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Politicians have spent years telling you that they will never raise taxes. What they don’t admit is that your taxes can rise anyway, simply by letting current laws expire.And rise they will. Though the “Bush-era” tax cuts were given a two-year extension at the end of 2010, it’s overwhelmingly likely that many of these decade-long tax breaks will expire at the end of the current quarter.
That’s the impending “fiscal cliff” the media is buzzing about. Now that the presidential election is over, it’s time to get to work.
That dawning reality has tax advisors scrambling, suggesting key moves now to protect gains from the tax hikes to come.
Let’s take a closer look at eight key tax breaks and assess the likelihood that they will soon evaporate.
In 1921, the government passed the “Revenue Act,” which provided for a 12.5% tax rate — lower than ordinary income tax rates — for assets held for at least two years. Lawmakers have vacillated ever since, at times pushing the tax rate on investors’ profits up to income tax rates, then pushing them lower. In fact, a key component of tax reform under Ronald Reagan in 1986 pushed the capital gains tax rate from 20% to 28%.
Yet when George W. Bush took office, lawmakers pushed through the “Economic Growth and Tax Relief Reconciliation Act of 2001,” which lowered capital gains tax rates to just 15%. More than a decade later, this investor treat is likely coming to an end. Lawmakers are expected to come up with a new rate — somewhere between the current capital gains rate and the current income tax rates. Estimates of a 20% or 25% tax rate are being discussed, and we’ll get a clearer sense of the actual number as lawmakers revisit the topic.
Payroll Tax Relief
Every American saw their payroll tax rates fall from 6.2% to 4.2% in 2009 as a way to help out beleaguered consumers. Although both parties stress a continued commitment to middle-class tax relief, an extension of this particular measure actually has little support.
As noted, lawmakers appear set simply to look the other way when the payroll tax cut expires at year end. That will help boost government revenue by an estimated $115 billion every year, though the typical worker will take home roughly $1,000 less in 2012, according to the Tax Policy centre.
Child Tax Credits
Higher payroll taxes are likely to coincide with a reduction in the $1,000-per-child tax credit, perhaps to $500.
For a family with three children, we’re talking about $1,500 in more taxes, which could have a chilling effect on retail spending.
This is a tax that will be deeply felt by middle-income families, as families earning more than $130,000 were ineligible for the tax credit anyway.
Medicare Surcharge Tax
Even as middle-income taxpayers will feel the pain, higher-income taxpayers won’t be spared.
The 3.8% income tax surcharge, aimed at taxpayers making more than $250,000, was developed to help defray the costs of the Affordable Health Care Act. Now that President Barack Obama has been reelected, it appears that “Obamacare” will be fully implemented and this Medicare tax likely will go into effect.
Earned Income Tax Credit
While the Medicare surcharge would hit high-end taxpayers, a reduction or repeal of this tax break would be felt by low-income taxpayers.
The earned income tax credit (EITC) is highly controversial, with many voters viewing it as an essential form of financial support in a time of deep economic distress, while many others see it as a policy that keeps many Americans from paying income taxes.
Many who are eligible for the EITC are among the 47% that Gov. Mitt Romney spoke of in those controversial, secretly recorded comments. Though the EITC is unlikely to be eliminated, it may be subject to a reduction, perhaps back to levels seen before they were hiked in 2009. This would mean the average EITC-eligible family would be in line for roughly $2,000 less in tax credits.
Alternative Minimum Tax
A range of tax breaks start to peter out once income reaches certain thresholds, and without the breaks, many tax bills can become quite high. In response, the Alternative Minimum Tax (AMT) exemption was devised to ensure that at least some income is shielded from taxes. Though this tax break is hugely popular and enjoys bipartisan support, it could conceivably expire at year’s end and not be renewed if legislators get bogged down in gridlock.
There’s no cause for alarm, though: it’s likely that Congress eventually will come around to extending this tax break, as it always does, and retroactively apply it back to the date of the last expiration. Still, it’s just one more item to potentially spook taxpayers — at least temporarily — in coming months.
College Tuition Credits
An increasing number of students are facing high student loan balances, and in a bid to support them, the tax credits against college tuition payments were hiked in 2009 from $1,800 a year to $2,500 a year (and eligibility was extended from two to four years). As is the case with the AMT, lawmakers are loath to move against this popular tax break, though their inaction may push these breaks back to pre-2009 levels anyway.
Under current laws, the first $5.12 million of any estate is shielded from taxes when its owner passes away. After that, the remaining value of the estate is taxed at 35%. If the estate tax isn’t extended, those figures would change to $1 million and 55% at the end of this year, ensnaring many family-owned businesses that would conceivably need to be sold off to pay the tax man.
That’s why both parties would like to see this tax break extended, though both sides differ on the size of such a break, as well as the tax rate on the unsheltered portion of the estate. The issue is already being used by financial advisors to scare clients into bold estate-planning moves, but we should expect an eventual solution that delivers rates and thresholds very close to current levels.
The Investing Answer: The risk here is inaction. Lawmakers routinely wait until the last minute to get serious and have always addressed major tax issues before they impacted taxpayers. Following the election, senior lawmakers have begun making overtures to the president on coming to an agreement on dealing with the impending changes.
But gridlock in Washington grows worse by the year, and these lawmakers now run the risk of letting the tax situation get quite messy as they stand by ideological purities. So don’t simply assume that lawmakers will avert a crisis in coming months.
It’s becoming clearer that some taxes will go up, while some of these tax breaks will be renewed. Radically altering your financial planning efforts to offset these looming changes is unwise. You should stick with long-term, wealth-building plans — even if higher taxes will have a negative impact. Pursuing aggressive tax avoidance measures can lure you into risky gambits that may be rejected by the IRS anyway. If and when the U.S. government’s finances are on firmer footing and the U.S. economy looks healthier, we may again be talking about fresh tax breaks. But that’s an unlikely scenario in the near-term.
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