If Congressional gridlock sends the U.S. Government tumbling over the "fiscal cliff" at the end of this year, many Americans will see their taxes go up.
Federal Reserve Chairman Ben Bernanke described it as the "fiscal cliff" others have referred to it as "Taxmageddon." Either way, unless Congress acts soon, beginning January 2013 the U.S. economy will experience a double hit of automatic spending cuts and expiring tax breaks. If all these provisions are allowed to end at once, as scheduled under the current law, they could stall economic growth and tip the U.S. back into recession, according to the nonpartisan Congressional Budget Office (CBO).
The programs set to expire include the Bush-era tax cuts, the payroll tax cut, the alternative minimum tax (AMT) patch, and other tax-relief programs, as well as the start of automatic U.S. Government spending cuts agreed to in 2011.
Will Congress act before year end? It’s impossible to predict exactly how all of this will play out, although most expect lawmakers to work out a compromise plan after the November election. The final deal, of course, will hinge on who is in charge in Washington and the nature of whatever agreement is reached.
What is the potential impact of the fiscal cliff?
- Income Taxes Will Rise
If the Bush-era tax cuts are allowed to expire, we can expect to see tax rates increase for basically all taxpayers, as illustrated in the chart left/right/below. According to the nonpartisan Tax Policy Center, this could translate into an average tax increase of close to $3,500 per household in 2013. Those making $120,000 - $150,000 could expect a tax increase of closer to $6,000 a year, and the highest earning families may see their average tax bite increase as much as $14,000.
Source: Congressional Research Service, "An Overview of Tax Provisions Expiring in 2012."
*Specific increases vary by income level. Check with your tax professional to see how the increases could impact you.
- Payroll Tax Cut Would End
The Social Security payroll tax cut which was extended for 2012 is also set to expire. This would mean an average increase of $1,000 in taxes for American workers.
- Child Tax Credit Would Be Cut in Half
Families would see the $1,000 child tax credit drop to $500.
- Earned Income Tax Credit Would End
The earned income tax credit, which is a refundable tax credit, is also scheduled to expire.
- Estate Taxes Would Jump Sharply
Currently the first $5.12 million of an individual’s estate avoids estate taxes. Anything above that amount is taxed at a 35 percent tax rate. If the current estate tax provisions are allowed to expire, the estate tax exemption would drop to $1 million and the tax rate would increase to 55 percent.
- Medicare Surtaxes Will Begin
Individuals earning more than $200,000 ($250,000 for married couples filing jointly) will be subject to a new Medicare surtax on investment income, as well as an increase in the Medicare payroll tax.
- Standard Deduction for Married Taxpayers Will Fall
The so-called "marriage penalty" is scheduled to return, which means married couples filing jointly no longer will be able to claim twice the standard deduction available to single filers.
- Dividend Tax Rate Will More Than Double
The tax on dividends will skyrocket from 15 percent to as much as 39.5 percent.
Although the clock is ticking, there’s still time for Congress to act. Whether or not taxes increase immediately, however, it’s important to be prepared. That’s why it makes sense to work with your tax and investment professionals to determine what steps, if any, you can take this year to prepare for future tax implications. Consider having a discussion with your tax and investment professionals about the following:
- Review Estate Planning
Time is running out to take advantage of the $10.24 million that couples are allowed to transfer without gift- or estate-tax consequences. While no one knows whether the exemption will fall back to $1 million in January 2013, one thing is certain: it’s time for families to protect their wealth.
- Review Your Investment Portfolio, Consider Realizing Capital Gains
Take a look at your goals, current allocation, and tax considerations to determine if you need to make any changes in your portfolio. Realizing capital gains ahead of potential capital gains tax increases may be beneficial.
- Analyze Your Tax Bracket
You may find it necessary to accelerate income in 2012 or defer certain deductions if you’re in a higher tax bracket in 2013 than 2012. Work with your tax advisor to determine if either of these strategies is appropriate for your situation.
- Portfolio Tax Efficiency
Depending on your goals and situation, you may consider increasing holdings in more tax efficient investments such as municipal bonds. In addition, consolidating less tax efficient investments in tax-deferred accounts such as 401(k)s and IRAs will allow you to postpone taxes on dividends or distributions.
- Roth Conversion
If you have a traditional IRA, you may want to consider converting the account to a Roth IRA to take advantage of tax-free growth potential.
- Think About Permanent Life Insurance
In addition to the death benefit, permanent life insurance provides guarantees that can help your cash value grow. Life insurance proceeds are generally income tax free and, if owned by an irrevocable trust, can be estate tax free as well.
As the end of the year approaches, now may be an opportune time for investors to review their portfolios with their investment and tax professionals and to consider the potential tax ramifications of the approaching fiscal cliff. As each individual’s personal situation is unique and we don’t know exactly what is going to happen with the "fiscal cliff," it is critical to base any actions on your overall situation and goals. Investors are wise to concentrate on the basics of tax planning — a strategy that makes sense in any economic or tax environment.
Wealth management advisors do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent tax advisor.
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