Residents of the north Atlantic seaboard that are still trying to cope with the devastation of hurricane Sandy are in the crosshairs of yet another costly storm. But this one is originated from Washington, DC.

If dozens of tax cuts expire on Jan. 1, taxpayers who will be hit the hardest live in New Jersey, Connecticut and Maryland. 

According to an analysis by the non-partisan Tax Foundation, the income of a “typical household” in these states tends to be higher than the national average. As a result, taxpayers in these states are more likely to be subject to the Alternative Minimum Tax (AMT).  The problem is, Congress has failed to pass any adjustments to the AMT- including the rules affecting the current tax year, so unless the situation changes, the exemption amount will revert to where it stood 12 years ago and certain tax credits will also disappear.  

Ironically, households at the opposite end of the income spectrum are facing the second-highest tax increases. This includes folks living in states such as West Virginia, Arkansas and Mississippi where the average family is set to lose the benefit of several tax changes passed during the Bush administration. The biggest impact will come from a reduction in the child tax credit, the loss of the 10% tax bracket and the lower standard deduction for married couples. 

Also set to expire at the end of this year is the 2% reduction in payroll tax, which (for the second year in a row) was theoretically supposed to stimulate the economy by putting more money into consumers’ wallets. Instead of paying 6.2% toward Social Security each pay period, workers have only being paying 4.2%. (1)  When this reverts back to its normal level, lower income taxpayers are likely to feel the pinch the most.

In addition, investors will face higher taxes. The top capital gains rate is set to return to 20% and dividends will again be taxed as ordinary income- at rates as high as 39.6%. Of course, when you add in the 3.8% Medicare surcharge, the top rates will actually be 23.8% and 43.4%. “This is not good for investors and businesses,” says Tax Foundation economist Will McBride, who points out that the tax rates on dividends and capital gains are headed to levels not seen since the late 70s and early 80s. “It’s why we saw the stock market tank. Huge tax increases are already baked into the cake. We’re returning to Clinton-era rates. And Obamacare is already law.” (2)

Why should you care? Well, taxes have consequences. And people make choices.

Talk to your dry cleaner. The couple who owns the local bakery. The Gulf War vet who bought the franchise rights to an oil change shop. Chances are, they’re not incorporated. Their tax bill is based on the higher rates that individuals pay, so they’re going to be looking for ways to cut costs just to stay in business. They may be fored to lay off an employee or two...or more. Hire part-time help so they’re not subject to Obamacare. Reduce the hours they’re open, or stop sponsoring the high school homecoming game. 

Taxes have consequences. And people make choices.

If you’re old enough to remember, think back to the presidency of George H.W. Bush and passage of the so-called “luxury tax.” It, too, was only supposed to affect “The Rich,” remember? This additional 10% surtax applied to cars and boats- oops! Pardon me, yachts- that exceeded a certain price.  “Average Americans” would never feel it. And, The Rich?  Oh, they could afford it.

So what happened to the luxury tax? It got repealed. Never raised the money it was expected to. Turns out, the Geoffreys and Bunnies of the world decided they would live with the yachts they already had rather than upgrade to newer ones and have to pay the additional tax.

Oh. There was one consequence: the luxury tax essentially destroyed this country’s small boat industry and its dealers. That put lots “average folks” out of work. Oops.

Taxes have consequences. And people make choices.

Faced with higher costs for employee benefits and taxes, larger businesses will also look to reduce expenses. They don’t replace equipment as quickly and will become less likely to expand. Lower demand for equipment means there is lower demand for the workers who make it, so those people get laid off or face reductions in their hours. When construction declines, there are layoffs in that industry. When workers do not have the most up-to-date equipment they are less productive. Similar products made in other countries become better and cheaper, and the United States becomes less competitive. 

Of course, everyone expects that some kind of last-minute compromise is going to be reached between the Republican-controlled House and the Democratic Administration regarding the fiscal cliff. Perhaps all our leaders in Washington will do is postpone the inevitable and extend the current tax rules another year. How will that help reduce our out-of-control deficit? And, don’t forget: The added cost of  health-care reform is not on the table. It will kick in on January first no matter what is decided with regard to tax rates. 

If, in the end, we end up with little change in tax rates, but runaway debt and high unemployment remains, we’re headed for another recession. “We’re going to become more like Greece,” predicts McBride.

Take a look at the chart below, compliments of Thomson Reuters:

  Tax Rate on December 31, 2012 Tax Rate on January 1, 2012
Top Individual Income Tax Rate

35%

39.6%

Additional Medicare Tax on Wages

N/A

.9%

Medicare Contribution Tax on Investments

N/A

3.8%

Maximum Rate on Long-Term Capital Gains

15%*

20%

Maximum Rate on Qualified Dividends

15%*

39.6%

Top Marginal Rate on Long-Term Capital Gains

15%*

23.8% (20%+3.8%)

Highest Marginal Rate on Wages

35%

40.5% (39.6+.9%)

 Top Marginal Rate on Qualified Dividends & Interest

15%

43.4% (39.6%+3.8%)

*0% for Persons w/ Marginal Tax Rate <25%

 

 

 

If you happen to live in a part of the country- such as the northeast or California- where the cost of living is higher and, thus, both spouses have to work, there’s a good chance your taxes are headed significantly higher. It doesn’t matter that you’re just pulling in the average income for your area; you are considered “rich.” So your taxes are headed higher and your standard of living will go downcAt this point, you have two choices: do nothing and hope that our leaders extend the status quo, or contemplate some changes you could make to your income and your assets before this Washington-induced train wreck comes crashing through at the start of the new year.

1. However, Social Security is still collecting the full 12.4% payroll tax. Employers continue to pay their half, i.e. 6.2% and the Treasury Department is kicking in the 2.0% not being contributed by workers. 

2. To see how much taxes would go up for the “average” family in each state if the scheduled changes are allowed to take place January 1st, visit http://taxfoundation.org/article/how-would-fiscal-cliff-affect-typical-families-each-stat

 

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.