Watch out for these tax increases if we plunge over the fiscal cliff

Man standing on mountain peak

Now that the election is over, we can only hope Washington buckles down to avert the automatic tax increases set to hit in 2013.

According to the Tax Policy Center, a nonpartisan group based in Washington, D.C., the average household could wind up paying $3,500 a year in additional federal taxes.

No one really wants that.

Yet they're part of the so-called "fiscal cliff" — an onerous combination of tax hikes and spending cuts scheduled to take effect Jan. 1 if Congress and President Obama can't agree on a better long-term plan to reduce the federal deficit.

Both parties say they're determined to avoid a plunge that could literally drive the economy into a recession.

But we can't just ignore the fact that we could be looking at significantly higher taxes in just a couple of months.

Neither should you.

That's especially true since at least one of those tax increases is probably coming our way, even if there is a deal to avoid the cliff.

Let's start with that one.

Tax Increase 1. The payroll tax cut will expire.

Since 2010, a temporary tax break has lowered everyone's contribution to the Social Security system from 6.2% to 4.2% of gross income.

It was enacted to put more money back in the pockets of consumers and help the country climb out of the Great Recession.

But both parties believe that tax cut has outlived its usefulness and is too costly to extend.

As a result, there's a good chance the Social Security tax will return to 6.2% next year no matter what.

It looks like families earning the median annual household income of $50,000 can pretty much count of having their take-home pay reduced by about $1,000 in 2013.

Tax increase 2. Tax brackets will reset to their pre-Bush levels.

While it's certainly true that the wealthiest taxpayers enjoyed the lion's share of the savings from President George W. Bush's controversial tax cuts, middle-income filers also benefited.

Now the 10% bracket created by the Bush tax plan is scheduled to go away, leaving 15% as the lowest tax rate.

The 25%, 28%, 33% and 35% brackets would also rise to 28%, 31%, 36% and 39.6%.

Those rates reflect the percent of taxable income each filer must pay in federal income taxes.

Take, for example, a single person with a taxable income of $40,000.

For 2012, he or she would fall in the 25% bracket and owe about $6,030.

If we return to 2000 tax rates, that same person would fall into the 28% bracket and owe $7,788 in income tax for 2013 — or about 30% more.

Tax increase 3. Capital gains rates rise.

The top rate on long-term capital gains and dividends is currently 15%. Starting in 2013, the maximum rate will increase to 20%.

The health care reform act also contains a provision that adds another 3.8% for high-income Americans starting next year, making their rate 23.8%.

Those in the lowest two tax rate brackets of 10% and 15% currently pay nothing on long-term gains and dividends. If the break expires, they will pay 10% on long-term capital gains.

This rate will apply for the sale of stocks that you've kept for longer than a year and for the sale of investment property.

Middle-class homeowners shouldn't see much of an impact on the sale of their primary residence since the first $250,000 in profit is exempt from capital gains taxes for single owners and $500,000 for married owners.

Tax increase 4. Taxes on dividends will rise dramatically.

Most dividends are currently taxed at no more than 15%.

But the new law requires those payments to be taxed at the same rate as ordinary income.

Taxpayers who fall into the 28% tax bracket will have their dividends taxed at 28%.

That means they'll get to keep only 72 cents of every $1 they earn.

For the wealthy, the top rate on most dividends will jump from 15% to more than 43%, which includes a new Medicare tax on investment income for top earners as part of the health care reform act.

If you have dividend-paying stocks in an ordinary investment account, you may still want to hold onto them.

Even if you're paying higher taxes on those dividends, it still beats any yield you could earn on a certificate of deposit or government bonds.

The tax you owe on dividends paid by stocks or mutual funds held in an IRA or 401(k) plan will continue to be deferred until you withdraw it from the retirement account.

Tax increase 5. Several IRS rules would change, boosting tax bills in other ways.

The Child Tax Credit, for example, would be lowered from $1,000 to $500 if the law isn't changed.

The exemption from federal estate taxes would fall from $5.5 million to its pre-2001 level of $1 million.

That could have a significant impact on small business owners who want to pass their business on to their heirs.

Many retirees also have over $1 million in assets, which means if they passed away, their children could owe taxes on anything over that amount.

The so-called "marriage penalty" would return, as well.

Prior to 2003, spouses who earned about the same amount of money were often thrown into a higher tax bracket, and therefore paid a higher percentage of their income in taxes, than single filers.

Congress changed that so that the bottom two tax brackets for couples filing a joint return are exactly twice as wide as for singles.

Next year, however, the tax brackets for joint filers will contract, causing higher tax bills for many married couples.

How did we get here?

The fiscal cliff was created by the expiration of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, and spending reductions demanded under the Budget Control Act of 2011.

It reflects the fundamental disagreements over how to reduce the federal deficit that have largely paralyzed Capitol Hill since Republicans regained control of the House in 2010.

In August 2011, GOP lawmakers balked at raising the federal debt ceiling unless Democrats agreed to big spending cuts.

Democrats refused to go along unless the Bush tax cuts that benefit the wealthiest Americans were allowed to lapse.

In the end, the two sides essentially decided to kick the problem down the road.

They agreed to allow all of the Bush era tax cuts to expire and a broad array of spending cuts to kick in if they couldn't work out an agreement by 2013.

The fiscal cliff they created was supposed to be so severe it would force both sides to compromise.

But election year politics intervened, and now here we are with less than two months to go before the big plunge.

  • jillbecc

    This is terrific information. Thank you! I suspect that Congress will find a way to kick the can down a few more months. They should find a way to address this right now because Americans will pay the penalty of gridlock.