Is your portfolio ready for higher taxes and inflation?

The days of robbing Peter to pay Paul have come home to roost. For the first time in our history, the U.S. credit rating was downgraded last summer. Today our debt stands at over $15 trillion. Add the pressure of huge, underfunded programs like Medicare and Social Security coupled with gridlock in Washington, and you've got the ingredients for a perfect storm of higher taxes and inflation. The only solution is to raise revenue and cut spending. Given this backdrop, it's safe to say that both taxes and inflation are headed up.

In the 11th hour before the holiday break, Congress agreed to extend tax cuts for two months into 2012. As you read this article, the President and Congress will be debating whether to extend the cuts for the entire year.

As a Michigan resident, your taxes have already changed. Though our state income tax rate will actually decrease by .10 percent in 2013, several far-reaching credits and deductions disappear this year, increasing the tax bill for many. The Homestead Credit will change for many as will the child tax credit. Some charitable deductions will go away and many who were born after 1946 will see their pension income taxed. It's clear we need to plan for these changes.

Five ways to insulate your portfolio from taxes

1. Fund a tax-qualified retirement plan. A married couple with an income between $69,000-$139,000 is in the 25 percent tax bracket. You can save 25 percent on every dollar you contribute to a qualified retirement plan. Any growth within your account accumulates tax deferred.

2. Look into funding or converting to a Roth IRA. Unlike qualified plans, contributions to Roth IRAs offer no tax relief but the withdrawals are income-tax free.

3. If you are a small-business owner with net operating losses, look for creative ways to utilize losses. You may be able to convert some or all of your taxable IRAs into a Roth IRA with virtually no income tax consequences. There are no income limits or phase-outs for Roth conversions.

4. Determine if there are any long-term gains or losses in your non-qualified accounts that can benefit your tax planning needs.

5. Consult with your Certified Financial Planner™ Practitioner and your CPA early in the year for more proactive and comprehensive planning. Waiting until tax filing time is often too late. Horizon Financial does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.

The Threat of Inflation

Things that can cause inflation include the government quickly printing excess money and a high level of government debt. Another is the rise in production costs. While production costs have recently decreased in the U.S., they are on the rise in places such as China. Knowing what causes inflation to rise, it's clear we should expect increases in the coming years. In fact, we already see higher costs at the grocery store and the gas pump, in college tuition bills and in health insurance premiums.

Four asset classes that have historically held up well during inflationary times:

1. REITS (Real Estate Investment Trusts)-There are several types of REITS including traded and no-traded, retail, commercial and sector-specific like healthcare and travel.

2. Gold and other commodities-As the dollar declines, the price of gold and other precious metals tends to rise.

3. Ultra Short Term Treasuries-The shorter the duration, the less vulnerable the principal is to rising inflation.

4. TIPS-Treasury Inflation Protected Securities- By definition, TIPS are tied to the CPI. If the CPI goes up three percent, the principal amount you invested goes up by three percent and you begin earning interest on the larger principal amount.

Before investing, consider the current price of each holding and where in its cycle we appear to be. For example, gold has been a very strong investment the last few years. It could be the next big bubble, so don't assume it will be a perfect hedge against inflation. Consult with a professional and diversify across several asset classes. (Diversification does not assure a profit or protect against losses in declining markets and diversification cannot guarantee that any objective or goal will be achieved.)

To be prepared for the likely onset of higher taxes and inflation, you need a plan. Begin with a written detailed roadmap for your financial future. Once you are clear where you stand, you'll be ready to commit to a specific investment strategy for your portfolio. Staying on the sidelines is not a strategy.

For more information about this article or to schedule a complimentary stress test using your current investment strategy, give our office a call. Complimentary reviews for Traverse City Business News readers are available through March 15.

Holly Gallagher, CFP®, AIF® was recently voted the #1 financial planner in Northern Michigan's magazine's Red Hot Best Survey as voted by readers of Traverse Magazine June 2011 Issue. She has 20 years experience as personal CFO to a limited number of clients.

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