As the deadline for a congressional compromise that would prevent the automatic expiration of the Bush-era tax cuts and other stimulus benefits approaches, your clients are likely asking themselves one seemingly simple question—how will this affect me? The deadline for reaching a compromise that would avoid sending the United States over the “fiscal cliff” is less than 20 days away and, in the eyes of some observers, the prospect of reaching a compromise is becoming less likely by the day.
So we present a case study below, excerpted from Tax Facts Online, of how going over the cliff will affect your clients.
The Clients: Jack and Marilyn
Your clients, Jack and Marilyn, have scheduled an appointment to discuss how the expiring provisions will affect them. Jack and Marilyn are a relatively typically couple—they’re in their mid-50s, live in New Jersey and have three children—two in college and one in high school. Jack works in advertising and Marilyn is a high school teacher and, together, they earn approximately $300,000 annually. They each contributed the maximum $17,000 to their employer-sponsored 401(k) plans in 2012 (though they were unable to manage the additional $5,500 catch-up contributions), to reduce their taxable income to $266,000.
They have invested during the years, and tend to sell stocks, bonds, and mutual funds each year as the college tuition payments become due; to help offset college expenses, they need to bring in approximately $25,000 from these sales each year. Additionally, they will recognize about $5,000 in dividend income in 2012, which is what they have typically seen each year and what they anticipate recognizing in 2013.
They own their primary residence—they purchased it for $200,000 twenty years ago—but took out a second mortgage to expand their small home as their family grew, and are still paying off their mortgages. Further, they own a beach house in Florida where they intend to retire after all of the kids have finished school. The beach house is rented to vacationing families much of the year to help cover expenses, but upon retirement, Jack and Marilyn plan to sell their home in New Jersey and retire to the beach permanently. In today’s market, they hope to sell their primary home for approximately $750,000, though the future is, of course, uncertain.
Jack and Marilyn have done plenty of reading on the potential impact of the expiring tax provisions, but are really concerned with how a plunge over the fiscal cliff would impact them on a more personal level. How do you advise?
Jack and Marilyn are in the same situation as thousands of taxpayers today—they’re relatively comfortable after years of planning and responsible investing, but they’ve become accustomed to the current tax system and have no idea what to expect concerning their financial future if negotiations that would prevent a fiscal cliff crisis fail. Right now, they’re interested in the “worst case scenario” that could play out if all of the current expiring tax provisions are permitted to expire.
Impact No. 1: Higher Income Taxes
If the fiscal cliff negotiations fail, the most noticeable impact for Jack and Marilyn will be a substantial increase in their marginal income tax rates—in other words, they will see an obvious decrease in their take-home pay. The current income tax rate brackets were agreed upon in 2001, with rate reductions accelerated in 2003 that brought today’s rates into play.
Jack and Marilyn’s current income would place them in the 33% tax bracket for 2012. Though they were able to reduce their taxable income through retirement savings contributions, they were not able to defer enough to drop them into the lower 28% bracket. The marginal income tax brackets will increase if we fall off the fiscal cliff—meaning that in 2013, Jack and Marilyn will be taxed at 36% on their ordinary income from wages.
Under the Patient Protection and Affordable Care Act (also known as the PPACA, or Obamacare), an additional 0.9% Medicare tax on Jack and Marilyn’s income that exceeds $250,000 ($200,000 for single taxpayers) is scheduled to take effect regardless of the outcome of fiscal cliff negotiations. Further, the 2% Social Security payroll tax cuts that have been in place for the past few years will expire at the end of 2012. Assuming this happens, we can assume Jack and Marilyn’s income tax rate on their first $250,000 will effectively rise by 5%, and by 5.9% on their income that exceeds the $250,000 mark. State, local and property taxes, while not directly affected, only steepen the slope of the fiscal cliff.
Impact No. 2: Higher Capital Gains and Dividends Taxes
While the income tax ramifications will affect Jack and Marilyn greatly if Congress fails to reach a compromise, this is far from the end of their story. This is because they have begun to sell investments to fund their children’s education, and this income is taxed under a different system.
Today, Jack and Marilyn’s long-term capital gains are taxed at 15% because they fall within one of the higher income tax brackets (capital gains rates for taxpayers in the lowest tax brackets were reduced to zero through 2012). However, if this reduced rate is allowed to expire, their capital gains rate will increase to 20%—resulting in about $1,250 more in capital gains taxes each year. Effectively, they will be required to sell more investments each year to fund their children’s college expenses.
Their dividend income requires consideration, as well. Today, dividend income is treated as income from capital gains—so Jack and Marilyn have been paying tax at the reduced 15% rate. Prior to 2003, however, dividend income was taxed as ordinary income—reverting to those rates in 2013 will mean that the taxes Jack and Marilyn pay on their dividends would more than double—from the 15% they’re paying today to the 36% income tax rate that would become effective in 2013.
Impact No. 3: New Obamacare Tax
As outlined above, taxes on investment income will increase (dramatically, in the case of dividends) if fiscal cliff negotiations fail, but because of Jack and Marilyn’s income level, they must also consider the new tax on investment income that will come into play January 1. Under the PPACA, a 3.8% tax on “unearned income” will apply to taxpayers with adjusted gross income (AGI) of more than $200,000 for single filers, or $250,000 for married couples filing jointly.