To Our Clients:

We hope your holiday season was filled with warmth and good cheer. And we hope our elected officials in Washington got coal in their stockings because their behavior has been naughty.

Just as we'd warned since last summer, Congress and the President delayed until virtually the very last moment an agreement on a plan to avoid the "fiscal cliff." As we've said many times, we expected the plan to be approved at the proverbial 11th hour for one simple reason: to give the President and everyone in Congress political cover. By waiting until the deadline, everyone gets to say to their constituents, "I didn't like the bill and didn't want to vote for it, but I had no choice." Well, they met their goal – and they created turmoil for all Americans by doing it.

And the worst part is that no permanent solution to the federal budget and national debt was reached. Instead, a temporary measure was approved – one that will require the attention of our newly elected officials. (And we can't help but notice that the 113th Congress first met on 1/3/13, to the dismay of people suffering from triskaidekaphobia – a fear of the number 13!)

The American Taxpayer Relief Act of 2012 and The Patient Protection and Affordable Care Act (commonly called Obamacare – remember that?) mean that the amount of taxes we all pay will increase in 2013. So we will review the new tax rates, then turn our attention to what we expect to happen next and explain the impact we believe all this will have on your investments.

Tax Law Changes for 2013

• Income tax rates remain the same, unless your taxable income will be more than $400,000 this year ($450,000 if married filing jointly), in which case you will pay a maximum income tax rate of 39.6% (up from 35%) and a capital gains and dividend tax rate of 20% (up from 15%). These top rates apply only to the amount of taxable income that is above $400,000/$450,000.
• If your Modified Adjusted Gross Income will be more than $200,000 this year ($250,000 if married filing jointly), then you will also pay a new 3.8% tax on long-term capital gains and dividends (making your total federal tax on capital gains 23.8%) and an additional 0.9% Medicare tax (on top of the 1.45% that all wage earners pay). Both of these new taxes are due to the health care law.
• If your Adjusted Gross Income will be more than $250,000 this year ($300,000 if married filing jointly), then you will not be eligible to claim certain deductions, credits and exemptions.

Have you noticed that different tax rates are determined by different definitions of income? Taxable Income, Adjusted Gross Income and Modified Adjusted Gross Income are all different computations. Congress ignored this opportunity for tax simplification and instead allowed unnecessary complexity to occur. Maybe the new law instead should be called the Tax Preparer Job Protection Act. But I digress. Let's continue with our list.

Tax Law Changes for 2013 - continued

• The payroll tax, which has been 4.2% for the past two years, reverts back to its prior rate of 6.2%. In 2013, you'll pay this tax on every dollar you earn, up to $113,700.
• The Alternative Minimum Tax will apply to those earning $50,600 or more ($78,750 for joint filers). These figures will be adjusted for inflation in the future.
• Emergency Unemployment Compensation and Extended Benefits Unemployment Insurance will continue through January 1, 2014.
• The tax exemption for gifts to individuals is $14,000 for 2013, up from $13,000 last year.
• The exemptions for estate, gift and generation-skipping transfer taxes are increased to $5.25 million per person, and will be indexed for inflation. However, the top tax rate (applicable to estates over $5.25 million) is now 40% (up from 35%).
• Certain business incentives are reinstated for 2012 and extended for 2013.
• Retirement plans, including 401(k) and 403(b) plans, may permit workers to convert their balances to a Roth account. (We generally do not recommend that you do this. Please talk to us before you consider it.)
• It reinstates for 2012 and 2013 a provision allowing you to donate up to $100,000 directly from your IRA if you are age 70½ or older.
• It extends through 2017 college tuition tax credits under the American Opportunity Tax Credit, the Child Tax Credit, the Child and Dependent Care Credit and the Earned Income Tax Credit.
• The mortgage interest tax deduction is unchanged.

There is another attribute worth noting: Many people can contribute more to retirement accounts this year – up to $5,500 to an IRA ($6,500 if you are 50 or older) and up to $17,500 ($23,000 if you are 50 or older) to a 401(k) or 403(b) plan. Talk to your tax advisor to confirm your eligibility.

What Happens Next

Although it seems that the new law has resolved everyone's outstanding questions, nothing is actually resolved quite yet. The "fiscal cliff" had two elements – tax increases and spending cuts – but Washington dealt with just one (the taxes). What our elected officials did not do is address the question of spending cuts. Had no law been passed, $110 billion of federal budget cuts would have occurred automatically on January 2. The American Taxpayer Relief Act of 2012 delayed those cuts – but only until March 27. Like I said, the 113th Congress will have to deal with this issue. In other words, there's another deadline coming, and it's a mere 11 weeks away.

Therefore, we expect continued wrangling in Washington for the foreseeable future, as Congress and the White House decide whether to raise the federal debt ceiling so the government can continue operating, or to reduce spending to avoid hitting the ceiling – or something in between. The new Congress might even decide to revisit some of the tax changes contained in the American Taxpayer Relief Act of 2012. Although very unlikely, we just might find ourselves dealing with tax law changes in March that are made retroactive to January 1.

The Impact on the Financial Markets

As annoyed as virtually all Americans are over this situation (and rightfully so, in our opinion), it is important that we keep all this in context. This is not the first time we have experienced tax increases or spending cuts, nor will it be the last. Yet, despite all the attention these issues have been receiving in the media, it's important to remember that the debates in Washington do not dictate market performance.

If that statement surprises you, consider this: The S&P 500 Stock Index gained 26% in 2009, 15% in 2010, 2% in 2011 and 16% in 2012, according to Bloomberg. That's a four-year average of 15%, above the historic 12% average annual return of the S&P 500 since 1926, according to Ibbotson Associates.

Few would have thought in 2008 that the S&P 500 would perform so well in the following four years. How was that possible, considering how dreadful the economy was?

It's simple: After the economy sank sharply in 2008, corporate profits began to recover. As they grew, stock prices began rising. It's hard for many consumers to understand that corporate profits have been rising, because so many visible signs of the economy have been negative. After all, jobs, housing, gas prices, interest rates, food, health care and college costs have all been disappointing (or worse). But that's the left-over effects of the recession, which was (let's remind ourselves) the worst in decades. But ever since 2008, things have been (quietly) getting better: the unemployment rate is dropping, housing prices are rising, inflation was virtually nil last year, interest rates remain near historic lows, consumer debt is down and spending is up. The result: corporate profits are zooming, and stock prices reflect it. All these fundamentals remain intact – despite the shenanigans in Washington – and we expect them to continue.

But worries remain. Geopolitical issues are plentiful – Europe's economy remains weak, there is continued strife in the Middle East and nefarious activities in North Korea. The weather has been a big challenge lately with hurricanes, tornadoes, fires, earthquakes and volcanos a constant threat, and one that occasionally becomes a genuine disaster. Terrorism is ever-present, and more recently, home-grown – not that that makes it any less appalling, atrocious or tragic.

Financially speaking, the threats of inflation, rising interest rates, or economic slowdown here or abroad remain real. For these reasons we temper our enthusiasm with practicality: This is no time to make big bets.

And let's be clear: Holding large portions of your net worth in any one asset class is a big bet. That includes bank accounts and CDs (in excess of the proper amount for cash reserves), as well as gold, annuities, MLPs, non-traded REITs and other choices that often times are bought due to fear, pessimism or negativity of any sort. Some overly aggressive salespeople tout words like "safety," "guaranteed," "tax-free," "tax-deferred," "lifetime income" and other alluring come-ons, but all too often people who succumb to such sales pitches incur high fees, big risks, large tax bills, limited liquidity and/or low returns. Succumbing to wild panting about hyperinflation, the collapse of the dollar, the end of capitalism and other incendiary rants is no way to help you achieve your financial goals.

In times like these, when fear, uncertainty and anger abound, it is important to remain focused on your goals. Thus, given today's environment, we are convinced that the best way to manage assets is the way we have been consistently managing them for you: Using a highly diversified portfolio filled with thousands of securities from dozens of nations, comprising a wide array of asset classes and market sectors and rebalancing that portfolio when market fluctuations create such opportunities.

It's counter-intuitive, but a properly managed portfolio actually welcomes market volatility. That's because fluctuating market prices create the opportunities to rebalance (and thus add value to) your portfolio. Ironically, the very thing that many investors fear – volatility – is something we harness for your benefit. That's why you don't have to fret when market prices change, unlike so many other investors.

Indeed, extensive diversification and rebalancing reduce the risk of making a bad decision, while preserving your ability to receive the returns generated by the global financial marketplace.

We expect there to be lots of news this year, in many areas. It might be tempting to make quick maneuvers in response to the latest headline, but history convinces us that emotional decision-making only serves to increase costs, produce higher risks, and result in lower returns. It is important that we resist the temptation and stay focused on your long-term goals.

We will continue to keep you informed throughout the year on all the vital issues affecting your investments and personal finances. As always, if you have any questions, please call your Edelman advisor.

Wishing you the best for 2013 and beyond, and thank you for allowing us the honor of serving you!

Regards,
Ric Edelman
Chairman and CEO