The term “fiscal cliff” is swiftly becoming a normal part of the American vocabulary, as Ben Bernanke, the Congressional Budget Office and economists galore view the combination of spending cuts and tax increases on tap for January as a cliff that our mildly growing economy cannot afford to fall over. The spending cuts matter, but at $1.2 trillion over 10 years, when our actual spending clocks in at $3.5 trillion per year (and growing), the effects are muted compared to an instant, gargantuan tax hike on Jan. 1. If no further action is taken, the tax increases will unfold as follows:
Payroll tax rate: Rises from 5.65 percent (Medicare and Social Security combined) to pre-2011 levels of 7.65 percent.
Federal individual income tax rates: The number of brackets shrinks from six to five. In addition, the lowest rate rises from 10 percent to 15 percent, while the highest rate moves from 35 percent to 39.6 percent. Other increases are slated for other brackets.
Long-term capital gain tax rates: The lowest rate rises from 0 percent to 10 percent, while the top rate moves from 15 percent to 20 percent.
Dividend tax rate: Currently, qualified dividends are taxed at the same rate as long-term capital gains (15 percent). Beginning in 2013, those dividends are taxed at ordinary income rates, swelling the top dividend rate to 39.6 percent.
Obamacare payroll tax: The Obamacare legislation enacts an additional Medicare tax of 0.9 percent on earned income above $200,000 for single taxpayers and $250,000 for married-filing-jointly taxpayers. This would increase the higher income earner’s total employee FICA tax rate to 8.55 percent.
Obamacare unearned income tax: Obamacare also establishes a 3.8 percent surtax that applies to individuals and married-filing-jointly taxpayers with modified adjusted gross incomes exceeding $200,000 and $250,000, respectively. Therefore, for higher income earners, long-term capital gain tax rates will move from 15 percent to 23.8 percent, and qualified dividend tax rates will skyrocket from 15 percent to 43.4 percent.
Federal estate tax: The top federal estate tax rate rises from the current rate of 35 percent to a new level of 55 percent. In addition, the federal gift and estate tax exemption plummets from $5.12 million this year to only $1 million, exposing many more households to that new 55 percent rate.
As we mentioned three weeks ago, we do not believe that the Washington brass will go into legislative paralysis, allowing the economy to free-fall over the cliff. The numbers are too glaring, the warnings are too widespread, and the calls for action will only grow more deafening in volume. Action must be taken and numerous proposals exist. Granted, deadlines seem to love being tested in our government lately, and any resolution short of New Year’s Eve will be deemed progress. Do not be surprised if another temporary patch is put in place to avoid the cliff on 1/1/13, but also to allow for the permanent fix to happen in early 2013. For investors, business owners and budget conscious American families, the sooner the fog lifts on these issues, the better. Uncertainty equals heartburn, while clarity equals relief!
Mark Sorgenfrei Jr. is vice president and investment analyst for Waddell & Associates Inc.