Client Newsletter: January 10, 2013

All of the major U.S. stock indexes finished 2012 solidly in positive territory, successfully climbing what Wall Street dubs the “wall of worry” in the process. The biggest winner was the technology-dominated NASDAQ composite*, which gained 15.9%. The Russell 2000*, an index of small-company stocks, rallied 14.6%. The S&P 500*, a large-company stock gauge, was next with a gain of more than 13%. The worst performer of the four major indexes was the blue-chip Dow Jones Industrial Average*, which rose 7.3%.

In 2012, the economy started to show signs that it could start growing again at a more normal rate, witnessed by growth of 3.1% in the third quarter of 2012, its fastest pace since the final three months of 2011 and its second-best quarter of growth since 2009. Stocks also got a boost from an improvement in the jobs market. In November, the unemployment rate dropped to 7.7%, far below its 10% peak in October ’09 and its lowest level since December 2008.

Even though we had a great investment year in 2012, we still have a few big issues left to discuss which could cause major anxiety for all investors in 2013. The fiscal cliff deal does nothing to resolve the debt limit, high unemployment, soaring government debt and the long-term horizon. A recession is likely if Congress doesn’t raise the debt ceiling and the country defaults. Even if it does raise the ceiling, continued wrangling could disturb financial markets and slow the recovery.

The fiscal cliff compromise doesn’t remove the uncertainty that’s been plaguing American businesses. With the debt ceiling issue unresolved, American businesses may be reluctant to hire more employees and consumer spending may be more constrained. About 12 million Americans remain unemployed, but the fiscal cliff settlement actually makes the problem worse by allowing the payroll tax cut to end, which increases social security payroll tax by two percentage points to 6.2%. This takes money that would have been spent in the economy out of the pockets of Americans.

And despite the tax increase for wealthier Americans, the deal does nothing to reign in the government’s skyrocketing debt. Spending will escalate faster as baby boomers retire and healthcare costs for the aging population rise.

“The deal … is truly a missed opportunity to do something big to reduce our long-term fiscal problems, but it is a small step forward in our efforts to reduce the federal deficit,” Erskine Bowles and Alan Simpson, who co-chair the president’s National Commission on Fiscal Responsibility and Reform, stated in a press release.

We will be continuing to watch the events in Washington and how they will impact our client’s investment portfolios. As always, please do not hesitate to contact us if you would like to discuss your personal financial situation.

Important Information from Pershing 

Form 1099’s (B, DIV, INT, OID and Misc) from your Pershing brokerage accounts will be mailed by February 28, 2013. Pershing has decided this delayed date is appropriate to reduce the need for 1099 revisions, due to the late information received from issuers regarding income reclassifications and cost basis related adjustments.

Social Security/Medicare Cost of Living Adjustments 

Beginning in January, 2013, social security recipients will receive a 1.7 percent cost of living adjustment. Medicare Part B premiums are based on your modified adjusted gross income (includes tax-free interest) from 2 years ago. Therefore, for tax year 2013, the Medicare Part B cost will be based on your 2011 income. The following chart lists Medicare Part B cost:


The share of social security wage tax that is paid by employees has increased from 4.2% on earnings up to $110,000 to 6.2% on earnings up to $113,700 (2013 wage base).

Annual Gifts 

Starting in 2013, the annual exclusion for gifts goes up to $14,000 per year from $13,000. Spouses can combine their annual exclusion to double the size of the gift. A gift made with a check must be cashed before the end of the year.

Retirement Plan Limits 

  • The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan is increased from $17,000 to $17,500. 
  • The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan remains unchanged at $5,500. 
  • The limit on annual contributions to an Individual Retirement Arrangement (IRA) and Roth IRA rises to $5,500, up from $5,000 in prior years.

Estate Taxes 

As part of the Fiscal Cliff new law signed by President Obama, the federal estate tax basic exclusion amount still remains at $5 Million per person ($5,250,000 indexed for inflation amount). That was an important achievement, for without any action from Congress, the tax-free amount would have automatically reverted to $1 million per person, and the rate for most estates would have gone up to 55%. But at the end of the day the only thing the lawmakers actually changed is the gift- and estate-tax rate, which has gone up to a top rate of 40% from a maximum of 35%. Portability of the estate tax exemption between spouses is also still permitted.

Income Tax Changes 

Income Tax Rates: Higher income taxpayers in 2013 are now defined as individuals earning more than $400,000 and married filers earning more than $450,000. Starting with the 2013 tax year, those high earners will pay a top tax rate of 39.6% on ordinary income and 20% on both dividends and long-term capital gains. Taxpayers under those limits listed above will continue to pay a 15% rate on dividend and long-term capital gains, the same level in place since 2003. In addition, their income tax rates did not change from last year rates.

Medicare Surcharge: In 2013, the 3.8% Obama care tax on net investment income will be implemented on the lesser of 1) A taxpayer’s net investment income (generally interest, dividends, royalties, annuities, rents and capital gains), or 2) Modified adjusted gross income (this will be the same as AGI unless you’ve got foreign earnings) in excess of the applicable threshold: $250,000 for MFJ, $200,000 for single). This new tax is now effective for taxpayers over these amounts. Tax-free interest is exempted, along with payouts from retirement plans such as 401(k)s, IRAs and pension plans.

Personal Exemptions: The phase out for personal and dependent exemption deductions phase out is back. As a result, your personal and dependent exemption write-offs can be reduced or even completely eliminated. Phase-out starts at the following adjusted gross income (AGI) thresholds: $250,000 for single filers, $300,000 for married joint-filing couples, $275,000 for heads of households, and $150,000 for married individuals who file separate returns. The phase-out is 2% for every $2,500 over the threshold amount.

Itemized Deduction Phase-Out: As a result, you can potentially lose up to 80% of your write-offs for mortgage interest, state and local income and property taxes, and charitable contributions if your AGI exceeds the applicable threshold. The thresholds are $250,000 for single filers, $300,000 for married joint-filing couples, $275,000 for heads of households, or $150,000 for married individuals who file separate returns. More specifically, the total amount of your affected itemized deductions is reduced by 3% of the amount by which your AGI exceeds the threshold. However, the reduction cannot exceed 80% of the total affected deductions that you started off with.

Charitable Rollover from IRA: The fiscal cliff act reinstates the ability of an individual to make a tax-free distribution from an IRA directly to a qualified charity, which technically expired on December 31, 2011.

Alternative Minimum Tax and Individual Tax Credits: Middle class taxpayers will benefit from a permanent fix to the alternative minimum tax (AMT) as the fiscal cliff act permanently adopts new inflation-indexed AMT exemption amounts ($78,750 for married taxpayers filing jointly). In addition, the fiscal cliff act extends for an additional five years (through 2017) the American Opportunity tax credit for education expenses, the child tax credit and the earned income tax credit.

Summary: As a whole, there are many income tax changes that could be applicable to you in 2013. We will be discussing these changes as well as others at our annual review meetings this year. As always, please contact us if you have had any changes to your personal financial situation or investment portfolio. We sincerely appreciate the continued loyalty and confidence you have placed in our firm and will continue to serve you to the best of our ability.

Best Regards,

Peter K. Hoover, CFP®

* Indices mentioned are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.