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Falling Off the Fiscal Cliff: How Would It Affect You?

There has been much said in recent weeks about the so-called fiscal cliff. The fiscal cliff is a combination of tax increases, as well as spending cuts set to take place in January. The effect is expected to be greatest on the middle class [3], since the cuts might result in job loss, as well as higher taxes.

With the presidential election over, a lot of the focus is on what happens if members of a very divided Congress can come together, compromise, and pass a law that blunts some of the effects of the fiscal cliff. Some of the options for blunting the effects of the fiscal cliff include raising taxes for the top earners, but leaving middle class tax brackets [4] in place, as well as keeping some of the spending that most affects middle class families in terms of jobs.

Higher Income & Payroll Taxes

The so-called Bush Tax Cuts were extended as a way to promote economic growth, but the extensions are just about done with. If these tax breaks expire, taxes pretty much rise across the board. That means the lowest marginal tax rate rises from 10% to 15%, and the top rate goes up to 39.6% from the current top rate of 35%. According to the Tax Policy Center [5], that means an average increase of $2,000 a year for middle class families.

Also, the current FICA/Social Security tax cut will expire at the end of the year. The employee portion has been seeing a 2% reduction, and the loss of that is going to show up in your paycheck. Realize, though, that only the first part of your income is subject to Social Security taxes. So, once you get beyond $113,700 (for 2013), it doesn’t matter how much you make, you will only pay FICA/Social Security on the first $113,700 that you earn.

There are some suggestions that tax rates could be allowed to rise for the top earners, but remain where they are for everyone else. Some have also suggested raising the amount of income subject to Social Security taxes. Even most of those who don’t end up paying federal income tax still pay taxes in the form of the payroll tax.

Higher Investment Taxes

You also have to watch for investment tax changes. The capital gains top rate goes from 15% to 20% with the new year, and there is no more special treatment for dividends. Those go from being taxed at 15% to being taxed at your marginal rate. If you are afraid of these changes, now is the time to sell your long-term capital gains. You also need to realize that, if you receive money from dividend income, that you are probably going to see a little bit less of it.

Cut Benefits

One of the biggest cuts to benefits includes the extension of unemployment benefits. The loss of unemployment benefits would affect families collecting these benefits, and using them to help keep the household afloat. Other cut benefits might affect doctors that accept Medicare, reducing their payouts, as well as money that goes to research and development. There are estimates from the Congressional Budget Office [6] that indicate that some of the cut benefits could result in unemployment heading up above 9.1%.

Bottom Line

Many on both sides of the aisle recognize that the rate of deficit spending has to be reduced and that steps need to be taken to help the economy. However, how to that is a thorny question. While some insist that more tax cuts are the way to create jobs (in spite of the CBO’s assertion that tax cuts alone are one of the least effective ways to help the economy and create jobs) and boost the economy, others insist that tax increases on the wealthy should offset spending.

However, the reality is that any drastic measure — tax cuts or spending cuts or massive tax increases — will likely shock the system. As a result, some are calling for a measured and gradual approach that combines some modest tax increases on some segments of the population with targeted, measured spending cuts.

What do you think is likely to help the situation? And do you have plans to shore up your finances against the fiscal cliff?

(Photo: m.prinke [7])