The times they are a changin’ for taxes in the United States if legislation doesn’t change things soon. Most americans are unaware of their taxes will be reshaped by the impending “fiscal cliff.”
The phrase that is being tossed around in the media is “falling off the fiscal cliff” or “taxmageddon”, and both are fairly accurate as to the repercussions.
Understanding exactly what is going to happen if we fall of the fiscal cliff is critical to your personal finances for 2013, so we’re going to break down some of the big points for you.
Repercussions of Falling Off the Fiscal Cliff
This list is pretty terrifying unless you enjoy paying higher taxes.
Expiration of Payroll Tax Cut
For the last two years we have all enjoyed a 2% decrease in payroll tax for Social Security.
Normally you pay 6.2%, but we’ve all been paying 4.2%. Self-employed individuals will go back to paying the full 12.4% in Social Security tax. (Your employer pays the difference if you are a W2 employee.)
This is a minor tax increase, and one that should probably go back to being normal considering the current future of funding for Social Security.
Expiration of Bush Tax Cuts
This is the big one.
Here is a snapshot of the major taxes that would go up if the Bush tax cuts are allowed to expire. There are a lot of nuances to the Bush tax cuts that I won’t go into, but these are the ones that will impact most individuals:
- Tax bracket increases across the board
- 10% bracket becomes 15%
- 25% bracket becomes 28%
- 28% bracket becomes 31%
- 33% bracket becomes 36%
- 35% bracket becomes 39.6%
- Capital gains tax increase from 15% to 20%
- Child tax credit goes down from $1,000 to $500
- Estate tax rates up, estate tax exemption down, no longer able to deduct state or local taxes paid, and estate tax exemptions will not be portable between spouses
- Dividend taxes will increase dramatically from 15% t0 39.6%
Expiration of Alternative Minimum Tax Patch
The Alternative Minimum Tax was a good idea when it was first written into law. The intent was to keep extremely wealthy individuals from using specific tactics to avoid paying any tax at all by requiring them to pay tax by a different set of rules called the Alternative Minimum Tax.
The only problem is the income level that would trigger the AMT was never set to inflation.
As incomes rise with inflation more and more middle class earners are caught up by the AMT. That means each year Congress has to pass a band-aid patch that increases the exemption to a certain amount to make sure those important middle class voters aren’t hit too hard. The most recent patch will expire if nothing is done about the fiscal cliff.
Expiration of Unemployment Benefits
The extended unemployment benefits many individuals have been surviving on will expire.
New Healthcare Taxes Kick In
On top of previous tax cuts expiring — essentially increasing taxes from their current levels — Congress has new taxes for us as part of the Affordable Care Act.
The Medicare tax will increase for those earning over $200,000 by 0.9%. Additionally, a 3.8% surtax on net investment income will kick in for those with a high enough modified adjusted gross income (MAGI).
Those MAGI levels are:
- $200,000 if filing Single or Head of Household
- $250,000 if Married filing Jointly
- $125,000 if Married filing Separately
Required Spending Cuts
On top of the tax cuts there will be automatic cuts to spending on defense and non-defense.
The hit to the defense spending ranges from 9.4% to 10%, the hit to payments to Medicare providers will be 2%, and the hit to non-defense spending (things like education and research) range from 7.6% to 8.2%.
The overall amount that was supposed to be covered through both tax increases (or expiration of tax cuts) and decreased spending was $1.2 trillion. A majority of that hole is made up through the tax increases. However, $109 billion is scheduled to be cut from spending.
Will We Really Fall Off the Fiscal Cliff?
Congress has elected to consistently kick the can down the road when it comes to dealing with our massive debt load and overspending.
The same thing happens with individuals in debt: instead of spending less than they earn, they just take on more debt, increase their minimum payments, and keep on with the status quo.
At the very least the fiscal cliff forces Congress to once again reevaluate our current predicament.
However, I just can’t believe that all of those elected officials will let such a shockingly high tax increase to occur overnight. They are elected officials, and they’ll want to keep their records clean for the next election. I do think reforms are necessary, perhaps including paying higher taxes across the board, but having every tax increase hit all at the same time would be significantly unpopular.
I would imagine some sort of compromise would be found before Congress leaves for the holiday recess; essentially another band-aid on a massive problem that no one wants to tackle because they don’t want to be unpopular and end up unelected the next time around.