How to prepare for the fiscal cliff

U.S. Capitol Building

Barricade the doors. Hide gold in your mattress. Listen to the worst doomsayers about the possibility the federal government could plunge off a “fiscal cliff,” and you’d think that’s what you should do to prepare.

Luckily, there’s more practical advice about the steps you can take if the end of the year approaches and Washington hasn't reached a deal to avoid the dreaded combination of tax increases and government spending cuts scheduled to take effect Jan. 1, 2013.

(Click here to learn more about what the fiscal cliff really means for the federal government and how it's likely to impact you.)

The first thing most of us would notice is a drop in our take-home pay because more taxes would be withheld from our paychecks.

Then this financial double-whammy could hit the economy hard enough to push it back into a brief recession.

None of this is sure to happen. If there’s a rule that applies to Congress, it’s that nothing difficult gets done until the last minute. As the fiscal cliff approaches, pressure will increase for a budget compromise that reduces the impact of the changes.

But planning for the worst never hurts. If the deadline approaches without a deal, Greg Womack, a certified financial planner in Edmonds, Okla., advises reviewing your personal finances in preparation.

“Don’t panic, but take a good look and develop a game plan, whether it’s your investment portfolio or your budget,” he says. For a household budget, he suggests seeing where you could trim spending, if necessary, in preparation for a smaller paycheck.

“If you can increase your 401(k) (retirement) savings, that might also help offset some of the tax implications,” he advises. That’s because contributions to a traditional 401(k) plan or Individual Retirement Account (IRA) can be deducted from your taxable income.

The maximum long-term capital gains tax rate would go from 15% to 20%.

“A 20% capital gains tax is not the end of the world, particularly if you’re in a higher tax bracket,” Womack notes, “but it could have an impact on the market.”

Indeed, combine that with even a brief economic contraction, and stock prices seem very likely to fall early next year.

To avoid those losses, Womack says investors should consider selling some of their shares or equity-holding mutual funds now and moving that money into safer cash savings.

Last year, when the government’s credit rating was downgraded during a battle over raising the federal debt limit, he notes, “You saw the market go down, and you saw U.S. Treasury (bonds) and gold go up. People fled to safety ... If things do go crazy, it doesn’t hurt to have some money sitting in cash.”

If the fiscal cliff is avoided, the extra homework will still stand you in good stead, particularly when it comes to a household budget.

“If it doesn’t happen, you’re still better off,” Womack says. “Maybe keep that same plan, and use the extra cash to save or reduce debt and get on top of your finances.”