The fiscal cliff can be largely avoided if Congress can agree on limited tax increases and cuts in spending. Based on recent history, it is hard to imagine the two opposing parties agreeing on anything. However, times have changed. Compromise might be possible now that with the election behind us and neither side wants to take blame. However, a bi-partisan solution might be logistically impossible before year end. A retroactive decision occuring early 2013 is more likely.
So, how can we prepare? Our clients are nervous about the stock market and taxes. Communicating with clients is imperative - even if you only repeat the standard "stay the course" advice.
No matter what Congress decides to do, we can count on taxes going up. Congressional inaction will result in the expiration of the Bush tax cuts along with the Obamacare tax increases. Even with a compromise, tax hikes will certainly be a realtime and we can expect ordinary tax rates to increase for the wealthy, higher taxes to apply to investment income and capital gain rates to bump up for all.
The bottom line is that advisors need to pay attention to taxes more than ever. I am not a proponent of accelerating capital gains into 2012 - unless the client has a significant one-time gain, such as the sale of a business. It will be important to harvest tax losses on an ongoing basis, pay attention to location optimization (putting income-producing investments in IRAs and appreciating assets in taxable accounts), choose high cost tax lots on sales, and look at greater allocations to municipal bonds. Although permanent tax reduction is best, postponing taxes is a worthwhile goal. To the extent clients hold appreciated assets at death, the step-up will eliminate any tax.
The complexity of implementing and coordinating all of these strategies when managing hundreds of portfolios is difficult at best. To truly meet the ever-expanding needs of clients, automated portfolio management is essential. Just as CPAs no longer attempt to prepare tax returns by hand, advisors must embrace software. Rebalancing software's ability to rebalance at the household level, minimize numbers of transactions, avoid redemption fees, avoid short-term gains, automatically consider location optimization, and harvest tax losses instantaneously, will result in lower taxes for clients, greater efficiency for advisors and the elimination of trade errors.
Clients are becoming more educated and more demanding. To successfully compete and serve clients well, advisors must make tax considerations a material part of portfolio management.