Fiscal Cliff Averted, For Now…

January 2, 2013

In true Congress style, a deal was passed at the last minute to keep the US from going over the fiscal cliff.

On Tuesday night the House passed a bill that will extend the Bush tax cuts for most of Americans, extend unemployment benefits, and delay spending cuts. Unfortunately, the bill left a lot of big issues on the table.

Here are the details:

The fiscal cliff related to both the tax laws that were scheduled to expire on December 31, 2012 and the spending cuts that were set to take place automatically on January 1, 2013.

Taxes

The deal raises taxes for higher-income people (individuals who earn more than $400,000 and couples who earn more than $450,000), but keeps taxes the same for everyone else. Basically, the Bush tax cuts were made permanent for everyone except those who earn more than $400,000. If you earn more than $400,000 the Bush tax cuts will expire for you, causing your top tax rate to jump from 35% to 39.6%.

The lower and middle income groups didn’t escape increased taxes completely, however, as the 2% payroll tax cut was allowed to expire. That means most Americans will see their first paycheck in 2013 go down. This was expected so no surprise here…

One good thing to come from the bill is that the alternative minimum tax will be adjusted permanently for inflation. The AMT has never been adjusted for inflation causing more and more people to owe it every year. Without a legislative change, up to 30 million Americans would have had to pay the AMT for the first time on their 2012 income tax returns. The bill will permanently adjust the income exemption amount for inflation.

The itemized deduction and the personal exemption phaseouts were extended, meaning people who earn less than $250,000 (single) or $300,000 (married filing jointly) will not see their deductions phased out.

Capital gains and dividend tax rates will remain low for most taxpayers. A 20% rate will apply for individuals above the top income tax bracket, middle brackets will pay 15% and the zero rate is retained for taxpayers in the 10% and 15% brackets.

Parents will be happy to hear that the expanded American Opportunity Tax Credit, Child Tax Credit, Child Care Credit and Earned Income Tax Credit will all be preserved for the next five years. These credits were expected to return to pre-Bush levels on January 1, making many people ineligible for them.

Oh and remember the marriage penalty? You know, the smaller 15% tax bracket and the smaller standard deduction that applied to married taxpayers (compared proportionately to single taxpayers)? Well you can breathe easier, the marriage penalty has been permanently banished from the tax law.

Teachers will be happy to learn that the deduction for books, supplies, etc., was extended (although $250 is nowhere close to what most teachers pay for classroom supplies, every deduction helps). Also extended were the tuition and fees deduction and the ability to deduct state and local sales taxes in place of state and local income taxes. These were extended for one year.

Retirees can continue to make charitable donations from their IRA; the tax-free distributions from IRAs for charitable purposes provision was extended through 2013. This is a win-win for both retirees and charities, so hopefully this will be made permanent in future legislation.

Estate taxes were also addressed in this bill; the current exemption of $5.12 million will be preserved but the top tax rate will go up to 40% from the current 35%, however, that’s lower than if the bill had been allowed to expire completely.

While taxes will remain low for most people, there are a couple of new taxes for high income taxpayers. The additional 0.9% hospital insurance tax on high income taxpayers ($200,000 if you’re single, $250,000 if you’re married and filing jointly) took effect on January 1. Also effective on January 1 is the 3.8% Medicare tax on the lesser of an individual’s net investment income or the amount the individual’s modified adjusted gross income exceeds a threshold amount. The threshold amounts are the same as the additional hospital insurance tax.

One of the surprises in this bill, for me anyway, is that the higher floor for deducting medical expenses was not axed. In 2012, you could deduct medical expenses that exceeded 7.5% of your adjusted gross income (AGI). Starting in 2013, the “floor” was raised to 10% of your AGI. The bill does include some relief; if you or your spouse has turned 65 before the end of the year the increased floor does not apply, but only for the years 2013-2016. So retirees will still be able to deduct medical expenses, but the higher floor will mean many taxpayers under age 65 will no longer be able to deduct medical expenses.

Spending Cuts

The deal also delayed the automatic spending cuts from happening, but only for two months. Congress will need to come up with a new plan for the deficit before March or the US will face another cliff scenario.

Two of the biggest spending cuts on the table were unemployment benefits and Medicare. The bill includes an extension of unemployment benefits for one year. Without this clause, more than 2 million people would have lost their unemployment benefits.

Regarding Medicare, doctors were facing a large pay cut in 2013 as Medicare reimbursement rates were set to be adjusted automatically to stay in line with GDP growth. This would have caused a 27% pay cut for physicians. While you may not be overly concerned with high income doctors taking a pay cut, you should be. Doctors fed up with looming pay cuts have been turning Medicare patients away, making it hard for consumers to get the care they need. The bill prevents this pay cut from happening, but just for one year. This issue will need to be addressed soon as it adds $31 billion to the deficit.

What’s Next

The bill will go to the White House next to be signed by President Obama. It is expected to be signed into law by Thursday.

Unfortunately, this is not the end of the fiscal cliff. According to CNNMoney, we have three more cliff-like deadlines in the next few months including the debt ceiling (not addressed in the current bill), the sequester (a series of automatic cuts in federal spending that will take place if Congress doesn’t act), and the continuing budget deficit. These must all be addressed by the end of March, so keep your seat belts on, the ride isn’t over yet.

 

Comments

Comments

  1. Mary says:

    Kristine, thank you for your clear reporting on the state of our taxes at this time. The government seems to do what many of we individuals tend to do – living in reaction. It would be a great step forward if time was spent productively planning rather than putting out fires.

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Kristine McKinley, CFP®, CPA, is the founding principal of Beacon Financial Advisors, LLC, an independent, fee-only financial planning firm located in Lee’s Summit, Missouri. Kristine focuses on providing fee-only financial planning, investment advice, and tax preparation to individuals and families from all income levels. Continue reading About Us

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Kiplinger Magazine/NAPFA (February 2013) – Kristine McKinley answered reader’s tax questions during the 2013 Jump Start Your Retirement Plan Days sponsored by Kiplinger magazine and the NAPFA Consumer Education Foundation. Click here for more News...