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Judy Loy: Falling Off the Fiscal Cliff

by on September 09, 2012 8:00 AM

According to the media, the U.S. could be diving off a "fiscal cliff" that could greatly impact the financial future of all Americans. We reach the edge of this fiscal cliff on Jan. 1, 2013, unless Congress takes action before year-end.

On Dec. 31, 2012, Bush tax cuts end and a congressional budget-cutting “trigger” goes into effect that will result in $7 trillion in tax increases and spending cuts.

Let’s start by defining what the U.S. "fiscal cliff" really is. As mentioned, unless extended, the many Bush tax cuts will end on Dec. 31, 2012. The Bush tax cuts offered a little something for everyone and their demise will penalize every taxpayer, causing tax rates to revert to higher levels in the following ways:

  • Income tax rates will rise from 10 percent to 15 percent, 15 percent to 28 percent, 25 percent to 31 percent, 28 percent to 36 percent and 35 percent to 39.6 percent. In essence, everyone paying taxes will pay a higher rate.
  • For those investing in non-qualified (non-retirement) accounts, capital gains rates rise from 15 percent to 20 percent for most tax filers. Therefore, if you are considering selling an asset for a gain, you might want to do that in 2012 to be sure to get the lower long-term tax rate.
  • Short-term gains for assets held less than 12 months are still taxed as income to the taxpayer.
  • Most investors getting qualified dividends will see an increase in taxes on those dividends going from 15 percent to their income tax rate, which can be as high as 39.6 percent.
  • The child tax credit reverts to $500 per qualified child as opposed to the current $1,000.
  • The marriage penalty returns three-fourths this means low- or middle-income, two-income couples will owe the IRS more than they would if they were single with identical earnings.
  • If Congress does nothing before Dec. 31, estate taxes will apply to estates of $1 million or more, rather than the current $5 million or more.
  • Anyone who pays into Social Security(SS) will see an increase of 2 percent in SS tax as rates go from 4.2 percent to 6.2 percent.
  • High wage earners making $200,000 and married couples making $250,000 will be assessed an additional 0.9 percent surtax on all wages.

The fiscal cliff also affects unemployment compensation. On Dec. 31, 2012, unemployment benefit extensions will expire; workers who lost a job after July 1 will only receive 26 weeks in state unemployment benefits, down from the recent extension of up to 99 weeks.

These tax cuts and changes will affect everyone, including doctors. On Jan. 1, Medicare payment rates for physician services will drop by 27 percent. How would you like to get paid 27 percent less for the same services?

The bottom line is that the tax changes are expected to slow the economy even further, and some financial experts predict that the U.S. will go into a full-blown recession. When the Congressional Budget Office (CBO) came out with their analysis in August, the CBO warned that the country would fall into a recession in 2013 if we fall off the fiscal cliff. The CBO also estimates that unemployment would increase from the current 8.2 percent to 9.1 percent.

What is the plus side of these tax increases and spending cuts? They will improve the U.S. deficit outlook considerably. This year, the deficit hit a huge $1.1 trillion three-fourths about 7.3 percent of gross domestic product (GDP). Due to the impending tax increases and spending cuts, the CBO estimates the deficit would fall to $641 billion or 4 percent of GDP in 2013. The deficit picture would continue to improve until 2018 when an aging population would again put a strain on U.S. finances.

There is no doubt that tax increases and spending cuts are inevitable to stem the tide of U.S. debt. We certainly don’t want to get into the fiscal mess that Greece is experiencing. It is easier to make these changes now than to make them when the country is at a tipping point (think Greek default and bailouts).

The question is whether now is the right time. Federal Reserve chairman Ben Bernanke spoke on Aug. 31 about the "stagnation of the U.S. labor market" and indicated the Fed would be ready to support the U.S. economy yet again. With the Fed willing to spend more now due to our weakening economy, should Congress let the 2013 spending cuts and tax increases take effect all at once on Jan. 1?

The decision lies with Congress, which is in gridlock. In July, Democrats threatened to let the nation go over the fiscal cliff unless Republicans agree to a “balanced" deficit package that includes some tax increases. Both sides are not coming to terms and are using the fiscal cliff as a bargaining chip rather than the obviously dire threat to our economy. Hopefully, action will be taken to alleviate some of the spending cuts and tax increases before year-end.

Otherwise, be prepared.



Judy Loy, ChFCâ, is a Registered Investment Advisor and CEO at Nestlerode & Loy Investment Advisors, State College, Pa. A graduate of Penn State University, Loy has been with the firm since 1992, assisting clients with retirement planning, brokerage services and investment advice. She can be reached at jloy@nestlerode.com.
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