How the Fiscal Cliff Will Affect You

This article is the second in a series of articles discussing the fiscal cliff. To read previous stories, follow the links at the end of this article.

With the fiscal cliff less than a month away, you'll find a wide range of opinions about its potential impact, ranging from nonchalance to near-panic. To make informed decisions about what steps you should take to prepare for the various outcomes of the fiscal cliff, though, it's essential to get down to the facts of what will happen under current law, as well as what would happen if various solutions were enacted.

The numbers
Last month, the Congressional Budget Office (link opens PDF file) provided a useful picture comparing its baseline scenario, which has us going over the fiscal cliff under current laws, with an alternative scenario in which current tax brackets are extended. As you can see, the differences are striking:












Deficit Under Baseline Scenario











Deficit Under Alternative Scenario











Source: Congressional Budget Office. Figures in billions.

The alternative scenario results in more than $7.7 trillion in additional debt by 2022.

However, lest you misunderstand what's truly at stake, no one in Washington is seriously arguing for the permanent across-the-board tax increases under the baseline scenario. Rather, even those seeking tax increases are content to impose them only on high-income individuals. The added revenue from such increases will raise only about a fifth of the revenue that the full-blown over-the-cliff scenario would generate.

How it affects you
Of course, as this report (link opens PDF) from the Tax Policy Center explains, how big an impact the fiscal cliff has on you depends on your particular situation. For low-income taxpayers, the expiration of the 2-percentage-point reduction in payroll taxes will reduce take-home pay by 2%, and the elimination of the 10% tax bracket would add another 5 percentage points of tax, even on joint filers earning $17,400 or less. It would also push taxes on couples earning up to $70,000 higher by as much as $870.

Source: Tax Policy Center.

For those in higher brackets, two effects could boost taxes. Increases in the 25%, 28%, 33%, and 35% bracket rates by 3 to 4.6 percentage points would increase total tax liability. In addition, certain anti-marriage-penalty provisions would go away, causing couples to enter higher brackets at lower income levels.

Under most likely compromise scenarios, though, low- and middle-income taxpayers would only face the payroll tax break expiration. Only high-income taxpayers face a significant risk of a return of rising tax rates on ordinary income.

Finally, one element that many leave out of fiscal-cliff analysis is the looming impact of the alternative minimum tax. As of now, Congress hasn't passed its usual annual patch to the AMT for this year, potentially costing 30 million taxpayers thousands of extra dollars in taxes if it isn't fixed retroactively.

Source: Tax Policy Center.

Investments under siege
The bigger issues, though, apply to investment income. Preferential capital gains rates would rise from 15% to 20%, with a current 0% capital gains rate for low-income taxpayers rising to 10%. Dividends would get even harsher treatment, with preferential rates going away entirely, leaving much higher ordinary tax rates to apply to dividend income.

The particularly big fiscal-cliff impact on investors, in addition to a new 3.8% surtax on investment income for couples earning more than $250,000, explains why the Dow Jones Industrials (DJINDICES: ^DJI  ) has moved seemingly in lockstep with sentiment over the cliff. Already, Dow component Wal-Mart (NYSE: WMT  ) has moved up its scheduled January dividend payment to December, and several huge companies, including Las Vegas Sands (NYSE: LVS  ) , Costco (NASDAQ: COST  ) , and Sturm Ruger (NYSE: RGR  ) among many companies announcing substantial special dividends to take place before year end.

Spending cuts
The fiscal cliff isn't just about tax rates. Big spending cuts are also set to take effect totaling $1.2 trillion over 10 years. According to preliminary figures from the White House Budget Office, cuts would hit defense programs by 9.4% and many domestic programs by 8.2%, including the Forest Service, Office of Federal Student Aid, Food and Drug Administration, and FEMA, just to name a few.

Few expect those spending cuts to take place in their current form. But the magnitude of the targeted dollar figure will inevitably require tough choices, and companies that rely on government spending are almost certain to take big hits.

In addition to mandatory spending cuts, some favorable programs will expire when 2013 begins. An estimated 2.1 million Americans receiving unemployment insurance payments will lose eligibility at the end of the year unless programs extending benefits beyond 26 weeks are renewed.

Keep your eyes open
Negotiations over the fiscal cliff make all these figures moving targets, so pay attention to the proposals that leaders make in the coming days and weeks. In the end, what lawmakers agree to could make a big difference to what happens to your wallet.

The bottom line
The Motley Fool wants to help investors understand the fiscal cliff and put it in its long-term context. This article is part two in a series of fiscal-cliff articles. Make sure to visit tomorrow for part three of our series, in which we'll take a deeper look at the cliff's impact on business.


Read/Post Comments (8) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 06, 2012, at 1:20 AM, dgmennie wrote:

    What is most likely to happen with interest rates once the 'fiscal cliff' is breached? Specifically, those investments that most small investors use to provide steady income: municipal bonds, treasuries, stocks that pay dividends, corporate bonds, carefully-selected junk bonds (such as found in a high yield bond fund).

  • Report this Comment On December 06, 2012, at 8:20 AM, CelticDuck wrote:

    Personally, I'm kind of encouraged by sequestration cuts. I'd be more than happy to take the tax hit across the board just to see a little fiscal restraint actually happen. We all know the clowns in Washington will never get this done left to their own devices. The economy will clearly go right into the tank, wailing and gnashing of teeth, yada, yada, yada, but we've got to get our economy and government through detox from this insane spending addiction of the last 5 years. Got to hit bottom before we can hope for any real recovery.

  • Report this Comment On December 06, 2012, at 8:26 PM, rdub76 wrote:

    Last five years Celtic? Last 75 years is more like it and the last 11 especially.

    I don't think I can stomach paying another 4% in taxes and if the deductions I use are axed I could be looking at paying an ETR of 20% more. I would literally be working for almost nothing. I am in the lower end of the top quintile but I spend 9 months a year away from home working 7 days a week 12 hours a day to get it. It's criminal what these tax increases demand of people. Of course the spending increases will decelerate slightly in the near term but as soon as everyone gets used to the loss of income the frivolous spending will return to normal in Washington.

  • Report this Comment On December 07, 2012, at 6:28 PM, TMFGalagan wrote:

    @dgmennie - Economic theory would suggest interest rates would go lower, as the inevitable hit to economic activity would slow down borrowing and reduce supplies of bonds, driving up prices. Municipal bonds in particular might do well given higher tax rates yielding better after-tax equivalent yields. But that's more a guess than a prediction.


    dan (TMF Galagan)

  • Report this Comment On December 08, 2012, at 12:46 PM, MCCrockett wrote:

    Foolishly, I didn't read the fine print when I opened an IRA in the Seventies and a 401(k) in the Eighties. I was under the mistaken impression that I would be only paying ordinary income taxes on my deferred income. Now that I am about to retire, I've learned that I will be paying ordinary income tax on my capital gains.

    After I retire in January, I will be moving from the top to the fourth quintile. As my income will be dropping by 50%, I doubt that I will notice the "Fiscal Cliff".

    My engineering colleagues in the Defense and Aerospace industry will definitely feel the effects of the "Fiscal Cliff" as those that have been working part time for the last 2 years get their "pink slip".

    For those that don't work in the Defense and Aerospace industry, we will be entering the third year of the "Fiscal Cliff" on 01 January 2013.

  • Report this Comment On December 08, 2012, at 5:56 PM, lmrohde wrote:

    The data are immensely helpful but you offer so little explanation as to greatly reduce understanding and usefulness. Example 1, in the tables it would help if the number of taxpayers in each quintile were shown. Example 2, what is an extender? Example 3, estate tax has not been in the news lately, so what's the story?

    Lee Rohde

  • Report this Comment On December 09, 2012, at 8:39 PM, blairsp wrote:

    Maybe I'm paranoid but I think these increases are going to have a measurable, negative impact on unemployment, decrease investor confidence in the stock market and limited impact on the deficit as the behavior that got us here isn't changing. Instead Washington is just digging deeper into pockets that seem to get smaller each year. Remember wages have been stagnant for many. I am wrestling with whether to sell my dividend paying stocks, even those bought in a Roth IRA as I have no confidence the Roth is immune from tax changes with this administration. What are other doing with regard to investments in stocks?

  • Report this Comment On December 12, 2012, at 6:20 PM, Johnwzee wrote:

    I seem to have missed the cuts that Congress and the White house are going to take. Oh I see they have been working so hard raising our taxes, they havent had a chance to make cuts to their budgets.....

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