When Federal Reserve chairman Ben Bernanke used the term "fiscal cliff," it quickly became the newest Washington buzzphrase. As the deadline to avert the cliff nears, it has overtaken the European debt crisis as the most talked-about story in the financial media. The fiscal cliff refers to the enactment of a number of laws that would, if not changed before Jan. 1, 2013, substantially affect taxes and budgetary spending cuts in the United States. There has been a lot of talk about how going over the fiscal cliff will affect the country, but how will it affect you? The answers are sobering.
Marginal Tax Rates Will Rise
Your marginal tax rate is the tax you pay on each additional dollar of income you earn. As your income rises, your marginal tax rate (better known as your tax bracket) rises. For 2012, the tax brackets are 10%, 15%, 25%, 28%, 33% and 35%. If Washington does not act, those rates will go up respectively to 15%, 28%, 31%, 36% and 39.6% starting on Jan. 1, 2013. This translates to about $2,000 extra per year in taxes for middle-income families, according to the nonpartisan Tax Policy Center. Although the U.S. may be one of the countries with the lowest tax rates, many feel Americans won't be happy at all with these changes if they go through.
Unemployment Will Also Rise
The October 2012 unemployment rate of 7.9% represents significant improvement over the October 2009 rate of 10%. The Congressional Budget Office believes that up to 3.4 million jobs would be lost, post fiscal cliff, due to a slowing economy with layoffs stemming from cuts in the defense budget and other things. This could result in an increasing unemployment rate up to 9.1% or more.
Extended Unemployment Benefits Will Expire
Congress passed a law in 2008 providing federal unemployment benefits to those who exhausted their state payouts. This program is set to expire at the end of 2012, and it will affect an estimated 2 million Americans. While some lawmakers believe that providing federal assistance is unsustainable and may encourage people not to seek employment, an additional 1 million would lose their benefits in April.
Investments Will Be Taxed at a Higher Rate
The potential expiration of the Bush-era tax cuts also affects tax rates on investments. The long-term capital gains tax rate will increase from 15 to 20%, and qualified dividend rates will increase to the individual's marginal tax rate up from a fixed 15% under the current plan. This not only affects Wall Street investors but also retirees and retail investors who are withdrawing from qualified retirement plans and brokerage accounts.
Estate and Gift Tax Exemptions Will Drop
The current estate and gift tax exemption of $5.12 million will drop to $1 million. Currently, the tax on estates valued over $5.12 million is 35%. After the fiscal cliff, a 55% tax rate on estates over $1 million will apply.
Social Security Payroll Tax Rates Will Increase
In 2010, Congress approved a temporary reduction in the Social Security payroll tax. This 2% reduction took the tax from 6.2% down to 4.2% on the first $110,000 in earnings. This temporary rate is set to expire at the end of the year. This would cost somebody making $50,000 per year an additional $20 per week in taxes.
However, that may not be the end of the impact of the fiscal cliff on Social Security. Social Security has a lot of moving parts, and lawmakers from both sides of the aisle believe that making changes to Social Security, in addition to the lapse of the payroll tax cut, could raise much-needed revenue.
The Bottom Line
For those who opposed the 2008 $700 billion Troubled Asset Relief Program (TARP), a program that ultimately paid out $432 billion, the price tag of the fiscal cliff is even larger. According to the Washington Post, the combination of tax hikes and spending cuts will total about $500 billion, a jolt that a recovering economy will not easily endure. What will happen if we go over the fiscal cliff? This unprecedented event has many guessing. Soaring unemployment and a plunging stock market are but a few of the possible scenarios.
More From Investopedia