Taxmageddon: How to Prepare for the Daunting Realities of the Fiscal Cliff

The draconian $500 billion across-the-board tax increases coupled with the paltry $109 billion in spending cuts for 2013 have been deemed “the fiscal cliff” by Fed Chairman Ben …

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The draconian $500 billion across-the-board tax increases coupled with the paltry $109 billion in spending cuts for 2013 have been deemed “the fiscal cliff” by Fed Chairman Ben Bernanke. Both pieces of scrapped-together legislation will have a different effect on various demographics, but the Tax Policy Center still estimates tax increases alone will directly affect nine out of ten American families. Indirect effects, like those resulting from cuts in federal expenditure, are more difficult to gauge, but still could contribute to what experts are saying may be a federal policy-induced recession. Certain components are out of most Americans’ control, but let’s take a look at a few stark realities and how to plan appropriately.

With dependent children tax deductions being halved (from $1,000 to $500), larger families will certainly notice the zing. Almost no households will be immune. In fact, according to the Tax Policy Center, even households making only $21,000 annually will see an increase in the amounts they pay of up to 2% annually, not to mention the trickle-down effects of other taxes which will be passed down to them and everyone else. It is estimated that the across-the-board average increase for each working household in America will amount to roughly $3,500.

The top 1% of taxpayers are expected to have increases north of $120,000, which includes an axing of Obama’s 2% payroll tax holiday. High income earners will also feel the effects of the Affordable Care Act. The Act obtains most of its funding from an additional 3.8% increase in capital gains taxes. Capital gains, perhaps one of the most disputed taxes because it favors the wealthy, is also set to increase to 20% from its current 15% baseline level. Tacking on Obamacare, you now have a minimum capital gains rate of 23.8%. The maximum rate on dividends and capital gains rates, based on other income will be bumped to a whopping 43.4%. Other Obamacare taxes are set to hit the markets as well including a medical device manufacturing tax and tax write-off deduction decreases for pre-retirement seniors.

Successfully avoiding taxes is difficult. Legal loopholes, like tax incentives that allow some earned income to be recognized as capital gains, will have a smaller impact and incentive in 2013 than they did in the past. The question remains, what are the savvy investors to do prior to and after the coming fiscal cliff? Here are a few suggestions:

  • Sell off assets in 2012. If you have long-held assets where large gains can be recognized (like bonds, equities or privately held businesses), it would be wise to divest such in 2012, taking advantage of the low capital gains rates. Most experts agree capital gains rates will never hit such low points in our lifetimes again. In other words, front-load your taxable income in 2012 as much as possible.
  • Stock-pile some cash. If the analysts’ estimates are correct, we may see an induced recession when all the cuts and tax increases hit the fan simultaneously. If this is the case, there may be opportunities to buy into assets at lower-than-market rates once the cliff comes. However, don’t be too conservative as inflation may deplete such holdings as well. 
  • Plan on spending an additional $3,446 next year. Just budget for the tax increases that are sure to come. If you understand your position and are expecting and can plan for the increases, it will make it easier to stomach them.
  • Talk to a tax professional. It’s best to get expert opinion, especially on something as complex and convoluted as the U.S. tax code. Speak to a local expert about how the new taxes will affect your particular tax bracket and financial aspirations.

Apart from direct tax effects, the reality of the situation appears somewhat daunting. And, as Mr. Bernanke points out, “I’m not in charge here, Congress is,” which is all the more frightening, given the poor approval ratings (and sickeningly poor performance) for both Congress and The Fed.

Nate Nead is a financial writer for SmallBusinessTaxes.com.

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