Now that the elections are over, America's focus has shifted to the two most important and soon to be overused words: fiscal cliff. I have read hundreds of articles about this issue and most are overly technical and do not describe how it will impact the average American. So let me lay it out: the average American's tax bill will increase approximately $4,000 or more in 2013 if we take this step off of the cliff.
What is the "Fiscal Cliff?"
A series of tax benefits set to expire at the end of this year. Some affect businesses, others affect individuals. The Congressional Budget Office estimates these tax changes will have an overall effect on the federal budget deficit of about $607 billion, or approximately four percent of GDP. With an ever-moving estimated growth next year of only an approximate 2.5 percent, the expiration of these cuts alone will send America off the cliff into another downward recession, which is where the term "fiscal cliff" derives.
The Fiscal Cliff's Impact on Your Paycheck
To demonstrate how the fiscal cliff could cost the average American around $4,000, we'll assume the "average" family with two children has gross wages of around $85,000 per year. Some of these changes will hit your first paycheck; some will not be seen until you file your 2013 income tax return in early 2014. But they will all eventually diminish your bank account.
1. The Middle Class Tax Relief and Job Creation Act of 2012 extended a two percent cut in the Social Security payroll tax that is currently withheld from all Americans' paychecks. The current rate is 4.2 percent. This will increase to 6.2 percent and impact your very first paycheck of the new year. The annual impact: $85,000 X 2 percent = $1,700.
2. The most commonly used tax credit by middle American families is the child tax credit, providing a $1,000 tax credit on your income tax return for each qualifying child under the age of 17. This tax credit is set to expire at the end of this year and revert back to its original smaller amount of only $500 per qualifying child. This means the average American family with two children will lose $1,000 in tax credits when they file their 2013 income tax return ($500 per child). You might say that your children are over the age of 17 and in college so it doesn't affect you. Unfortunately, there's another expiring credit that will: the American opportunity tax credit, which increased the tax credit up to $500 for qualified educational expenses for college students. So if those two children are in college, you may not be affected by the child tax credit, but in return, you will lose $1,000 in additional educational tax credits, or $500 for each of them.
3. The Economic Growth Tax Relief Reconciliation Act of 2011 created a new lower income tax bracket of 10 percent below the existing 15 percent tax bracket for individuals. It also reduced the other tax brackets each by 3 percent to 25 percent, 28 percent, 33 percent and 35 percent. This, along with the elimination of the increased standard deduction for married taxpayers filing jointly (marriage penalty relief), can cost the average American family anywhere from $1,000 to $1,500 in additional income tax owed on your income tax return, depending on your deductions and other income.
4. There are also many other expiring items that could increase your tax bill further if they are indeed allowed to expire. Some of these include: increased capital gains tax rates, changes to the estate tax provisions, higher earned income credit phase-out ranges, deductibility of mortgage insurance premiums as interest, elimination of various energy credits and changes to the alternative minimum tax for individuals.
Timeline for Potential Changes
All of the above items will expire or take place on Dec. 31, 2012 or Jan. 1, 2013. Your two percent increase in social security tax will occur on your first paycheck of 2013. Additionally, your federal tax withholding should also change if your employer(s) adjusts accordingly to the change in individual income tax rates. However, it may take some time for them to make the changes effective. Be sure to understand when and if they have made the changes, or you may find yourself with an unwanted tax bill at the end of the year.
This is simply a case for what would happen should we take this step off of the fiscal cliff. However, I don't think that it will come to this. I truly believe that all parties will come together for the good of the country's economy and renew all of these tax incentives, but there must be compromise.
There may be some give and take, especially for those who earn more than $250,000 per year, but I predict the average middle American family will not take these tax hits next year. Neither political party wants to face another recession or answer to the voters as to why they couldn't come to an agreement. Nevertheless, businesses and individuals alike will be holding their collective breaths until this is settled.