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:

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 (^DJI 0.06%) has moved seemingly in lockstep with sentiment over the cliff. Already, Dow component Wal-Mart (WMT -0.65%) has moved up its scheduled January dividend payment to December, and several huge companies, including Las Vegas Sands (LVS -8.66%), Costco (COST -0.55%), and Sturm Ruger (RGR 1.10%) 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 Fool.com tomorrow for part three of our series, in which we'll take a deeper look at the cliff's impact on business.

• Click here to read part one of this series.

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