Cliff Notes: Peering over the Fiscal Cliff and Living to Tell the Story

By Steven Smith | Financial News

Dec 27

The election is over and 2012 is rapidly coming to a close. Our country faces some of the most important financial decisions in generations. The most immediate being: in what direction to take the nation’s fiscal policy.  The decisions are largely framed by three converging events.  First, expiration of the agreement in December of 2010 to extend, for two years, the expiring Bush era tax cuts under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. Second, the agreement reached in the Budget Control Act of 2011 in August of that year to raise the debt ceiling. Linked with automatic, across-the-board spending cuts to begin taking effect in January of 2013, these fiscal time bombs were designed to impel the Congress and the President toward reducing the country’s fiscal deficit, which is now around $1 trillion per year. For good measure, the debt ceiling Damocles re-emerges in January or February, with the need to raise it again.

When President George W. Bush took the oath office in January 2001 life was a veritable Shangri La. Yes, the internet bubble had burst, but it was not yet clear how far the markets would fall.  The terror of 9/11 was still 9 months away. And the nation’s budget was in surplus – revenues exceeded expenditures. But the events of the past decade – including two wars and two recessions (one of which was the worst since the Great Depression) – concomitant with long-term challenges presented by the pressures our aging population places on Social Security and Medicare demand action toward resolution of these problems.

While, of course, these issues present major political and economic questions, there are immediate wealth planning implications that need to managed as well.

Debits and Credits

The term “fiscal cliff” was coined by Federal Reserve Chairman Ben Bernanke and refers to the contractionary economic impact to the fragile economy that would occur due to the simultaneous tax increases and spending cuts if an agreement is not reached to modify the deal made in August of 2011. The Congressional Budget Office (CBO) estimates that falling all the way off the cliff would reduce GDP in 2013 by .5% and increase unemployment from 7.9% to 9.1%. This, despite the salutary effect these policies would achieve toward balancing the budget.

Highlights of Prospective Tax Changes

  • Increase in income tax rates – the top marginal rate is schedule to go from 35% to 39.5%.
  • Intermediate rates are set to increase as well (including the elimination of the 10% bracket) and a number of credits and deductions geared toward working families are set to expire.
    • The child tax credit drops from $1,000 per child to $500.
    • The child and dependent care credit is reduced.
    • The adoption expense credit is more than halved, from $12,650 to $6,000.
    • The marriage penalty is increased. The standard deduction for married couples will revert back from 200% of the deduction for singles to 167%.
    • The earned income credit for married couples will phase out at $42,952 rather than the current $47,162.
    • Deductions, credits and contribution limits for education expenses will all be lowered.

Consequently, an average married couple making $20,000 to $30,000 would see their tax go up to $1,423 from essentially zero. If you make $65,000 your tax bill will increase by $3,500 and if you earn $143,000 taxes will increase by $8,200.

  • Capital gains rate are scheduled to increase from a maximum of 15% to 20%.
  • Dividend income, which is now taxed at capital gains rates, will be taxed at ordinary income rates.
  • The estate tax exemption will be reduced from $5 million to $1 million and the top rate increased from 35% to 55%.
  • Expiration of the temporary payroll tax holiday, which reduced the employee’s share of Social Security taxes from 6.8% to 4.8%.
  • The Alternative Minimum Tax (AMT) “patch” for 2011 does not apply to 2012, which could subject as many as 30 million taxpayers to the AMT for 2012.
  • Other important, but less impactful tax provisions are scheduled to change as well.

Highlights of Prospective Spending Cuts

  • Congress and the President agreed to cut $900 billion over 10 years from annual appropriations.
  • Additionally, agreement was reached on across-the-board spending cuts (the “sequester’) amounting to $110 billion per year for ten years, divided evenly between defense and non-defense discretionary spending. (This does not include spending on Social Security or Medicare, but they have become part of the negotiations, particularly on the Republican side.) The total discretionary budget for 2011 was $1,277 billion with $712 for defense and $566 for non-defense. Bear in mind that even under the sequester, overall discretionary spending will increase over the next ten years, but by only 1.5% annually, far less than the 6.6% annually at which it has been growing since 2000.
  • $26 billion in emergency unemployment compensation benefits is expiring.
  • There will be an $11 billion reduction in Medicare payments to physicians because of the failure to agree on the annual “doc-fix.”

Total tax revenue in 2013 is scheduled to increase by approximately $500 billion (about half the deficit) and nearly 3% of GDP. About $160 billion of this is from higher rates, approximately $95 billion of which would come from taxpayers with under $200,000 ($250,000 for joint filers.)  $115 billion is from the AMT and $120 billion from the expiration of payroll tax holiday.

Political Negotiations Begin

While there may be a few die hard fiscal hawks out there, both Democrats and Republicans largely agree that the coming dose of austerity is too much for the economy to bear. Republican leadership claims to prefer that all deficit reduction come from the spending side, with social programs bearing the brunt and defense being spared – with reductions in both Medicare and Social Security.

President Obama and the Democrats campaigned on the issue of maintaining the Bush tax cut regime for taxpayers with taxable income of less than $200,000 ($250,000 for joint filers) and having higher income taxpayers be subject to the pre-2000 tax rates. (Since upper income taxpayers claim average itemized deductions of around $60,000, higher rates would really only begin to affect taxpayers earning closer to $300,000.)

Republicans have insisted on no rate increases for anyone. But in the event new revenues must be part of the equation, Republicans would like most, if not all, new revenues to come from reigning in deductions rather than from an increase in rates. But there are obstacles to this approach. The social policies behind certain “tax expenditures” (i.e. incentives) such as the mortgage interest deduction to encourage home ownership and the charitable deduction to encourage philanthropy would need to be carefully assessed. Not to mention that the beneficiaries of these policies (homebuilders and charities) have strong lobbies. The third most utilized itemized deduction is the one for state and local taxes.

Limiting these deductions hurts people in the $250,000 to $400,000 income levels the most. Whereas higher rates (including higher capital gains rates) affects more intensely the uppermost income earners, particularly those with incomes above  $1,000,000 annually. But even President Obama is in agreement that there should be some limitation on deductions for affluent taxpayers as part of overall reform and to contribute to balancing the budget. There has even been talk of limiting the deductions (at least in part) for employer provided health care and retirement contributions.

The President would like at least $1.4 trillion of deficit reduction over ten years to come from increased revenues, with the balance of $2.6 trillion (for a total of $4 trillion) coming from spending cuts.

Cliff, Slope or Curb

Some observers have described the cliff as more like a slope or a curb, so that the effects might be gradual. Another description is of a bungee jump in which we go over the cliff and bounce back up. This would give Congress and the President some period – perhaps weeks or even a few months – to reach an agreement. Over a longer period, the economy might slip back into recession (the average family’s taxes would increase by $3,500 and the billions in federal spending reductions are estimated to cause as many as two million lost jobs.) But the Treasury Department has discretion to temporarily adjust withholding tables to retain lower rates while negotiations ensue. And government agencies might not immediately reduce their spending either.

Negotiations toward a possible “grand bargain” (including reductions in spending on Social Security, Medicare and Medicaid) began in the lame duck session on November 13. But that seems highly unlikely at this late juncture. Any agreement now appears more likely to happen in stages, with only a slight chance of any agreement being reached in 2012. In one sense the most pressing issue is the expiration of the temporary AMT fix, which will affect 30 million taxpayers for the 2012 tax year, returns for which would need to be filed by April 15, 2013.

The politics of this controversy are inscrutable, including the almost farcical notion that certain changes – held until after the new year and the sequester has gone into effect – technically become a “tax cut” relative to 2000 levels, as opposed to a tax increase based on 2012 rates. Such a delay might allow Republicans to go along with a deal without violating their “Taxpayer Protection Pledge,” a stand taken by Republican representatives that makes Speaker Boehner reticent to bring to the floor any measure that would not obtain the votes of a majority of Republicans. (The new Congress is expected to have 55 Senators voting with the Democrats and 45 Republicans. There will be 233 Republicans and 200 Democrats out of 433 filled seats in the House. 217 votes in the House will be required to pass any legislation.) One possible antidote has been talk of a “discharge petition,” which requires the signatures of a majority of representatives – which allows a measure to come to the floor without the Speaker’s approval.  And, of course, both parties are jockeying to blame the other party if this turns into a train wreck.

At the same time, the need to once again raise the debt ceiling (currently at $16.4 billion) arises, the drama around which caused the markets to erupt in the summer of 2011 and which resulted in the political bargain now set to expire. The President would like that piece (peace?) to be resolved for a longer period as well.

Wealth Planning Implications

Something is going to happen. We don’t know exactly what, but we can plan for what can be realistically anticipated.

I tend to divide the universe of planning challenges presented by the fiscal cliff into two categories. The first category involves market prognostications. Investors remember what happened in the summer of 2011 as we navigated the debt ceiling.  Standard & Poor’s downgraded the country’s debt and the stock market dropped 14% in just a couple of weeks.  But in my view it is simply not worth undertaking a market timing strategy, successful implementation of which requires that you be right twice – getting out before the drop and then getting back in before the rise. There’s a very good chance you’ll be wrong. See this recent report from Vanguard demonstrating the futility of predicting what the market is going to do, especially in the short-term.

In the second category falls everything else; which for the most part pertains to tax planning. Regardless of whether we go over the cliff and or which side blinks, it’s a fair wager that taxpayers with incomes under $250,000 will see continuity in their income tax rules – retroactive to January 1, 2013 – although it appears likely the payroll tax holiday, in which employee payroll contributions have been reduced from 6.1% to 4.1%, will end. But for higher income taxpayers it’s another story – and much of the new tax regime is already baked into the cake.

Affordable Care Act Taxes

Not included in the regular tax increases scheduled to occur in January are those for higher income taxpayers contained in the Patient Protection and Affordable Care Act (“Obamacare”):

  • Medicare Payroll Tax. Currently, wages are subject to a 2.9% Medicare tax, divided equally between employer and employee. (Self-employed pay both halves but deduct half from income taxes.) This tax is levied on all income, unlike Social Security which has a cap of $110,000. For single taxpayers earning above $200,000 ($250,000 for joint filers) the Medicare tax will increase by 0.9% on income above the threshold.
  • Investment Income. There is a new 3.8% Medicare tax on unearned “net investment income” for taxpayers with incomes above $200,000 ($250,000 for joint filers.) This tax also applies to trust income above the top tax bracket of $11,650. The tax applies to income from interest, dividends, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities. The tax also applies to most capital gains, but not those from the sale of a personal residence, within the $500,000 exclusion. Also excluded are municipal bond interest and distributions from qualified plans such as 401(k)’s and IRA’s. There is a comprehensive discussion at http://www.irs.gov/uac/Affordable-Care-Act-Tax-Provisions , including links to hundreds of pages of proposed regulations.
  • Avoidance Strategies. Some strategies to avoid this tax would be accelerating capital gains into 2012, utilizing tax sheltered retirement accounts, Section 529 college savings plans, annuities and life insurance. It might also be beneficial to use traditional income shifting strategies, by gifting income earning investments to family members in lower tax brackets. S corporation dividends are not subject to the earned or unearned Medicare income tax, assuming the taxpayer is an active participant.

Income Taxes

  • Tax Rates. If you are an upper income taxpayer – above $200,000 ($250,000 for joint filers) – be prepared to pay higher taxes in the future, from both higher rates and limitations on deductions. Negotiations may raise the threshold to $400,000 or even $1,000,000 (you’re not my client, but give me a call).
  • Dividends. Up until 2003, dividends (distributions to shareholders) from C Corporations were taxed at ordinary income rates, similar to interest payments on bonds. The Jobs Growth and Tax Relief Reconciliation Act of 2003 (the second expiring “Bush tax cut”) made “qualified” dividends taxable at the taxpayer’s  long-term capital gains rate – between 0% and 15%, depending on an individual’s tax bracket. Reversion to the old system would make dividends taxable at a top rate of 43.4% (including the Medicare tax.) It is not clear at what income level future taxpayers will be affected or if a compromise rate can be achieved. However a number of companies have advanced their January 2013 dividend payments into 2012. And if you are the controlling owner of a closely-held C corporation with a large amount of retained earnings, it might make sense to take a substantial dividend in 2012.
  • Estate Tax. The estate tax is scheduled to revert to its pre-2000 status, with an exemption of $1,000,000 ($2,000,000 for couples with proper planning) and a top rate of 55%. The current exemption is $5,120,000, with a 35% top rate – including an inflation index now built into the law. Even President Obama is not proposing going back to the old levels, but instead has proposed a $3,500,000 exemption and a top rate of 45%. In addition, over the years there have been some significant and positive innovations, such as “portability” which allows couples to take advantage of two exemptions without doing complex planning. While it’s impossible to know for sure, I wouldn’t be surprised to see the current law extended which taxes about 4,000 estates per year as opposed to the 7,500 per year that would be affected with a $3,500,000 exemption.

An Important Month

The month of January 2013 should be the most critical to watch, particularly if no kind of temporary fix is agreed upon in the last few days of 2012. The new Congress will be seated and the President has both his inaugural address and the State of the Union Address to further solidify public opinion around his policies. If this spills over into February, it would be a good time to start worrying. In the meantime, now may be a good time to contact your advisor to see how all of this affects you.

 

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