As an investor, you can sometimes feel you’re at the mercy of forces beyond your control. This may be especially true today, when the entire country appears to be on edge about the approaching “fiscal cliff.” What can you do in the face of such a dire prediction?
First of all, you’ll need to understand what initially led the Federal Reserve to issue the fiscal cliff warning. Here’s the story: Some $1.2 trillion in spending cuts are scheduled to begin in 2013, while, simultaneously, the Bush-era tax cuts —including the reduction in capital gains and dividend taxes — are set to expire. This combination of spending cuts and higher taxes could take some $600 billion out of the economy, leading to a possible recession — and maybe something much worse, at least in the eyes of the Fed.
Still, there’s no need for panic. Despite its political infighting, Congress is likely to reduce the “cliff” to a smaller bump. But as an investor, you may need to be prepared for two significant events: market volatility, at least in the short term, and higher taxes, probably for the foreseeable future.
To combat market volatility, you may want to take these steps: Rebalance — You may need to rebalance your portfolio to ensure it still reflects your target mix of investments, based on your long-term goals and your risk tolerance.
Diversify — A broadly diversified portfolio can help you navigate “bumps,” “cliffs” and other rugged investment terrain. (Keep in mind, though, that while diversification can reduce the impact of market volatility, it can’t guarantee profits or protect against all losses.)
Upgrade investment quality — Generally speaking, higher-quality investments are better positioned to withstand the tempests of volatile financial markets. Consequently, when investing in stocks, look for companies with solid track records, strong management and competitive products. And when purchasing bonds, seek those that earn the highest grades from the independent rating agencies.
Now, let’s turn to taxes. Even if taxes on income, capital gains and dividends do rise, they will still, in all likelihood, be much lower than they’ve been at various points in the past. Nonetheless, you may want to consider a variety of steps, including the following:
Take advantage of tax deferred vehicles. Contribute as much as possible to your traditional IRA, your 401(k) or other employer-sponsored retirement plan, and any education savings accounts you may have, such as a 529 plan.
Convert your traditional IRA to a Roth IRA. A Roth IRA provides tax-free earnings, provided you don’t start taking withdrawals until you’re 59-1/2 and you’ve had your account for at least five years. (Be aware, though, that this conversion is taxable, and may not be appropriate if you don’t have money readily available in other accounts to pay the taxes.)
Consider municipal bonds. If you’re in one of the upper tax brackets, you could benefit from investing in “munis,” which pay interest that’s free of federal taxes, and possibly state and local taxes as well.
Above all else, don’t abandon your long-term plans due to short-term uncertainty — and avoid making unwarranted and extreme changes to your portfolio. By staying focused on your goals, and by making well-thought-out moves at the right time, you can help prevent your financial goals from going “over a cliff.”