11/7/2012 3:45 PM ET|
Fiscal cliff takes aim at your wallet
It's the crisis no one wants to face. But the fiscal cliff is looming -- and it will hit your finances hard if Congress doesn't act soon.
At least the fiscal cliff is aptly named. If we reach it, our economy could plunge off a precipice.
On Dec. 31, a raft of tax cuts will expire, and a bunch of automatic federal spending cuts will kick in. If you haven't heard much discussion about it, that may be because many people don't realize yet what's at stake.
"There hasn't been a lot of talk" among regular people about the fiscal cliff, said CPA and attorney Mark Luscombe, the principal federal tax analyst for tax research firm CCH. "People could start complaining when they see their first paycheck in January."
What's expiring includes some $500 billion in tax cuts. According to CCH, here's what that means:
● Higher tax brackets: The lowest 10% bracket would disappear, and the highest would rise from 35% to 39.6%.
● Higher payroll taxes: The "payroll tax holiday" of the past two years will expire, raising workers' Social Security contributions to 6.2% of their paychecks from the current 4.2%.
● Higher rates on capital gains (from a current 15% maximum to a 20% maximum) and dividends (from a current 15% to as high as 43.4%).
● Significantly lower child and dependent care tax credits.
● The return of the so-called marriage penalty.
● The end of temporary fixes that keep nearly 30 million families from having to pay the dreaded alternative minimum tax.
● Dramatically lower gift and estate tax exemptions (the limits will plunge from $5.12 million to $1 million) and higher tax rates on transfers in excess of those limits (from a maximum 35% to a maximum 55%).
The Tax Policy Center estimates that the end of virtually every tax cut enacted since 2001 would boost taxes an average $3,500 per household. Middle-income families would see an average annual tax increase of almost $2,000, the center said.
The $100 billion in automatic spending cuts -- which include $30 billion in cuts to the defense budget -- are a result of Congress' previous failure to come up with a workable compromise to cut the deficit.
Our wobbly-kneed economy doesn't need to have billions of dollars pulled out from under it right now. The Congressional Budget Office has warned the fiscal cliff will trigger a "significant" recession, throwing an additional 2 million people out of work.
OK, that's bad, but simply taking a U-turn could be worse. The CBO warns that if the tax cuts are all extended and the spending cuts averted, the deficit will explode. As a result, the national debt -- which is now a worrisome 70% of our gross national product -- would rise to 90% of GDP within 10 years.
The money we spend paying interest on that accumulated debt wouldn't be available for more productive uses, like investing in businesses that could provide jobs. The economy could slowly strangle. Other government services likely would have to be sacrificed to pay the tab. Those who buy our debt might decide we're not all that creditworthy and demand higher interest rates. In fact, Moody's ratings service has already threatened to cut the nation's credit rating if Congress doesn't come up with a plan to cut spending.
In short, keeping everything as it is now -- tax cuts in place but no spending cuts --"would improve the economic outlook in the short run but would boost deficits and debt significantly and would place the budget on a path that is ultimately unsustainable," the CBO wrote in its August report. (Italicized emphasis added.)
CBO uses the word "unsustainable" to describe this trajectory three more times in its report, just so we get the point.
Clearly, a lot is at stake, and some hard choices have to be made. The uncertainty is already a drag on the economy and interfering with people's ability to plan their finances. So it should be no surprise that Congress has dithered. No one knows whether lawmakers will be able to put together a deal to avert the fiscal cliff or to soften its effects.
Oh, yeah, and we're also scheduled to hit our debt ceiling again at the end of the year. Last time that happened, the political theatrics spun so far out of control that we almost defaulted on our debt.
Since the Nov. 6 election, there have been a few signs that a compromise may be possible as pressure mounted on Congress to act. The CBO repeated its warnings in a Nov. 8 report, but also indicated that letting taxes rise only on wealthier people—as President Obama has advocated—would not hurt the economy much. The CBO estimated tax hikes for households that make $250,000 or more would cost 200,000 jobs in the short run, rather than the 700,000 claimed by Republican Speaker of the House John Boehner.
Boehner, for his part, has indicated he would be open to “new revenue sources” and a “fairer, cleaner, simpler tax code” but not necessarily tax hikes. Both sides have been trying to parse his remarks, with some concluding that certain tax deductions, like those for mortgage interest and state and local taxes, may be targets for reduction or elimination.
It’s also possible that the lame-duck Congress will punt, at least until next year, by passing measures that put off the fiscal cliff for now. Then newly-elected lawmakers could wrestle with a longer-term compromise on taxes and deficit reduction.
Only a few things seem clear in all the murk:
Payroll taxes are almost certainly going up. The 2 percentage point cut in Social Security taxes was meant to be temporary, and not even President Barack Obama championed the idea of extending it any further.
An alternative minimum tax fix may be possible. The fix was actually among a bunch of tax provisions that expired last year. There's significant congressional support for extending it, especially since the lack of a fix is now interfering with the 2012 tax filing season, Luscombe said.
Few in Congress like the defense cuts. On both sides of the political aisle, lawmakers are worried about blows to military bases and defense contractors in their districts. Plus, few want to be seen as weakening our national defense.
So what should you do now? You needn't stock up on ammunition and canned goods -- we've survived worse crises than this. But here are some things to consider:
- The stock market could get more volatile if Congress fails to act in time. That doesn't mean bailing on your stocks. Just get prepared for a bumpy ride.
- Tax planning is a big question mark. If it were certain that income and investment tax rates were going up, it would make sense to take capital gains now and move as much income into 2012 as possible while delaying deductions. But the only tax hikes that are virtually certain at this point are the expiration of the payroll tax holiday and the imposition of a new 3.8% Medicare tax on the net investment income of high earners. (Read more here: "Know the facts about the new 3.8% tax.") If you're a high earner or have a lot of investment income or a large estate, you should definitely talk to a tax pro before year's end.
- Your opinion matters. The fiscal cliff has stayed low on the national radar because not enough people have demanded that Congress act. You might want to let your lawmakers know how you feel about the whole mess.
More from Liz Weston:
Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.
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