With the election decided, the national focus now is on the impending fiscal cliff. The fiscal cliff is the financial precipice that lawmakers must negotiate as various tax increases and spending cuts are scheduled to automatically go into effect unless Congress takes action before Dec. 31.
On Jan. 1, 2013, current tax rates, compliments of the Bush tax cuts, are slated to expire. That's also when the employee payroll tax rate, now 4.2 percent, is scheduled to go back up to 6.2 percent. More estates will face higher taxes in 2013. And don't forget about the 70-plus temporary tax breaks known as extenders that haven't yet been renewed for 2012 or 2013.
The convergence of these tax events has been dubbed taxmageddon, taxopocalypse or likened to standing on the edge of a fiscal cliff. But it's possible that the tax catastrophe, whatever it's called, might be averted.
Now that the election is behind us, a lame-duck Congress and President Barack Obama could reach a deal similar to the one agreed to in late 2010 that put off the tax decisions until now. Or maybe a more definitive deal will be struck. The Congressional Budget Office's warning that the economy would contract by 0.5 percent in 2013 if action isn't taken before the end of the year may spur the Congress to take action sooner rather than later.
Regardless, the uncertainty is almost as troubling as the expiring tax breaks. And both are making life very unsettling for taxpayers and their financial advisers.
Lots of higher tax rates
If 2013 arrives without Capitol Hill taking action on the Bush tax cuts, tax rates will rise for all, not just the top tier of taxpayers. The 10 percent rate will disappear, meaning that everyone will see at least some of their income taxed at 15 percent.
Income ranges for the tax rate brackets also will change, meaning the marriage tax will return for more couples. With the so-called marriage tax penalty, a husband and wife pay more in taxes when they file jointly than they would as single taxpayers.
Below are some key provisions that, without further legislative action, will change dramatically next year. Most of these tax law changes took place when President George W. Bush was in office. Known as the Bush tax cuts, they were enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA.
Fiscal cliff: A heap of tax laws set to expire
|Tax law||In effect through Dec. 31, 2012:||Will change Jan. 1, 2013, to:|
|Payroll tax rate||4.2 percent withheld from employees' paychecks||6.2 percent withheld from employees' paychecks|
|Individual income tax rates||Six income brackets taxed at rates of 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent||Five income brackets taxed at rates of 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent|
|Capital gains and qualifying dividends tax rates||Most capital gains are taxed at 15 percent. Investors in the 10 percent and 15 percent tax brackets do not owe any capital gains on profits from asset sales. Qualified dividends receive the same treatment as capital gains.||Top capital gains rate for most investors will be 20 percent. The zero capital gains rate will return to 10 percent. Dividends will be taxed as ordinary income, meaning the top rate could be 39.6 percent.|
|Marriage tax||Standard deduction for a married couple filing a joint return was increased to twice the standard deduction for an unmarried individual filing a single return. Similar doubling increases were made to the 10 percent and 15 percent tax brackets.||The standard deduction for married couples will be, according to calculations from the tax publisher CCH, 167 percent of the single filer's deduction rather than 200 percent. There will no longer be a 10 percent income bracket and greater disparities between single and jointly filing couples will return.|
|Exemptions||Taxpayers, regardless of income, are allowed to claim full annual exemption amounts for themselves and dependents.||Personal exemption phaseout would return, reducing or eliminating this deduction for higher-income taxpayers.|
|Itemized deductions||Expenses claimed on Schedule A are not limited regardless of taxpayer income.||Total amount of a higher-income taxpayer's itemized deductions will be reduced by 3 percent of the amount that the taxpayer's adjusted gross income exceeds an annual threshold.|
|Child tax credit||$1,000 for each qualifying dependent child.||$500 for each qualifying dependent child.|
|Child and dependent care tax credit||Care expenses of up to $3,000 for one child and $6,000 for two or more dependents are allowed. The credit is between 20 percent and 35 percent of those amounts, based on taxpayer income.||Allowable care expenses will be reduced to a maximum of $2,400 for one child and $4,800 for two or more dependents. The credit will be between 20 percent and 30 percent of those amounts, based on taxpayer income.|
|Estate tax||Estates worth less than $5.12 million are not taxed. Estates worth more than that are taxed at 35 percent. That tax rate also applies to applicable gift taxes.||Estates worth more than $1 million will be taxed at 55 percent. That tax rate also applies to applicable gift taxes.|
Investments also would face a major tax hit.
"The scariest thing of all for investors is what could happen to dividends," says Brooks Mosley, president of and client adviser at Security Ballew Wealth Management in Jackson, Miss. Low rates on traditional fixed investment vehicles such as CDs prompted many people "desperate for better returns" to turn to high-dividend-paying stocks, says Mosley.
Qualified dividends are taxed the same as capital gains -- at a 15 percent rate for most investors. If that tax treatment isn't continued, they will once again be taxed as ordinary income, which could be as high as 39.6 percent in 2013.
A tax provision of the health care law will make the tax situation even costlier. An added 3.8 percent Medicare tax will begin in 2013 on unearned income (interest, dividends, capital gains, royalties and rents) of higher-income investors.
"They're accustomed to getting a very large dividend taxed at 15 percent, and the tax could go up to 43.4 percent," said Mosley. "That's got people on edge. They're wondering, 'When do I get out of these stocks?' In addition to tax concerns, there's the fear that the (dividend-paying) stocks will drop in value if nothing changes."
Less confidence in Congress
Adam Sherman, CEO of Firstrust Financial Resources in Philadelphia and a Certified Financial Planner, says most of his firm's clients are still willing to wait and see how things shake out in Washington, D.C. "Personally," he says, "I don't think things will get resolved until 2013. I don't think a lame-duck Congress is going to have the wherewithal to make changes."
If that prediction is correct, taxpayers and their tax professionals will have to deal not only with 2012's uncertainty but also with the complications of retroactively applied tax laws.
Who wants to suggest a catchy name for that situation?