The election is finally over, which means the tax clock is ticking. Congress now has eight weeks until the U.S. economy jumps over the much-dreaded “fiscal cliff,” the combination of tax increases and spending cuts that are scheduled to go into effect in January 2013.
Earlier this week, House Speaker John Boehner, R-Ohio, said that a lame duck Congress “probably shouldn’t do big things,” but “the best you can hope for is a bridge.” That bridge may mean a short-term extension, which would allow newly-elected lawmakers and President Barack Obama to hash out a deal.
Today, Speaker Boehner was a bit more conciliatory, saying that all sides are “closer than many think” to being able to revise the tax code and come to an agreement and Senate Majority Leader Harry Reid said “Of course” a deal is possible, adding that he had a “pleasant” conversation with House Speaker John Boehner this morning and a “nice conversation” with President Obama last night about moving forward on fiscal cliff negotiations.
If all of these kind words wear off behind closed doors and no deal occurs, it’s estimated that 80 percent of Americans would see some form of tax increase next year. The Tax Policy Center estimated that a typical U.S. household would face an average of a $3,700 jump in taxes.
The reason is that a bunch of tax cuts are set to expire, including:
— Bush-era tax cuts, which will bring the tax system back to 2001 levels
— President Obama’s 2 percent payroll tax cut holiday
— A series of other temporary tax cuts, including: The enhanced dependent care credit, the enhanced child credit, the enhanced adoption credit, a portion of the enhanced earned-income credit, the repeal of personal exemption phase-out, the repeal of limit on itemized deductions, the enhanced student loan interest deduction; and the exemption for mortgage debt forgiveness.
— Additionally, the following tax cuts have already expired, but are up for renewal in 2013: AMT adjustment, deduction for state and local sales taxes, IRA charitable donation provision for taxpayers 701/2 and older and Educator’s classroom deduction.
The stakes are high if the economy goes over the fiscal cliff. The Congressional Budget Office said that the U.S. economy would slide into a “significant recession” as a result of the tax increases and spending cuts. The CBO estimates that the economy would shrink by 2.9 percent in the first half of 2013 and by 0.5 percent for the whole year. The Fiscal Cliff would also likely increase the nation’s unemployment rate, from the current 7.9 percent to over 9 percent.
Here is the effect of the fscal cliff for various earners:
Low-middle wage earners: One of the biggest losses for low to middle wage earners will be the Earned Income Tax Credit, which was a refundable credit (meaning that even if your credit exceeds your tax liability, you don’t lose the excess and are entitled to receive any overage as a refund) for married couples filing jointly with 2011 earned income under $49,078 and singles with income under $43,998.
On top of the EIC, the expiration of the “payroll tax holiday,” a 2 percent Social Security tax cut on the first $110,000 in wages, will mean a tax hike of $1,000 per year. Add in the old tax rates that will go back into effect after the expiration of the Bush tax cuts, as well as tax and college credits, and you can see how tax bills for middle and lower taxpayers can pile up.
Upper middle wage-earners: In addition to the payroll tax increase, this group faces higher tax brackets. For every dollar above $70,700, the tax rate will be 28 percent, up from 25 percent. Over $142,700, the rate rises to 31 percent from 28 percent. The current capital gains rate of 15 percent will increase to 20 percent, while the 15 percent dividend tax rate will equal income tax rates.
High wage earners (over $200,000 single, $250,000 married): The two top tax brackets are set to rise from 33 and 35 percent to 36 ($217,450-$388,350) and 39.6 percent (over $388,350) respectively. In addition to the capital gain and dividend rates, as of 2013, the new health care reform will levy a new surtax of 3.8 percent on capital gains, pushing up the top capital gains rate to 23.8 percent for high income earners. Finally, the estate tax is also set to increase. Right now, each tax payer is entitled to a tax credit that wipes out the estate tax due on the first $5,120,000 of an estate. The tax rate above the $5 million threshold is 35 percent. When the Bush tax cuts expire, the exemption will drop to $1 million and the tax rate will increase to 55 percent.
What to do before end of the year: Given these potential tax increases, if you are sitting with ample gains in a taxable account, it could make sense to sell the position and lock-in the 15 percent capital gains rate this year. Even if Congress averts jumping off the fiscal cliff, most economists believe that capital gains rates will likely rise over the next five years. Additionally, this could be a great opportunity to re-balance your portfolio with lower cost assets, like no load index funds. Additionally, if you haven’t reviewed your estate plan in a few years, it’s a good time to dust off the file and make an appointment with your estate attorney.
Source: MONEY WATCH