Lately, Americans have been distracted by the ferocious debate in Congress centered on funding the federal government through the remainder of the 2011 fiscal year (ending on Oct. 1), as well as reducing the deficit. Earlier this month, the parties finally came to an agreement on a package to fund the government for the next six months. This agreement was immediately followed by two proposals addressing how to rein in the ballooning deficit. The House Budget Committee, led by Representative Paul Ryan (R-Wis.), released its “Path to Prosperity” plan (the Ryan plan) that would cut $6.2 trillion in spending from the president’s 2012 budget over the next 10 years. President Obama announced his own deficit reduction plan that promises $4 trillion in cuts over the next 12 years. Then came the alarming decision from Standard & Poor’s, to downgrade its outlook on U.S. Treasuries from “stable” to “negative.” This decision was based on the agency’s perception that deep political divisions in Congress would keep both parties from agreeing to a deficit reduction plan by the 2012 elections.

In the near future, Congress must also decide on two big issues that had been sidelined: a vote on whether to raise the federal debt ceiling, set to hit its limit by May 16 and a debate and vote on the 2012 federal budget. As Congress grapples with these major decisions, how can we best help our clients weather the budget storm?

The 2012 Budget

President Obama released his 2012 budget on Valentine’s Day, yet he received no love from Congress. Many Republicans complained that the budget—projecting $3.73 billion in government outlays that would eventually trim the deficit by $1.1 trillion by 2021—fell short of taking necessary and serious deficit reduction measures.

Most glaringly, the budget failed to adequately address the most significant threat to the federal deficit: entitlement programs. Recent findings of two deficit reduction commissions called for strategic reforms to Social Security, Medicare and Medicaid, yet the president failed to incorporate any of the proposed solutions–or suggest his own–into the budget.

While the president’s revised deficit reduction plan does call for small reforms to Medicare, the changes are minimal and vague and leave the program virtually intact. The Ryan plan proposes more invasive and controversial changes to Medicare, eventually turning it into a voucher program. Neither the president’s budget nor the Ryan plan proposed any changes to Social Security.

Further, the president’s proposed spending cuts apply only to the discretionary portion of the budget; at 12 percent, a small percentage of overall spending compared to entitlement payments, which account for almost 60 percent of government outlays.

Individual Taxes

Since taking office, President Obama has been clear about his position on the Bush tax cuts: Make the tax cuts permanent for the middle class and allow them to expire for the wealthy. During 11th-hour negotiations late last year, the president conceded to a temporary extension of the tax cuts for all Americans through 2012, along with other provisions in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act). Not surprisingly, in his 2012 budget as well as in his recent plan, the president returned to his original promise of allowing the Bush tax cuts to expire after 2012 for families who make $250,000 or more, and allowing the ordinary income and capital gains tax rates to return to their pre-Bush tax rates (39.6 percent and 20 percent respectively). The dividend tax rate would increase from 15 percent to 20 percent.

How likely is it that the tax rates will increase in 2013? The projected $1.5 trillion 2011 deficit continues to fuel a Congressional debate over the need for both spending cuts and tax increases. With Republican freshmen fighting for huge spending cuts and low taxes and Democrats fighting to preserve their 24 senatorial seats up for reelection in 2012, it seems most likely that any decisions on tax rates will be made during the 2012 lame duck Congress.

Moreover, for the third year in a row, the president included provisions in his budget to limit certain deductions, such as mortgage interest, state and local taxes and charitable deductions. This provision has been extremely unpopular with Republicans; however, as the tax debate rolls on, and concessions are forced on each side, we may see this back on the table.

Estate Taxes

While the 2010 Tax Act increased the estate, generation-skipping transfer (GST) and gift tax exemptions to $5 million for each and lowered the tax rate of each to 35 percent, President Obama’s plan would bring the estate exemption back to $3.5 million in 2013, along with a 45 percent estate tax. Both the gift and GST tax exemptions would also revert to 2009 levels; a $1 million exemption and a 45 percent tax rate imposed on each.

The president’s plan is likely to extend or make permanent the portability provision that was also included in the 2010 Tax Act.

The Opportunity

Most planners agree that the 2010 Tax Act provided us with long-awaited clarity and tremendous opportunity, at least until 2013, and now’s the time to take advantage of certain strategies before tax rates change. Beginning in 2013, an additional 3.8 percent Medicare tax will be imposed on investment income for families who earn $250,000 or more. The Medicare tax will be assessed in addition to any ordinary income, capital gains or dividend taxes owed on investment gains or distributions. In addition, key Congressional leaders have begun tackling entitlement reform, which could also bring about higher taxes down the road.

Wealthy clients may benefit from selling highly appreciated assets now to take advantage of the lower capital gains tax rates and avoid the potential Medicare tax later on. Similarly, the next 18 months could be a good time to take qualified distributions or tap into other assets that generate ordinary income tax or dividend income.

Clients should consider tax-loss harvesting and dividend-paying stocks. Tax-deferred investments, such as life insurance and variable annuities, may also be beneficial as tax rates increase. Keep in mind that as contract values increase within a life insurance or annuity policy, neither the ordinary income tax nor the Medicare tax will be assessed until a distribution is made.

Clients over age 70 1/2 in high-income brackets should consider contributing up to $100,000 of their required minimum distribution (RMD) to a charitable organization in 2011. While it won’t qualify as a deduction, the distribution won’t be included in their overall income, thus potentially reducing their tax bracket.

Further, expect entitlement reform to become another hot topic along with the deficit. As politicians propose drastic cost-cutting strategies and tax increases, it’s likely that Social Security benefits will change for individuals under age 55. For this reason, encourage your younger clients to participate in and maximize retirement plan contributions when possible.

While the president proposes to rein in the generous estate tax rules set forth in the 2010 Tax Act, it’s possible that Congress will either further extend or make permanent its provisions. In the meantime, now’s a good time for wealthy clients to consider making major gifts to individuals and to trusts. Spouses may gift up to $10 million or may utilize the portability rules to preserve a deceased spouse’s exemption.

Neither the 2010 Tax Act nor the president’s budget addressed changes to grantor retained annuity trusts or to family limited partnerships, although several bills last year proposed drastic limitations to both. While there are signs that these limitations will once again be on the table, consider these strategies now for clients who desire wealth preservation and tax-advantaged solutions.