Fiscal Cliff: What Could Happen and What Really Will?

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So much has been said about the upcoming ‘Fiscal Cliff’ the nation faces—much of it highly politically charged. Most would probably agree that after a bitterly contested campaign season, it’s time to throttle back the rhetoric a little and try to coolly analyze what’s actually going to happen and what it means for your personal finances.

Let’s unpack the ‘Fiscal Cliff’ concept by the numbers:

If nothing at all happens, income taxes, across-the-board, will go up as the Bush-era rates are slated to expire at midnight on December 31, 2012. Further, a whole host of other tax credits and incentives will fall off the cliff as well. Here are the biggies:

  • This graphic from an article in, for simplicity’s sake, shows how single filer rates would increase—though everyone takes a hit—if NO deal is struck:

LIKELY OUTCOME: Very few believe congress or the president would allow all these rates to go up—since that could tank the fragile economy. But since this is what we know absolutely will happen if negotiations fail to alter the outcome, it’s key to the conversation.

  • The Payroll Tax Holiday ends. The temporary cut in withholding taxes will expire, sending rates back up to 6.2% from 4.2% currently. The self-employed also got a break—theirs, too, will be gone.

LIKELY OUTCOME: Payroll taxes go to fund Social Security, so the rate cut may very well expire. However, it’s likely some other species of credit or tax holiday will kick in, possibly later in 2013, to spare those who pay withholding taxes a direct shot to their wallets.

  • The Estate Tax (what some call the ‘Death Tax’) exemption drops from $5.12 million to $1 million—broadening the number of Americans paying the tax from 3,300 now to 52,500 in the new year. Plus, their rates will increase from 35% to 55%.

LIKELY OUTCOME: The exemption level may remain in place but the ability of couples to combine their exemptions could disappear. Further, while the rate may increase from 35%, it probably isn’t allowed to hit the whopping 55% scheduled.

  • The Alternative Minimum Tax (AMT) will increase—this gets complicated! The AMT is designed to ensure the wealthy don’t use loopholes to pay less than they ‘should’. In 2013, the number of households paying the AMT would skyrocket from 4.4 million to 32.9 million, resulting in an average increase of $2,800.

LIKELY OUTCOME: The AMT can be extremely confusing, and this would likely be the most impactful tax increase coming—if it isn’t averted, that is. It is routinely fixed by legislative “patches” that prevent legions of taxpayers from getting slammed, so expect another quick-fix patch to avoid that result this time, as well.

  • Capital Gains Taxes go from 15% now to 20%. This is a tax on investment capital—say the amount you make from selling stocks or real estate. (Capital Gains are usually discussed in their ‘long-term’ forms, ‘short-term’ are typically taxed at normal income tax rates.)

LIKELY OUTCOME: It’s probable these rates—currently quite low—will, indeed, go up, possibly back to the 20% Clinton-era rate. It’s possible this increase could be offset in exchange for keeping overall income taxes lower.

Now, there are still more fiscal changes looming on the horizon (or dangling off the cliff, if you prefer), but these tax matters are perhaps the most consequential for your personal finances.

The Fiscal Cliff—if we’re pushed off—would cause great damage, indeed

If the lame duck congress and the re-elected president fail to find agreement, and everything that’s currently slated to happen actually happens, the effects would be utterly disastrous for the country.

What would happen if we go over the cliff, Thelma-and-Louise-style?

Mohamed El-Erian, CEO of the trillion-dollar-plus investment firm PIMCO, projects the cost of the fiscal cliff would be some 4% of U.S. GDP, (currently we’re growing at a sluggish rate of about 1.5%–so the national economy would cease all growth and shrink 2.5%).

Further, he adds that with interest rates already cut to near-zero, the federal government would have precious few options at its disposal to do anything about it. On top of all that, Europe is still facing a profound debt crisis, China’s growth is slowing, and the Middle East looks like more of powder keg than ever.

So, this isn’t just any old cliff, it’s one that appears to jut out over an abyss.

Hopefully, the elected leadership in Washington is prepared to recognize the seriousness of our challenges and then act accordingly, and in good faith, to reach a suitable bipartisan compromise. Exactly what will happen, only time will tell. But, as always, Quizzle will keep you posted.

What do YOU think will happen? Will a deal be struck that yanks the wheel, and keeps us from barreling over the Fiscal Cliff? Tell us your thoughts on these crucial matters.