors are here to help you in that planning.

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