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Risk of going over the "Fiscal Cliff"

Marginal tax rates are scheduled to go up in 2013 if the Bush tax cuts are not extended again.  Most politicians seem to agree that raising taxes while the economy is still recovery will halt the recovery and bring us back to recession and they are very possibly right. Plus the idea of raising taxes on middle and lower income families when wages are down is socially unacceptable. So it would be reasonable to assume that the tax cuts will be extended or made permanent (nothing is ever really permanent when it comes to the US Tax Code) for middle and lower incomes while higher incomes (the income in the higher brackets) will likely see higher taxes. For this reason, those with higher incomes should prepare to pay higher taxes.

Tax rates on Capital gains and dividends are expected to go up as well from 15% to 20% on capital gains and dividends will be taxed at ordinary income rates. In addition, those with investment income may be exposed to the 3.8% surtax which could bring capital gains and dividend rates to 23.8% and 43.4% respectively.

The payroll tax holiday that reduced the 4% tax on the first $106,000 of income for Social Security was reduced to 2% in 2010 and extended in 2011 through the end of 2012. If this is not extended, plan on a 2% increase on the first $110,000 of income in 2013. We also see a 0.9% increase tax for Medicare bringing the employee contribution from 1.45% to 2.35%.

To make matters worse, some of the phase-outs for certain deductions return such as personal and dependent exemptions as well as itemized deductions. We also see a return of the marriage penalty in which those who file married joint are able to claim only 167% of the single-files personal exemption instead of the current 200%. We also see a higher threshold in the deductibility of medical expenses from 7.5% of Adjusted Gross Income (AGI) to 10%.

If the Federal Estate Tax exemption, which currently stands at just over $5,000,000 per person with spousal portability, expires at the end of 2012 we could see the Federal exemption amount go back to $1,000,000 per person without spousal portability. This will require many people to re-visit their current estate plans.

On top of all of this, we will see government spending cuts dictated by the Budget Control Act of 2011 which required automatic spending cuts across the board if a budget reduction plan was not implemented which it wasn't so these cuts go into effect in 2013.

All of these tax increases and spending cuts are estimated to lower US GDP (growth) by 3.0% to 3.8%. With the economy only growing at a modest 1.9% and few prospects for higher growth ahead, this would surely bring us back into recession. Do I think all of this will happen? Mostly no, because I think something will be done between the November elections and the end of the year however the outcome of the elections is likely to determine what stays and what is cut. I would still bet on taxes going up for higher incomes. This should be a nail biter! 

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