Several clients and Glen Ellyn neighbors have asked me about the “fiscal cliff” lately so I have decided to blog about it. I have also included a calculator below so you can figure out what the fiscal cliff tax rate increases might mean to you.
The term “fiscal cliff “refers to the potential economic fallout from several federal government budget and tax law changes currently scheduled to take effect at the end of this year and the beginning of 2013. Those plans include the expiration of the Bush-era tax cuts, the payroll tax cut, and other tax-relief programs, as well as the start of automatic U.S. Government spending cuts agreed to by Congress in 2011. One estimate projects tax receipts to go up by $500 billion next year.
The U.S Government will get much deeper into our pockets if tax cuts that are set to expire are not extended. Unfortunately, many of us won’t be earning more money next year as the median family income has been going down the past three years.
U.S. households are facing an average tax increase of $3,446 in 2013 if Congress and the President do not avert the so-called fiscal cliff, the nonpartisan Tax Policy Center said in a study released today. Since this is the average number, you know that the typical DuPage County resident will see there taxes go up that much more due to their higher than average income.
What Tax Cuts, Deductions and Provisions Are Expiring?
So just which tax cuts, deductions and other tax provisions are expiring at the end of 2012 in order to cause the fiscal cliff? Here are a few of the major ones:
- Bush tax cuts expire: If the Bush era tax cuts were to expire after a 2 year extension by Obama, we would see the tax rates increase for basically all taxpayers. The current federal income tax brackets would be increasing 3-6%. The current tax bracket rates are at 10%, 15%, 25%, 28%, 33% and 35%. They would increase to 15%, 28%, 31%, 36% and 39.6% respectively if they weren’t renewed.
- Social Security payroll tax cut ends: The payroll tax cut which was extended for 2012 will expire, meaning an increase of $1000 in taxes on average.
- Child tax credit would drop: The $1000 child tax credit would be cut in half to $500, from the current $1000.
- Earned Income Tax Credit goes away: One thing that could hurt low and middle income taxpayers is the fact that the Earned Income Tax credit, which is a refundable tax credit, would go away.
- Estate taxes increase: Currently the first $5 million of an estate avoids estate tax. Above $5 million it would have a 35 percent tax rate. If it expires the exemption would drop to $1 million, and the tax rate would go up exponentially to 55 percent. This could definitely hurt those with small family owned businesses.
- High earners may be subject to new Medicare surtaxes: Those earning more than $200,000 single or $250,000 married filing joint may be subject to new surtaxes on investment income, as well as an increase in the Medicare payroll tax.
- The marriage penalty.. It’s back: The standard deduction for married filers would no longer be twice that of a single filer – re-engaging the so called “marriage penalty”.
- Dividends taxed as ordinary income: The tax on dividends goes up from 15 percent to as much as 39.6 percent, which could be extremely bad for many seniors who rely on dividends.
How should we react to all of this?
Use this 2013 tax calculator to figure out how you may be affected. Higher income tax rates usually do not lead to increased total tax revenue for the government. Higher tax rates encourage employers to cut back their workforce to offset the tax increase (you will see this in dramatic fashion if the new healthcare law stays on the books). This means less people will be employed and paying into the system. Higher tax rates decrease incentives for business growth as the tax burden makes it less attractive to grow. There is a pretty good chance that some of the current tax rates will be extended after the election. The potential capital gains rate change is one of the items to watch most closely.
- If that rate is going to go up, investors should consider selling profitable investments in their taxable accounts prior to year end.
- You may also want to change your withholding election for your paycheck if federal rates go up. This may also mean that you have to make changes to how much you can afford to save each month or use for credit cards, etc.
- You should also look into “Tax-Managed” portfolios for your taxable investment accounts if you want to minimize your tax contributions to Uncle Sam.
- Reallocating the bond portion of your portfolio so that the dividend income producing holdings are in qualified retirement plans or IRA’s and looking at municipal bonds for taxable accounts will also be popular.
- You have a national election next month. Get out and vote for your pocket book if you don’t want to see your taxes go up. If your family income is over $150,000 per year you are in the top 5% of wage earners in the U.S. . The top five percent pay about 60% of all income taxes.
Did I mention to contact your financial planner for specific advice regarding your financial plan?
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