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And with It Come Questions and Uncertainty for TaxpayersOn Jan. 1, the country may find itself falling back into recession, personal income taxes will go up, federal government spending will be cut, and unemployment most surely will rise. The good news, however, is that the federal deficit will undoubtedly be somewhat reduced.
This fiscal cliff, as it’s called, refers to a frenzy of fiscal changes that, collectively, have a far-ranging impact on all taxpayers and the economy. These changes in law are a result of a dizzying variety of tax laws enacted, altered, modified, or extended during the past 10 to 12 years. Congress’s failure to agree on its own budget cuts last summer forced the automatic spending sequestration of approximately $1.2 trillion in non-discriminatory spending cuts, across all line items, to be made over the next decade.
The Congressional Budget Office (CBO), a non-partisan arm of the U.S. Congress, estimates that the federal government could collect more than $200 billion more in personal income taxes in 2013 as a result of the changes in the personal income-tax laws. In addition, the CBO estimates that the expiration of the currently popular payroll tax cut of 2% on Social Security taxes will generate another $90 billion in revenue.
Obviously these gains are desperately needed to help balance the books of the U.S. government. However, they, in conjunction with the automatic spending sequestration, which is estimated to save the government $109 billion in 2013, will still fall well short of balancing the budget.
Other fiscal changes include the return of the 55% estate-tax rate. This item is actually a popular topic of discussion among most legislators, and has better curb appeal in getting reversed. However, the discontinuance of federally extended unemployment benefits is a hot potato, and their expiration could have a more serious impact on the U.S. economy, which relies heavily on consumer spending.
Other than a possible recession, the biggest impact of the fiscal cliff would be felt by individual taxpayers as the infamous Bush tax cuts are all reverted back to levels not seen since 2000. Gone would be the 10% income-tax rate and the imposition of a maximum 39.6% personal income-tax bracket. Also set to expire is the maximum 15% tax rate on long-term capital gains and qualified dividends.
In 2013, long-term capital-gains tax could be as high as 20%, and qualified dividends would be taxed at an individual’s ordinary tax rate, which could be as high as 39.6%. Both of these items, otherwise known as unearned income, would also be subject to an additional 3.8% surtax for taxpayers with adjusted gross income over certain levels.
The alternative minimum tax (AMT) will come into play for another 30 million taxpayers. The AMT is an archaic part of the tax code, first enacted in 1969 to increase the effective tax paid by taxpayers who, for a variety of reasons, were not paying any personal income taxes. The AMT basically increases the effective tax you pay by disallowing certain deductions that are allowed under the regular tax code.
Ironically, ever since the Bush tax cuts, more people became subject to the AMT because the built-in minimum tax rates of 24-26% had essentially wiped out the 10% and 15% tax brackets for higher earners. The CBO estimates that, even with the increase in the regular tax rates, the reduction in AMT income thresholds will still increase overall personal tax revenues. Taxpayers who reside in states where they pay higher real-estate taxes and a state income tax tend to be the victims of the AMT.
For residents in Massachusetts or Connecticut, it is very probable that an average married couple whose combined income is more than $100,000 will have the AMT.
Another area of concern is on the new 3.8% Medicare tax surtax that will be payable on unearned income, mostly by taxpayers in higher tax brackets (for example: a married couple with combined income of more than $250,000). This new tax could cause many people to shift their taxable investments, which may have an impact on financial markets.
With the expiration of the 2% Social Security tax cut, which was first enacted in 2011 and extended into 2012, an employee or self-employed individual should expect to pay up to an additional $2,202 more in Social Security tax in 2013.
So what does all this really mean? The fiscal cliff is getting nearer as Dec. 31 approaches, and without congressional action, the economy could very well give back the gains it recently made after the last recession from December 2007 to June 2009. Many experts suggest that, even though the country is not in a recession, the Jan. 1 fiscal changes will have a negative effect on the economy.
Government spending cuts will increase unemployment, higher income taxes will decrease consumer spending, and small-business owners may cut or curtail hiring. Meanwhile, investors may start shifting their portfolios to avoid the higher taxes on unearned income like capital gains and dividends. Basic uncertainty over fiscal policy and taxation is enough to make citizens pause and maintain the status quo; that alone will stymie an already semi-stagnant economy.
As a professional tax practitioner, I have learned to plan based on the tax code currently in effect. That code is complex and ever-changing. Changes in tax rates are a large part of careful tax planning, so making rash decisions or no decisions at all could increase your total tax burden.
We last saw major tax law changes at the end of 2010, but 11th-hour politics prevailed, and some tax relief was had as we headed into 2011. All taxpayers should stay abreast of the tax law changes, now and in the future, through self-awareness and professional support. Cautious optimism is my rule of thumb; the tax code is always in flux, and only over the long haul will proper tax planning really be effective, cliff or no cliff.
Nicholas LaPier, CPA, is the principal at Nicholas LaPier CPA P.C. in West Springfield; (413) 732-0200; www.lapiercpa.com