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How the Fiscal Cliff Will Affect You

Rick Newman

Washington hasn't sent you a parachute, yet it's pushing the nation off the fiscal cliff anyway. So it's time for ordinary people to figure out how the shenanigans in Washington will affect them.

Democrats and Republicans seem unable to make any kind of deal to prevent a huge set of tax hike and spending cuts from going into effect at the start of 2013. The media tends to refer to the cliff as if it's one huge measure that will instantly cause a recession if Congress does nothing to stop it. But the cliff really involves several different tax and spending policies that will affect taxpayers in many different ways, not all of them right off the bat.

So here's how the major aspects of the fiscal cliff are likely to affect ordinary people, assuming they go into effect beginning January 1, 2013:

An increase in payroll taxes. This is the simplest tax change to compute. The payroll tax withholding, which is used to fund Social Security, is due to rise from a reduced level of 4.2 percent--which was set temporarily in 2009--to the normal level of 6.2 percent. The payroll tax will apply only to the first $113,700 of earnings in 2013. So you can simply calculate what two percent of your income will be in 2013, to estimate the additional amount you'll pay. For the typical earner, a two-point increase will amount to about $700 in added tax payments per year.

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Income tax hikes. All rates are scheduled to revert to the higher levels of the 1990s, which for most workers would mean an increase of 3 to 5 percentage points in the tax rate they pay. But this won't necessarily affect anybody right away, because the government doesn't automatically increase the amount of tax payments withheld from your paycheck. In fact, higher rates would only hit taxpayers in 2014, when they file their 2013 tax returns. So if rates rise temporarily and Congress then lowers them retroactively to 2012 levels, nothing would change for most people.

A higher estate tax. In general, it would rise from a rate of 35 percent with the first $5 million exempt, to 55 percent with only the first $1 million exempt (and no scheduled increase in the exemption over time, to account for inflation). The Tax Policy Center estimates that the lower exemption limit would make 10 times as many estates subject to tax in 2013 as in 2012.

No "patch" for the alternative minimum tax. This complex part of the tax code basically requires higher earners to pay more than they would under normal rates and deductions. Since the cutoff point isn't indexed for inflation, Congress typically raises it each year, to prevent too many people from getting snared by the AMT. But it hasn't done that for tax years 2012 or 2013 yet. And if it doesn't, taxes will rise for tens of millions of taxpayers with incomes starting at about $34,000 for individuals and $45,000 for couples. Since this affects 2012 taxes, it would begin to hit taxpayers early in 2013, as they begin to prepare their 2012 tax returns.

A higher capital gains tax rate. The tax rate on capital gains is scheduled to rise from 15 percent to 20 percent. The 2010 healthcare reform law will raise capital gains taxes by another 3.8 percentage points for people with incomes over $250,000. As with income taxes, the higher rates wouldn't hit taxpayers until they prepare their 2013 taxes, in early 2014. But some people, anticipating the higher rates, have already been selling investments and locking in gains this year, to be sure they're taxed at the 2012 rate.

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A higher tax rate on dividends. Most dividends, including those paid on stocks, are now taxed at a maximum rate of 15 percent. In 2013, they're supposed to be taxed the same as ordinary income, which would be as high as 39.6 percent. As with capital gains, some investors have been selling dividend-yielding assets to lock in the lower 2012 tax rates.

Fewer tax credits for low-income families. A trio of tax breaks meant to help lower earners, including the earned income tax credit, would be worth less in 2013, raising taxes on a family in the lowest income bracket by about $200 per year. As with income taxes, this change wouldn't really hit until 2014, when people prepare their 2013 returns and claim the credits.

The end of miscellaneous tax credits. This grab bag of tax breaks, known in Washington as "extenders," includes things that affect businesses and some individuals, including the adoption credit, deductibility of state and local taxes, and the bonus depreciation provision for some business investments. The expiration of these measures would hit higher earners the hardest, including small-business owners. They wouldn't affect tax payments until people prepare their 2013 returns, but some businesses may make accounting or strategic changes in anticipation of the changes.

The end of extended unemployment insurance. It's not a tax, but the end of the federal extension of unemployment insurance could be one of most painful effects of the fiscal cliff. Up to three million jobless people who have exhausted the benefits offered by states--typically 26 weeks' worth--would also lose federal jobless aid if this program isn't renewed. That would hammer people who are already hurting, possibly leading to more foreclosures and lower consumer spending.

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Layoffs. Because the cliff also entails about $110 billion in government spending cuts per year, it would force most government agencies to pare their budgets, plus hit hundreds of private-sector companies that contract with the government. About half of those spending cuts must come from defense, which would directly affect companies like Lockheed Martin and Boeing, probably causing layoffs. These cuts would begin immediately in 2013, which means it could be messy trying to reinstate spending retroactively, if that's what Congress decided to do. One way or another, there will be some wreckage at the bottom of the fiscal cliff.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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