Many clients are calling to ask about the “fiscal cliff” referenced so often in the pre- and post-election news coverage. The fiscal cliff refers to a $7 trillion combination of automatic spending cuts and tax hikes put in place by the Budget Control Act of 2011, about $600 billion of which will go into effect in January 2013. Of that 2013 amount, about $536 billion will come in the form of tax increases, or about $3,500 for every household in the U.S. Roughly 88 percent of all households will see their taxes rise if the government allows the country to fall off the fiscal cliff. Middle-income households will see an average increase of about $2,000, and upper-income people will pay an additional $14,173 on average.

These increases will be in addition to the 2013 taxes imposed by the Patient Protection and Affordable Care Act (Obamacare).

Here is a synopsis for your review while following the negotiations within Congress, and between Congress and the President, which have commenced now that the election is over:

I. HOW DID WE GET HERE?

The automatic spending cuts and tax hikes that form the fiscal cliff result from the inability of the President and Congress in 2011 to agree on a long term budget and debt solution. When faced with the debt ceiling crisis of 2011, the government could not reach a deal, and so instead put in place the Budget Control Act of 2011, which created the fiscal cliff outlined below. The idea was that the fiscal cliff would be so financially catastrophic that the government would in the future have no choice but to agree on a budget, or that one party would assume enough control of the government to force a budget, neither of which has yet occurred.

Virtually everyone on both sides of the issue, as well as the non-partisan Congressional Budget Office, warns that if the government allows the country to go over the fiscal cliff the result will likely be a severe recession. If the government does not reach a budget compromise, you can expect the tax increases and spending cuts outlined below to take effect in January 2013:

II. FISCAL CLIFF TAX INCREASES:

The fiscal cliff will result in tax increases that actually mostly will occur due to the automatic expiration of existing tax provisions, as follows:

A. Expiration of the George W. Bush-era Tax Cuts:

The Bush tax cuts first put in place in 2001, and extended in 2010, will expire. The expiration of these cuts will result in:

1. Income Tax Rate Increases: Income tax rates will rise to 15%, 28%, 31%, 36% and 39.6%, up from 10%, 15%, 25%, 28%, 33% and 35%.

2. Capital Gains Tax Rate Increases: For long term capital gains, the rates will rise to 20% from 15% for most taxpayers, with a higher 23.8% rate for wealthier taxpayers due to an additional 3.8% wealth tax imposed under Obamacare. For short term capital gains, the rates will be taxed at the same rate as your ordinary income, up to 43.4% when factoring in the additional 3.8% wealth tax imposed under Obamacare.

3. Qualified Dividend Tax Rate Increases: The tax rate on qualified dividends will be taxed at the same rate as is your ordinary income, up from 15% for most taxpayers under the current tax laws. The maximum possible rate here, when factoring in the additional 3.8% Obamacare wealth tax, is 43.4%.

4. Restoration of the Personal Exemption Phaseout (a.k.a., “PEP” or “Pease limitations”): The limitations on the exemptions that can be claimed by high-income households will be restored, limiting some itemized deductions and personal exemptions.

5. Reduction of Child Tax Credit: This tax credit falls to $500 per child from $1,000. The refundable portion will also be reduced.

6. Decrease in Child Care Deduction Limit: The child care expense deduction limit drops to $2,400 from $3,000.

7. Elimination of Student Loan Interest Deduction: The current allowed deduction for student loan interest will be eliminated. The former, more restrictive, law will apply.

8. Reduction in the Education IRA Contribution Limit: The annual allowed contributions to an Education IRA will drop from $2,000 to $500.

9. Elimination of the American Opportunity Tax Credit: This college education tax credit expires. The lesser value HOPE tax credit for college tuition is reinstated. Several smaller education tax benefits also expire.

10. Reduction of the Earned Income Tax Credit: This tax credit for low income wage earners will be restricted to two dependents.

11. Elimination of Marriage Penalty Relief: The so-called marriage penalty, wherein married couples pay higher rates than single people, will be reinstated for low and middle income couples.

12. Estate tax: The estate, gift, and generation skipping tax exemptions, and the associated tax credits, will drop precipitously to pre-2001 levels, while at the same time the associated tax rates will increase dramatically. The IRS projects these changes will result in a tenfold increase in the number of estates subject to taxation. Please see our Estate Planning page for details.

B. Increase in the Alternative Minimum Tax:

The alternative minimum tax (AMT) will sharply increase taxes for about 27 million households, according to the Congressional Research Service. Any couple with children and an annual income of more than $45,000 will be facing a 2012 federal tax bill (NOTE: Yes, this will affect 2012 taxes) that is potentially thousands of dollars higher.

What is the AMT?: Congress created the AMT in 1969 to ensure that wealthy people could not use deductions to escape paying all taxes. But the tax is not adjusted for inflation, and therefore requires the regular application of an inflation adjustment “patch” to ensure that the AMT does not affect middle class families. Due to political gridlock, Congress and the President did not pass a patch in 2012, and if they do not do so before January 2013, then 27 million middle class households will face significant tax increases. Income exempt from the Alternative Minimum Tax for tax year 2012 falls to $33,750 for individuals and $45,000 for married couples. That is down from what should have been $50,600 and $78,750 exemptions, respectively, if the exemption amounts had been adjusted for inflation this year. As a result more than 27 million households will be hit by the so-called “wealth” tax, up from 4 million under the current tax code.

C. End of the Payroll Tax Holiday= Increased Social Security Tax:

The current Social Security payroll tax reduction will expire, resulting in a further 2% being taken from every paycheck (up to $113,700 in income) in 2013. This will affect approximately 163 million wage earners, and will almost certainly occur regardless of whatever else happens with the fiscal cliff.

II. OTHER NEGATIVE FINANCIAL CONSEQUENCES OF THE FISCAL CLIFF:

A. Cessation of Unemployment Benefits:

The extended emergency unemployment benefits previously authorized by Congress will expire. That means workers who lose their jobs after July 1, 2012, will only receive up to 26 weeks in state unemployment benefits, down from as many as 99 weeks in state and federal benefits that had been available.

B. Spending cuts:

These cuts are referred to as “automatic sequestration”, and the most visible cuts will result in an immediate $50 billion cut from the Pentagon budget, which is expected to result in the loss of thousands of jobs in the defense industry. However, there are cuts to hundreds of other government programs as well.

These are just the high points, as the Budget Control Act of 2011 contains myriad other tax increases and spending cuts.

III. WHAT ELSE IS ON THE HORIZON REGARDLESS OF THE FISCAL CLIFF?

A. Obamacare Taxes:

Don’t forget that in addition to, or regardless of, whatever happens with the fiscal cliff, Obamacare begins imposing significant additional taxes in 2013 (some are already in effect). According to the Joint Committee on Taxation and the Congressional Budget Office, between 2013 and 2022, the 21 taxes imposed by Obamacare will total $836.3 billion, with the following individual taxes being in effect in 2013:

1. Medicare Tax: Imposes a further .9% Medicare tax on households earning more than $250,000, or individuals earning more than $200,000 (on top of the 1.45% already imposed). This is the largest tax contained within Obamacare.

2. “Medicine Cabinet” Tax: This is already in effect, and prohibits reimbursement for certain over the counter medicine and medical product costs from pre-tax dollar funded Health Saving Accounts (HSA), Flexible Spending Accounts (FSA) or Health Reimbursement Accounts (HRA).

3. Investment Income Tax: Imposes an additional 3.8% wealth tax on investment income (capital gains and dividends primarily) for households with an annual income greater than $250,000, and individuals with annual income in excess of $200,000.

4. Flexible Spending Account Limits: Imposes a $2,500 limitation on contributions to flexible spending accounts.

5. Health Savings Account Withdrawal Tax Increase: Increases the tax on non-medical withdrawals from HSA’s from 10% to 20%.

6. Reduced Medical Expense Tax Deduction: Reduces the tax exemption for medical expenses. Medical expenses are currently deductible if they exceed 7.5% of your adjusted gross income (AGI). Obamacare reduces allowable medical deductions by increasing the qualifying amount from 7.5% of AGI to 10% of AGI.

7. Elimination of Certain Medical Expense Deductions: Medical expense deductions for any expenses that can be allocated to Medicare Part D will be eliminated, which primarily affects the ability to deduct certain prescription drug expenses.

8. Corporate Tax Increases: The law also imposes a variety of taxes on corporations, including several taxes on drug manufacturers and medical product manufacturers that are expected to translate into higher drug and medical device costs.

B. The Debt Ceiling is Still a Problem

On top of the fiscal cliff, early projections of Hurricane Sandy’s aftermath indicate the need for billions of dollars in federal spending to repair public transportation and roads damaged by the storm. This is money the government may not have, given that last week, the Treasury Department warned that the country probably will once again hit its $16.4 trillion debt ceiling. If the U.S. were to hit the ceiling and risk default on its debts, it could trigger a second downgrade of the U.S. government’s credit rating and another disruption of global financial markets. Recall that the government’s failure to reach a deal on the debt ceiling in 2011 resulted in the country’s debt rating being downgraded for the first time in history (and also resulted in the fiscal cliff).