By Jeffrey C. Simon, CFP®
RBC Wealth Management
What is the "fiscal cliff"? It's the term used by many to describe the combination of tax increases and spending cuts scheduled to go into effect on Jan. 1. The ominous term reflects the belief by some that, taken together, higher taxes and decreased spending at the levels prescribed have the potential to derail the economy. Whether we step off the cliff at the end of the year and what exactly that will mean for the economy depends on several factors.
Will expiring tax breaks be extended?
With the "Bush tax cuts" (extended for two years by legislation passed in 2010) set to sunset at the end of this year, federal income tax rates will jump up next year. We'll go from six federal tax brackets (10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent) to five (15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent). The maximum rate that applies to long-term capital gains will generally increase from 15 percent to 20 percent. And while the current, lower long-term capital gain tax rates now apply to qualifying dividends, starting in next year dividends will once again be taxed as ordinary income.
The temporary 2 percent reduction in the Social Security portion of the Federal Insurance Contributions Act (FICA) payroll tax, in place for the last two years, also expires at the end of this year. Lower alternative minimum tax (AMT) exemption amounts (the AMT- related provisions expired at the end of 2011) mean that there will be a dramatic increase in those subject to AMT when they file their 2012 federal income tax returns in 2013.
Other breaks go away next year as well.
Estate and gift tax provisions will change significantly (reverting to 2001 rules). For example, the amount that can generally be excluded from estate and gift tax drops from $5.12 million in 2012 to $1 million in 2013 and the top tax rate increases from 35 percent to 55 percent. Itemized deductions and dependency exemptions will again be phased out for individuals with high adjusted gross incomes (AGIs).
The earned income tax credit, the child tax credit and the American Opportunity (Hope) tax credit all revert to old, lower limits and less generous rules. Individuals will no longer be able to deduct student loan interest after the first 60 months of repayment.
There continues to be discussion about extending expiring provisions. The impasse centers on whether tax breaks get extended for all, or only for individuals earning $200,000 or less (households earning $250,000 or less). Many expect there to be little chance of resolution until after the November election.
Will new taxes take effect next year?
Beginning next year, the hospital insurance portion of the payroll tax — commonly referred to as the Medicare portion — increases by .9 percent for individuals with wages exceeding $200,000 ($250,000 for married couples filing a joint federal income tax return and $125,000 for married individuals filing separately).
Also beginning next year, a new 3.8 percent Medicare contribution tax is imposed on the unearned income of high-income individuals. This tax applies to some or all of the net investment income of individuals with modified adjusted gross income that exceeds $200,000 ($250,000 for married couples filing a joint federal income tax return and $125,000 for married individuals filing separately).
Both of these new taxes were created by the health-care reform legislation passed in 2010 and it would seem unlikely that anything will prevent them from taking effect.
Will mandatory spending cuts be implemented?
The failure of the deficit reduction super committee to reach agreement back in November 2011 automatically triggered $1.2 trillion in broad-based spending cuts over a multiyear period beginning next year. The cuts are to be split evenly between defense spending and nondefense spending. Although Social Security, Medicaid and Medicare benefits are exempt and cuts to Medicare provider payments cannot be more than 2 percent, most discretionary programs including education, transportation and energy programs will be subject to the automatic cuts. New legislation is required to avoid the automatic cuts. While it's difficult to find anyone who believes the across-the-board cuts are a good idea, there's no consensus on how to prevent them.
What's the worst-case scenario?
Many fear that the combination of tax increases and spending cuts will have severe negative consequences. A report issued by the nonpartisan Congressional Budget Office, "Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013," says taken as a whole, the tax increases and spending reductions will reduce the federal budget deficit by 5.1 percent of gross domestic product between calendar years 2012 and 2013. The office projects that under these conditions, the economy would contract during the first half next year. It's impossible to predict exactly how all of this will play out. One thing is for sure, though: The fiscal cliff figures to feature prominently in the dialogue.
Jeffrey Simon's website is jeffreycsimon.com. He works at RBC Wealth Management, a division of RBC Capital Markets LLC, member NYSE/ FINRA/ SIPC.