Greater health care spending and Washington's continued economic stimulus may spur inflation and higher tax rates. Here's how I think you can ready your portfolio for these possibilities.
As the U.S. economy looks forward to a recovery, government policies are likely to continue driving growth significantly. And while such federal intervention may be necessary, the resulting legislation may produce some undesirable long-term consequences. But you can take steps to make your portfolio ready for inflation, higher taxes or other possible side effects of these inititiatives.
Between March and October 2009, the fed spent $92.8 billion on business tax incentives, the expansion of COBRA health care benefits and many other recovery programs. When you add health care reform - estimated to cost $871 billion over the next 10 years - it's inevitable that the already large federal budget deficit will increase considerably.
Rising deficits can depreciate the dollar, opening the door to inflation. What's more, the government may need to raise the top income tax brackets, as well as the capital gains and dividend taxes. f these possibilities concern you, consider these asset-protection measures:
Thankfully, rising prices are not yet an issue. In November, the last month for which data are available, core inflation was flat compared with the previous month, and rose only 1.7 percent compared with the November 2008 rate. The Federal Reserve expects a low inflation rate, at least until the economy recovers. At that point, the combination of low interest rates and large budget deficits could raise prices significantly - and weaken Americans' purchasing power.
Here's how I think you should be ready for this possible scenario: First, maintain adequate exposure to equities. Also, consider investing a small portion of your portfolio in inflation hedges such as commercial real estate and commodities, which typically perform well during inflationary times.
Conversely, inflation typically has a negative impact on bonds, since it mitigates the expected buying power of future interest payments. That said, if you're a bond investor, consider diversifying your fixed income holdings among bonds of various maturities so you can attempt to capture any future increase in interest rates. At the same time, minimize your position in long-term bonds, since these are especially vulnerable to inflation.
The same long-term caveat applies to certificates of deposit (CDs). Avoid tying up cash, such as your household emergency fund, in this way. Instead, consider maintain a CD ladder, in which your portfolio holds several CDs with staggered maturity dates. When the CD with the shortest term matures, you can roll the cash into a longer-term CD.
Many analysts believe that Congress will raise taxes this year to finance health care reform and ongoing economic stimulus programs. With that in mind, you may want to adopt forward-thinking tax-minimizing strategies for your earned and investment income.
First, contribute as much as you can to your Traditional IRA, 401(k) or other traditional tax-deferred plans to reduce your taxable income. Roth accounts are particularly useful if you anticipate that your tax rate in retirement will be higher or if you will not need the income from the Roth account in retirement. Though your contributions are not tax deductible, your retirement-time withdrawals will be tax-free (provided you've held the account for at least five years and have reached age 59 1/2). Consider a Roth 401(k) if you have access to one, or look into converting a portion of your regular savings into a Roth IRA either directly if you are eligible to contribute to Roth IRA under IRS rules, or by making after-tax contributions to a Traditional IRA and then converting to a Roth IRA. In any case you should consult your tax advisor before contributing to an account to determine the tax consequences of electing the Roth option.
Also consider taking advantage of new and existing tax breaks before they expire. Among them:
• Tax credits for first- time homebuyers and certain repeat homebuyers.
• Credits for energy-efficient home repairs
• An expanded tuition tax credit
• The $2,500 to $7,500 electric vehicle credit.
The past year has presented investors with a difficult set of challenges - with more to come as the economic cycle continues to play out. Under these circumstances, investors who guard themselves now against inflation and possible tax hikes will enjoy a financial advantage if these possibilities come to pass.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of Morgan Stanley Smith Barney LLC. He can be reached at William.a.creekbaum@mssb.com or 689-8704.