For the moment let’s set aside the fiscal cliff discussion and talk about what seems to be definite.
In his first term of office President Obama passed a Medicare tax increase so in 2013 the Medicare tax rate for Married couples whose earned income exceeds $250,000 will increase by .9% ($200,000 for singles). Taxpayers whose earned income exceeds these thresholds will pay ninety-cents in additional income tax for every $100 they earn over the threshold amount. Those same taxpayers also face a Medicare surtax of 3.8% on unearned income to the extent that their total income exceeds those same threshold amounts. So regardless of whether or not the Bush tax cuts are extended, upper earners and many investors are assured of a tax increase. In addition to these, the 2% reduction in the employee’s share of Social Security taxes is scheduled to expire and is not expected to be reprieved. This will affect all earners.
Now let’s talk about expiration of the Bush income tax cuts, which may happen.
If the Bush tax cuts expire tax rates are scheduled to increase across the board with the lowest brackets going from 10% to 15% and the highest going from 35% to 39.6%. In addition to these increases, higher earners, generally families with income over $250,000, will lose some of the tax benefit for personal exemptions and itemized deductions, dividends will be taxed at the regular tax rates instead of a 15% maximum, and long-term capital gains will be taxed at a maximum of 20% instead of 15%. Keep in mind that the 3.8% Medicare surtax and the .9% Medicare tax increase are in addition to these tax rate increases. The result is that upper earners are faced with top tax rates of 40.5% on earned income and 43.4% on taxable interest, dividends, rents, and even S-corporation, Partnership, and LLC income if the member is not active in the enterprise. In addition to these tax increases, Alternative Minimum Tax will revert to year 2000 levels, which will cause many more taxpayers to owe additional tax.
Income taxes aren’t the only tax affected by expiring Bush tax cuts. As is widely known, the Estate tax exemption amount is scheduled to drop from its current $5.12 million to $1 million and the top bracket is scheduled to rise from 35% to 55%. Married couples with estates over $2 million should at least consider some year end planning. For very wealthy individuals, those who can do without $5.12 million of assets, using the entire $5.12 million gift exemption before the end of the year is a very serious consideration. Even though we are near the end of the year, thanks to a recent court decision against the IRS, you can lock in the gift amount in 2012 and fund it in 2013. This is a technical maneuver and requires a good CPA and attorney to do properly but can be done reasonably quickly.
The Fiscal Cliff and its impact on tax law:
As has been widely reported, the fiscal cliff is simply an automatic implementation of tax increases due to the sunset of the Bush tax cuts and spending cuts under the terms of the Budget Control Act of 2011. Ironically, the Budget Control Act of 2011 is the ultimate result of a bi-partisan committee’s inability to reach an agreement on budget control back in 2011. Specifically, the fiscal cliff is a $440 billion tax increase and $108 billion is spending cuts notably in areas such as defense, unemployment benefits, and Medicare. Economists agree that if Congress allows the country to go over the fiscal cliff it is very likely that the country will head back into recession. So the odds makers are hedging towards a compromise that includes allowing most if not all Bush era tax cuts to expire while promising to retroactively pass a middle class tax relief law in early 2013. On the spending side, a significant number of pundits are betting that Congress will once again defer meaningful cuts and "kick the can down the road" until a crisis such as a market crash prompts urgent action. The apparent result is that upper earners will pay more taxes but perhaps not be faced with lower earnings in the immediate future.
What we suggest: