What Exactly Is the Fiscal Cliff?

The fiscal cliff refers to a number of tax hikes and spending cuts that will go into effect on Jan. 1, 2013. If Congress and President Obama do not agree to act on averting this perfect storm of financial disaster, then America will, as the term has been coined, “fall off the cliff.” The tax increase alone will be more significant than any in the last half century.

According to a recent report from the Congressional Budget Office (CBO) the fiscal cliff (by virtue of taking billions of dollars out of the economy) would drive the U.S. into a recession next year and increase the jobless rate to 9.1% by the end of 2013. In addition, the CBO said economic output would drop by about one half of one percent in 2013 if Congress fails to act to reverse the tax increases and spending cuts put in motion by an earlier deficit agreement. It starts to take effect in January and includes $7 trillion worth of tax increases and spending cuts over a decade. In addition, the debt ceiling — the legal limit on federal borrowing — will need to be raised by early next year from its current level of $16.394 trillion.

So what tax hikes and spending cuts exactly make up the fiscal cliff?

Let’s take a look.

Automatic spending cuts

Since Congress failed last year to reach a debt deal, Budget Control Act provides for automatic spending cuts to begin on January 2, 2013 that will amount to $1.2 trillion in deficit reduction over 10 years. Frankly, that only amounts to about $120 billion per year which is a drop in the deficit bucket.

Defense spending would be cut about $55 billion in 2013, which translates to at least a 10% cut to every program, project and activity that’s not explicitly exempt.

Another $55 billion will be cut from projected levels of nondefense spending, which would include things like education, food inspections and air travel safety. That amounts to about an 8% cut to programs, projects and activities.

The Bush tax cuts

The current rates we have enjoyed for over the last decade are set to expire December 31 as follows:

Income tax rates / brackets: Rise to 15%, 28%, 31%, 36% and 39.6%, up from 10%, 15%, 25%, 28%, 33% and 35%.

Capital gains rate: Rises to 20% from 15% for most filers.

Qualified dividend rate: Rises to one’s top income tax rate, up from 15% for most filers.

Increased itemized deduction limitations: High-income taxpayers may not be able to take some itemized deductions and personal exemptions in full.

Child tax credit: Falls to $500 per child from $1,000. The refundable portion also reduced.

American Opportunity Tax Credit: This credit expires. The smaller value HOPE tax credit for college tuition is reinstated. Several smaller education tax benefits also expire.

Earned Income Tax Credit: Expanded eligibility for the credit expires.

Marriage penalty relief: This means that a low or middle income two-earner couple will owe more to the IRS than they would if they were single making the same income.

Estate tax: The estate tax exemption and credit levels revert to prior levels. The exemption level falls to $1 million from $5 million; and the top tax rate on taxable estates increases to 55%, up from 35%.

Payroll tax holiday

The Social Security tax rate reverts to 6.2%, up from 4.2%, on the first $110,100 in wages. Effectively, someone making $50,000 will pay another $1,000 in payroll taxes next year. Given the bankrupt state of the social security system as a whole, this was an incredibly misguided provision in the first place.

Unemployment benefits extension

The federal benefit extension period expires. For workers who lose their jobs after July 1, 2012, only 26 weeks of benefit payments are available, down from 99 weeks of benefits that had been available. This means that an estimated 2 million claimants will lose their benefits by January.

AMT patch

The Alternative Minimum Tax thresholds fall to $33,750 for individuals and $45,000 for married couples. That’s down from $50,600 and $78,750, respectively, if the exemption amounts had been adjusted for inflation. As a result, more than 30 million more people will now be hit by this tax, up from 4 million to date.


As part of Obamacare, which is now the law of the land, several new additional taxes will be added on top of the tax increases above.

A surtax of.9% will apply to wages or earned income over $200,000 ($250,000 if married). That’s on top of the 1.45% Medicare currently owed on all wages.

An additional 3.8% Medicare surtax will also apply to investment income for taxpayers earning incomes in excess of $250,000.

What to do now

Tax, estate and financial planning are key right now. A thorough review of your tax and financial situation should be taken to determine if it makes sense to sell any long term capital gain investments and pay the 15% tax today, rather than 20% or more after the first of the year.

A review of portfolio holdings should also be conducted to determine any possible exposure to adverse selling pressure to dividend paying stocks or funds. Likewise, the renewed favorability of municipal bonds should be considered, given the higher tax rates that are upon us, not to mention the additional 3.8% Medicare tax on investment income for high income earners under Obamacare.

Accelerating any ordinary income into 2012 from 2013 is also a possible strategy, depending on your individual circumstances.

Finally, for anyone with assets exposed to the new estate tax thresholds (currently $5 million per person, going down to 1 million per person) an immediate review of wills, trusts and estate planning options could save millions in death taxes.

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