The typical middle-income family will pay an extra $2,000 in federal taxes next year, if a collection of tax breaks and stimulus measures are allowed to expire at year-end, economists predict.
But “typical” will not help you much when estimating the impact on your budget. While about 90 percent of Americans would see some form of tax increase, your share depends on the profile of your income, deductions, tax credits and other factors, like investment income and the odds of losing your job in a recession.
While talks continue for a plan to steer around the edge of the cliff, you can do more than hope for an agreement in Washington, D.C. There are steps you can take, and knowing how to prepare begins with figuring out the shape of the slope ahead. (See the Fiscal Cliff Calculator to estimate the impact on your tax bill.)
Step 1: Gauge the shape of your slope
The tax effects of the fiscal cliff involve the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extended earlier tax cuts and added temporary stimulus measures. According to analysts, these are the biggest hits:
- Payroll taxes. The Social Security tax rate is set to rise from the temporarily reduced 4.2 percent back to the permanent 6.2 percent. That comes to about $860 more out of the average annual paycheck of about $43,000, based on the federal wage index. Even if a deal materializes, Congress is expected to let this stimulus measure expire.
- Income taxes. With the expiration of tax cuts enacted in 2001 and 2003 and extended in 2010, middle-income taxpayers will take a hit as well as those in higher brackets. Families earning $60,350 to $72,300 would see their top tax rate jump to 28 percent of taxable income from 15 percent. President Barack Obama proposes to extend the tax cuts for families with less than $250,000 in income.
- Investment taxes. For taxpayers in most income brackets, taking profits on investments will cost 20 percent after Jan. 2, up from 15 percent now. And taxes on most corporate dividends will rise from a maximum of 15 percent to the tax rate on ordinary income, meaning a top rate of 39.6 percent.
- Deductions and credits. The $1,000 child tax credit will be cut in half, and low-income families would see a reduction in the amount they can receive in refunds if they owe no taxes. Also, tax credits for college students under the American Opportunity Credit would cover fewer college costs and no longer be refundable to people who pay no taxes.
Even if a deal to avoid the cliff succeeds, some taxes will go up starting in January, policy experts predict, and jobs in some sectors will come under pressure as government spending cuts begin. The break on Social Security tax, for example, is not expected to survive the cliff. “I hear no talk of extending that — there’s no appetite for stimulus,” said Roberton Williams, senior fellow at the Urban Institute in Washington and co-author of a study on the fiscal cliff from the Tax Policy Center. “I think all the trade-off is going to happen on the income tax.”
Step 2: Take preventive measures
After assessing the effect on your taxes, it is time to plan how you can adjust income and savings to minimize the impact. Harder to predict is how the economic fallout from federal budget cuts, which would accompany the tax increases, will affect you. But some advisers say it is possible to predict whether your job is in a relatively high risk group and plan accordingly.
The cliff to avoid: Cliff planning is a hot topic at financial planners, especially among their clients with more than $250,000 in income. President Obama’s often-stated position is to keep income taxes from rising on families earning less than that threshold. For single taxpayers, the cutoff point is $200,000. Such a hike would affect only the top 2 percent in terms of income, but this assumes a deal is reached to halt automatic tax hikes across the board.
What to do: Some advice falls under the heading of good ideas that look even better now. “If you think your tax rates are going to go up, you want to be sheltering your income with IRAs and 401(k)s,” advised Steven Elwell, a financial planner in Amherst, N.Y. He recommends taking a hard look at tax deferred savings plans and boosting contributions where possible. “Let’s make sure we’re maxing all the retirement plans we can,” he said.
If you are one of the lucky few who have the ability to adjust your income, take more this year so it is taxed at the lower rate. This could be beneficial for people who provide professional services, advisers say, because they may be able to control the timing of their income from work performed under contracts.
Limit capital gains
The cliff to avoid: Capital gains and dividend rates are not expected to be preserved, and these taxes do affect taxpayers in brackets below the top tiers.
What to do: To minimize the hit from this tax hike, advisers recommend taking gains this year on investments that you would expect to sell anyway in 2013.
Even for stocks you want to keep, it is possible to sell them now — taking the tax hit at the lower, 15 percent rate — and buy them back without a waiting period. The restriction on re-buying stocks sold for a loss does not apply to stocks sold for a gain, Elwell noted. However, the strategy results in paying taxes upfront that could be put off. “You don’t want to do that blindly,” he said. “Don’t let the tax tail wag the investment dog.”
Watch out for deduction caps
The cliff to avoid: One wildcard is an idea for capping tax deductions. Although Mitt Romney was defeated in his run for the White House, his proposal to cap deductions at a choice of levels — $17,000, $25,000 or $50,000 — drew support from many in Congress and is favored by economists.
“Politically, this makes a lot of sense,” said Mark Hopkins, senior economist at Moody’s Analytics. Broad caps would blunt the outcry from groups that back a particular deduction. However, he added, a cap would have to be low — meaning it would affect large numbers of taxpayers — to generate significant revenue.
What to do: There is no firm proposal on the table, so just stay alert and have your tax adviser’s number on speed dial.
That’s especially true of those who claim high levels of mortgage interest tax deductions and those living in high-tax states such as California and New York, where the deduction for state income tax is a significant benefit.
It may be small comfort, but things are so bad in housing that politicians may be especially reluctant to make matters worse by capping mortgage deductions.Williams of the Urban Institute said that concerns about home values and foreclosures would make it politically difficult to limit the mortgage interest deduction, even as part of an overall cap. “A lot of people are hanging on by their teeth,” he said.
A lot of people are hanging on by their teeth.
|— Roberton Williams |
The estate tax hit
The cliff to avoid: The expiration of some tax breaks is difficult to plan around. For example, estate taxes face one of the steepest parts of the cliff. The amount of assets exempt from taxes would plunge from about $5 million to $1 million, and the top rate would rise to 55 percent from 35 percent. A deal on estate taxes has support from both parties, but differences remain on specifics, according to the Tax Policy Center, collaboration between the Urban Institute and the Brookings Institution. Obama proposes setting the exclusion at $3.5 million, with a 35 percent tax rate on amounts above that.
What to do: Those planning to leave more than $1 million to heirs may want to consult estate planners about bypass and insurance trusts.
Assess your job vulnerability
The cliff to avoid: Also hard to cushion is the effect of an economic slowdown as higher taxes absorb more consumer dollars and spending cuts under the Budget Control Act of 2011 play out. Even a relatively mild recession, with a 1 percentage point increase in the unemployment rate, would still mean an additional 1.5 million people out of work — one of them could be you. Meanwhile, long-term unemployed would face the expiration of extended unemployment benefits.
Analysts say that jobs at defense contractors are most exposed, given the size of defense cuts — more than half of the overall reduction — and the fact that war-related spending is exempt from the automatic across-the-board cuts. Defense spending would fall about 9 percent overall, according to the Congressional Budget Office, while war-related spending is projected to rise. Nondefense discretionary spending would fall 8.3 percent.
“Because more than half of the savings have to come from defense, anything connected to defense is at risk,” Williams said. Similarly, areas with large concentrations of military operations or federal jobs will take a harder blow than others. Policymakers are working on a deal to phase in the cuts, he said, which would blunt the impact but not eliminate it.
What to do: Instead of waiting for the ax, those in the path of layoffs can do more than brush up their resume and revive their professional networks. Setting up a consulting business on a sole proprietor basis now makes sense if you expect to undertake consulting work after job loss. Having a viable business makes you eligible for the home office deduction and other tax breaks — in addition to giving you a jump on a new source of income. Now is also a good time to set up a home equity line of credit as a potential source of emergency funds. You can decide later whether to tap the loan — a step fraught with pitfalls, including potential loss of your home.
“I wouldn’t incur any unnecessary costs ahead of time,” said Jason Nazelrod, a certified financial planner and head of Nazelrod & Associates in Baltimore. Some lenders will set up a home equity line for existing clients at little or no cost.
The cliff’s combination of higher taxes and lower federal spending would cause a new wave of job losses, pushing unemployment next year above 9 percent, Moody’s Analytics projects. The jobless rate in October was 7.9 percent.
“We’re basically saying that (fiscal cliff) would put us into a shallow recession for two quarters,” Hopkins said. However, the impact could be worse if unknown factors contribute, such as a deepening fiscal crisis in Europe. Consequently, economists at Moody’s expect some deal to emerge from Washington to soften the impact, rather than risk an economic downturn.
Going into a recession, Hopkins said, “is a bit like driving through a puddle and you don’t know how deep it is.”