“This is not a prediction, it is a certainty–there will be serious disruption in the world’s financial services industry…. It’s going to be ugly.” – The Times, London, 1999 (discussing the “Y2K” threat)

Years ago in the midst of another date-specific moment in time, the world became obsessed that planes would drop from the sky at midnight, ATM’s would freeze up and the power grid would shut down on January 1st.  The year was 1999 and after years of build-up around “Y2K,” the date-specific fear that computer systems across the globe would collapse – unable to handle the year shifting from ’99 to ’00 –  the world awoke to find little had changed as we began the new millennium.

As we reminisce, it is difficult not to draw parallels between the Y2K fears and investor behavior leading into the latest date-specific moment, the so-called “Fiscal Cliff” that began on January 1st.  In the aftermath of the intense 24-hour news cycle coverage and the ever-present ticking “Cliff Clock” on CNBC, the Fiscal Cliff of automatic tax hikes and spending cuts came and went in a dramatic fashion, but with little financial market impact to the New Year.

While the markets proved clairvoyant in predicting that outcome – like Sand Hill, they are focused on the underlying economic improvements in the private sector and not the headline growth rates – we do enter 2013 with a new set of rules.  Although the tax compromise reached by lawmakers does eliminate tax hikes that were scheduled to go into effect on January 1st for 99% of households, it does have ramifications for the vast majority of our client partners.

Specifically, some of the key provisions of the act that affect our clients include:

The “middle class” income threshold was reset: The “middle class” threshold was set at the higher level of $400K for individuals and $450K for those married and filing jointly. The tax brackets below the threshold were permanently set at 10%, 25%, 28%, and 33%, respectively, while rates for taxpayers above the threshold were increase from 35% to 39.6%.

Dividend and long-term capital gains tax rates were permanently reset at preferred levels: In a significant relative win for the majority of our clients, taxpayers with income below the $450K threshold will continue to be taxed as they were in the Bush-era at either 10% or 15%. Taxpayers above the income threshold will now be taxed at 20%.  Without this change, the tax rate on dividends would have increased to the taxpayer’s ordinary income tax rate.  Most taxpayers will also be subject to additional taxes on net investment income due to a 3.8% Medicare tax from the Affordable Care Act, as well as a tax related to the Pease limitation.

Limitations on exemptions and deductions were reinstated on high-income taxpayers. The threshold where a taxpayer becomes subject to the Personal Exemption Phase-out (PEP) and the Pease limitation on itemized deductions is $250K for individuals and $300K for married filing jointly.  Your CPA can help you determine how this may impact your specific circumstances.

The Alternative Minimum Tax provision was patched:  The 2012 exemption amounts increased to $50,600 for individuals and $78,750 for married filing jointly.  After 2012 the exemption and phase-out thresholds will be indexed for inflation.

Surprisingly, estate and gift tax exemption amounts were permanently maintained. The top estate and gift tax rate was increased to 40%, but the exemption amount was maintained at $5 million and indexed for inflation.  Meanwhile, annual gift exclusions were increased to $14,000 from $13,000 per person on a going forward basis.  This surprise compromise came in the eleventh hour, after significant wealth transfers to the next generation for most families had already occurred.

Payroll tax cuts expire.  Payroll tax on wages returned to 6.2%, up from 4.2%, which will likely reduce consumer spending power in 2013.  Additionally, federal “extended” unemployment benefits were extended until December 31st of this year.

A variety of programs were extended through the end of 2013. The R&D tax credit, 50% bonus depreciation, physician payment (“Doc Fix”), and energy tax credits were among those programs.

These specific outcomes, while providing a compromise for the “tax cliff,” created a subsequent “spending cliff” this quarter in order to deal with the debt ceiling debate and the automatic spending cut “sequester.” These coinciding debates may yet create some temporary volatility in the market.
That said, the key theme emerging for the economy is one of a “great race” between the recovery in the private sector and the offsetting contraction in government spending.  Sand Hill’s new normal base case is predicated on that  race likely ending in a draw in 2013, with slightly below trend growth, followed by a modest reacceleration in 2014 as these fiscal headwinds subside.  We see the Washington outcomes as forestalling the long-feared worst case scenario of a recession-inducing fiscal shock.  And importantly, the deals so far have permanently extended many tax rates, providing more certainty and confidence for financial planning purposes.  While certainty is unquantifiable, we firmly believe that building consumer and business confidence is the best economic stimulus plan.

The world is certainly a different place today than it was in the year 2000.  While the overall stock market has been mediocre during the 13 years since Y2K, corporate earnings have continued to rise and as a result, valuations of the stock market have dropped significantly.  While the readers of this newsletter may not agree with every outcome of the Fiscal Cliff debate, for the super majority of the country, life on January 1st looks about the same as it did on December 31st.  That’s the thing about the world:  despite the date-specific hurdles, the world doesn’t often “end tomorrow.”  Along the way – and with a bit of luck – we may actually begin to straighten out our country’s long-term financial challenges with greater certainty and confidence.

If you have any questions regarding the recent changes in tax structure and how it may impact your specific circumstances, please don’t hesitate to contact your Wealth Manager at Sand Hill Global Advisors.