Planning for the fiscal cliff

With little change in the balance of power in Washington heading toward the so-called fiscal cliff, economists warn that more than $500 billion in spending cuts and tax increases that Congress passed in the wake of 2011's debt ceiling debate - which will gradually take effect starting in January - could send the U.S. economy back into recession.Concerns about the impact of the fiscal cliff have helped send the Dow Jones industrial average down on six of the eight trading days since the U.S. election, while investor sentiment is at its most bearish in more than a year, according to a survey by the American Association of Individual Investors.But the stakes are considerably lower for investors this time around.In August 2011, the prospect of the United States defaulting on its debt seemed very real, and some economists and analysts warned it could trigger another global financial panic. This year's fiscal cliff debate, by comparison, is as much about tax planning as it is about investing.With that in mind, here are the plays that some financial advisers and investment strategists are turning to.

Focus on taxes

Nearly everyone will pay higher taxes if the planned changes take effect: federal income taxes will rise at all levels, with the top marginal rate increasing to 39.6 percent from 35 percent and the top capital gains rate rising to 20 percent from 15 percent.Also, payroll taxes will increase to 6.2 percent from 4.2 percent; dividends will once again be taxed as ordinary income; and estates worth more than $1 million will now be taxed at 55 percent. Currently, only estates worth more than $5.12 million are taxed, at a rate of 35 percent.With that in mind, some financial advisers are counseling clients to sell stocks that have dramatically appreciated now in order to pay a lower capital gains rate."There's not a lot of downside to taking that tax now before the start of the year," said David Abate, an adviser at Strategic Wealth Partners, a firm with $750 million in assets under management based in Seven Hills, Ohio.Another sell spot: dividend-paying stocks, which have become more popular on Wall Street as the yield on 10-year U.S. Treasuries has fallen below 2 percent.They will no longer be the deal that they once were, said Mike Piershale, head of Chicago-based Piershale Financial Group, who has been selling some positions in dividend stocks.An investor in the top tax bracket, for instance, would pay $4,340 in taxes for every $10,000 in dividend income next year - if the new tax rules take effect, compared with $1,500 under the current rules.The new tax rules could be a boost for tax-free municipal bonds, however, even as their yields touch 45-year lows, according to a UBS research note sent to clients last Thursday.If the fiscal cliff rules take effect, "municipal bonds (will be) one of the few tax advantaged investment choices available," UBS noted.For most investors, a mutual fund or exchange-traded fund that holds tax-free municipal bonds is an easier and less risky way of investing in the category than picking individual issues, analysts said.The $409 million T. Rowe Price California Tax-Free bond fund, for instance, yields 3.9 percent and has returned an annualized 6.2 percent over the last five years, according to Morningstar. The $1.4 billion Dreyfus N.Y. Tax-Exempt Bond Fund yields 3.5 percent and has returned an annualized 5.8 percent over the last five years.But read the fine print: some bonds are only tax-free for investors who live in certain states.'SHORT-SIGHTED'Despite the threat of higher taxes, some advisers counseled that short-term tax planning is also risky."I'm not sure it's worth it to liquidate good stocks to try and save a little money in the near term and be short-sighted in the long term," said Rick Scott, chief investment officer at Los Angeles-based L&S Advisors.Should stocks continue to fall as the fiscal cliff nears, Scott plans to increase his holdings in high-dividend-paying pharmaceutical stocks like Pfizer Inc, Johnson & Johnson and Bristol-Myers Squibb Co that all have reasonable price-to-earnings ratios and are in line for earnings growth. Pfizer yields 3.7 percent and trades at a P/E of nearly 19.Other strategists are making more tactical plays. Bill Stone, chief investment strategist at PNC Financial, has lowered the risk of his portfolios by shifting to a balanced holding of stocks and fixed income.Yet Stone is like many on Wall Street who do not expect the full slate of tax increases and spending cuts to go into effect, even if a deal is not reached until sometime in early 2013.Barry Knapp, chief strategist at Barclays, reduced his year-end price target for the S&P 500 to 1325 from 1395 last week, citing the stalemate in Washington. The S&P 500 rose 1.5 percent to about 1,380 on Monday.While he is cautious overall, Knapp recommends buying into large-cap dividend-paying stocks if they fall sharply as year-end approaches, noting that their dividend yields often best comparable Treasury bonds.