If the U.S. economy falls over the fiscal cliff, most Americans will be taken down right along with it.
Sure, we’ve heard all about Washington’s debate over tax hikes for the wealthiest Americans, but what about everyone else who will see a significant increase in their tax bill? Because that’s what’s coming if Congress doesn’t reach an agreement before January 1.
President Obama returned to Washington Thursday to resume talks regarding the fiscal cliff, but members of the House of Representatives didn't return until Sunday. That gives Congress and the White House a very short time window – Monday – to come up with a solution to this nation’s massive financial issues. The biggest issues in question are expiring tax breaks, new taxes and government spending cuts that are scheduled to take place on Jan. 1.
These changes will affect nearly 90% of Americans, according to the Tax Policy Center. So basically what that means is, if no deal is signed, you and your money will likely take a big hit.
The median income in America fell to about $50,000 in 2011, down 1.5% from 2010. Americans have been struggling financially for years now, as businesses, jobs and incomes have suffered in the aftermath of the Great Recession. A slow economic recovery has kept millions of people from reaching a personal financial recovery, and now, they’re about to get hit again. Before that happens, we asked HLN Money Expert Clark Howard for some guidance on what all this really means for average Americans, and what they need to know in order to prepare. Because if Congress doesn’t reach a deal, the government is coming for your paycheck.
One of the tax breaks set to expire is associated with the Social Security payroll tax. Without a deal, the rate will jump from 4.2% to 6.2%, back to the 2010 rate. That means people making $50,000 a year would receive $83 less per pay period beginning in 2013, according to CNNMoney.
“We were getting where we were paying reduced Social Security taxes the last couple of years to pump up the economy,” Clark said. “And both the Democrats and the Republicans seem to be of one mind on that, and that is to have Social Security taxes bounce back up. And that’s going to mean a smaller paycheck for virtually everybody, for the first payroll of 2013.”
Not everyone would see the change right away, since many people get paid next week and those checks will be cut using the 2012 withholding tables. Regardless if it’s the first or second check, most workers will soon be getting a smaller one.
Adjust your withholding
For a lot of people these days, $83 is a lot of money to lose from one paycheck. So if we do reach this point, Clark says there’s a way for you to even it out. A lot of people over-withhold so they can get a big tax refund in the middle of the year. By increasing the amount of federal income tax that is withheld from each paycheck, the taxpayer gets a bigger chunk back from the government the next year. Clark says all that does is give the government an interest-free loan, and you’re better off adjusting your withholding – of federal income tax that’s withheld from each paycheck – so when tax time rolls around, you either break even or you owe a tiny bit back. That way, your paychecks are bigger and you aren’t loaning the government your money for free.
Another way to come up with more money per month is to chip away at your monthly expenses and discretionary spending. So many Americans have had to make adjustments they never could have imagined, but even small changes can really help, at least for now.
Think about all the things you really don’t need.
Imagine how much you could save by changing even just a few of your regular expenses. And now is a great time to get in the habit, because the Social Security tax hike, and even income tax hikes, won’t be the biggest issues for most Americans. The biggest problem most Americans will face is the alternative minimum tax.
Alternative minimum tax
After a hike in Social Security tax, Clark said, “The second kick is if there is no deal to roll taxes back for income tax, then almost everybody on their second paycheck of 2013 will have an even smaller check yet again.”
The alternative minimum tax (AMT) was originally aimed at America's richest taxpayers, to ensure they pay at least some income tax, regardless of their eligibility for deductions and exemptions on their regular income tax bill. This tax takes effect at a specific income level and carries its own set of rates. The problem is the AMT doesn't account for inflation, so while incomes have gone up (with inflation) over the years, the income level at which this tax kicks in has stayed the same. Congress usually gets around it by issuing a temporary “patch” each year that increases the minimum income level subject to the tax. Basically, Congress spares the lower-income taxpayers who could be devastated by a tax with such high rates. But, no patch has been issued yet for tax year 2012 and if Congress doesn’t reach a deal, a lot of people will get slammed.
Last year, the exempt income levels were $48,450 for single taxpayers and $74,450 for married taxpayers. If Congress doesn’t issue a patch, these levels will drop significantly to $33,750 for single Americans and $45,000 for households. That means without a deal, nearly 28 million more Americans would be subject to the AMT when they go to file their 2012 tax return early next year.
Although it’s possible, Clark says it likely won’t happen. Congress has somewhat of a “grace period” when it comes to retroactively passing certain tax breaks or extensions of expiring tax breaks.
“If there’s never a deal made any time, let’s say, in 2013, everybody’s taxes would go up,” Clark said. “That’s not going to happen. Even if we go over the fiscal cliff, at some point, probably in January, a deal will be reached to exclude at least 90% of taxpayers from any tax increase on income tax.”
When it comes to retirement savings accounts, Clark says the best thing to do is to just leave it alone. The stock market may take hits due to uncertainty regarding taxes and lawmakers’ lack of confidence that a deal will be signed by Dec. 31, but you can control the general health of your retirement plan.
“Unless you need the money in the next three years, just keep going just as you are,” Clark said. “Make your contributions as you do and spread the money out among various stock-type choices in your 401k or your Roth account. Don’t let this change anything you do.”
Tax filing/refund delay
If no deal is reached, most everyone’s tax refunds next year will likely be delayed. In that situation, the IRS would have to revise the tax requirements and forms for tens of millions of Americans, as the AMT and other tax hikes kick in. Without a deal by Dec. 31, there will probably also be a filing delay.
Clark says people who like to file their tax returns early, maybe around January 15, well, better luck next year. “That’s almost certainly not going to happen this year for any tax filer,” Clark said, “because the IRS won’t have had time, by the time Congress does whatever it does, to figure out the computer programming for people being able to file taxes. So in the worst-case scenario, no one will be able to file until after the first of March. That’s worst case. And because of the alternative minimum tax, which hits higher income earners, they may not be able to file until sometime mid- to late spring.”
Married people also face a big tax hike. The number of married adults in the United States has dropped significantly over the past 50 years, and while it’s probably not the biggest contributing factor, U.S. tax law discourages marriage. As part of the Bush tax cuts, married couples now get a deduction that’s exactly twice that of individual taxpayers, but if Congress doesn’t specifically extend the marriage tax break, it won’t be pretty for married couples.
“Even if tax rates are rolled back on most people,” Clark said, “unless Congress also puts in the marriage penalty patch, a couple where both work and they’re married will pay much higher taxes than a couple where two people just live together.”
Without the tax break, financially speaking, it’s more beneficial for a couple to live together without being married.
The problem is married couples move into higher tax brackets more quickly than individual filers. Without extending the tax break, individual taxpayers would remain in the 15% tax bracket until they reach $36,250 in taxable income, while married taxpayers could be pushed above the 15% bracket after hitting only $60,550 in combined income, rather than $72,500, which would be exactly double.
“And that’s why it’s called the marriage penalty and that’s why it was done away with 10 years ago,” Clark said. “If Congress doesn’t act, even if they do roll back tax rates, married couples where both work could still get hit with a much higher tax bill.”