The fiscal Cliff is rapidly approaching, and the financial media is repeatedly warning that the $600 billion combination of tax increases and spending cuts will result in a sizable decrease in our disposable income starting next year. However, your income is not likely to be the only thing that will shrink if the fiscal cliff takes effect. The impact that it has on the economy will likely hit you in several other areas as well.
We can start with the obvious. Experts estimate that the fiscal cliff will raise taxes by about $2,000 a year for the middle class and considerably more for the wealthy, but even poor people will pay more tax if we go over the edge. This is coupled with a reversion to the normal level of Social Security withholding by employers. For the past two years, Congress has allowed employers to withhold only 4.2% of employee wages for Social Security as a means of easing the cash flow of working taxpayers. This will end at the same time that taxes will rise. This reduction in cash flow may force many workers to cut back on their retirement plan contributions or other savings programs in order to make ends meet, which in turn will reduce the amount of liquid assets that they can accumulate.
Many economists warn that the fiscal cliff could plunge the U.S. into another recession or at least a much steeper one. If this happens, then unemployment will rise again and property values will drop. This could translate into a few more years of stagnant home prices and possibly cause more homeowners to become underwater on their mortgages. Many home values have already declined substantially since the subprime meltdown, but this could make things worse for the foreseeable future.
Real estate won't be the only sector affected. The economic impact from the Fiscal Cliff could also send the stock market into a tailspin, which could translate into declining balances in your 401(k), IRAs and other retirement accounts. This could also keep interest rates low for a while longer, which means that fixed-income investments will continue to offer tepid returns in the near future. The value of your investments is only part of this picture. Capital gains taxes will also increase next year if we go over the cliff, which means that you'll be able to keep less of any gains that you realize. The top long-term capital gains rate will reset to about 20% (10% for taxpayers in the 15% tax bracket), which is 5% more than the current limit of 15%. Short-term gains will continue to be taxed as ordinary income, but these rates will also rise. Of course, smart investors already realize this is coming, and many of them along with professional traders and other major players in the markets will likely liquidate some of their holdings in anticipation of this, which could trigger a sell off in the markets in and of itself.
Unfortunately, income taxes aren't the only thing that will rise if we go over the cliff. The estate of even a moderately wealthy taxpayer may be saddled with estate taxes that would not apply now. The amount of assets that can be passed tax-free to heirs now stands at $5.12 million per person, but this will shrink back to $1 million next year. All millionaires will therefore have to restructure their estate plans in many respects in order to stay current with the tax laws.
The Bottom Line
These are just some of the ways in which the Fiscal Cliff could take dollars out of your pockets. For more information on this pending issue, consult your financial advisor or your tax advisor.