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What the 'Fiscal Cliff' Will Mean for You

Fiscal Cliff
The economy is rumbling along, out of control, with nobody at the reins. Straight ahead, the road abruptly ends, yet the horses show no signs of slowing. Next stop: the fiscal cliff!

Much like a scene out of an Indiana Jones movie, the wild ride to Jan. 1, 2013 is developing into a perfect storm of economic and political pusillanimity. And in a sense, it's been headed this way since the first reel: Facing a financial crisis that threatened to sink America's credit rating, Congress agreed to increase the debt ceiling, but only if the conservatives were given a major deal to reduce the deficit.

But those same legislators were unable to agree on what combination of tax increases and budget cuts would be employed to shrink the deficit, so they punted that problem to a "super committee" of 12 congressmen and senators who were tasked with untangling the Gordian knot of America's finances. That super committee was given the best incentive a congressman could imagine to craft a compromise: Failure meant automatic cuts to federal spending across the board, painful to both Democrats and Republicans alike.

It wasn't enough of a goad: The super committee also failed, triggering those billions in automatic cuts, which will kick in on New Year's Day.

But that's not all. In addition to the federal spending cuts, the Bush tax cuts that have been in effect since the early 2000s are also set to expire on the same day, automatically raising tax rates. So unless Congress acts, the federal government will start charging its citizens far more in an array of taxes and offering fewer services in exchange.

This, is the much-talked-of fiscal cliff. And for the average American family, it could be a pretty rough fall.

Getty ImagesHow the Fiscal Cliff Will Affect You

To get an idea of how the fiscal cliff will affect the average American family, it helps to understand exactly what that family looks like. According to the Census Bureau, the median American household has 2.6 people and brings home just under $50,000. With the expiration of the Bush tax cuts, the first thing that will hit this family is an immediate, steep increase in the amount that it sends to the IRS.

After the standard deduction, the average family currently pays 10% of its income up to $17,400 and 15% of all income between $17,401 and $70,700. For a family making $50,000, this works out to $4,845 in base taxes. If we revert to pre-Bush rates in 2013, the average family will pay 15% taxes on all its income. For a middle class family, this works out to a tax bill of $6,397, a jump of $1,552.

[An earlier version of this story used back-of-the-envelope calculations to estimate an even higher tax jump. This version more accurately reflects the tax brackets and standard deductions of the pre-Bush tax code.]

Of course, nobody pays the full tax rate; every family gets deductions that decrease its tax burden. Unfortunately, many of these deductions will vanish on Jan. 1, too. For example, the child tax credit, which gave this average family a $1,000 tax deduction this year, will be cut in half, increasing their tax burden by $500.

If our hypothetical family has a child in college, it will feel the pinch even more. Currently, families that make $100,000 or less can claim the American Opportunity Tax Credit, which allows them to deduct up to $2,500 in school expenditures for every student for up to four years. On Jan. 1, that benefit expires, and the less-generous Hope credit is all that's left to take its place. Under Hope, families making less than $100,000 can claim $1,800 per child for up to two years.

In other words, a middle class family with a child in college can expect to get $700 less in deductions immediately, and $6,400 less in deductions over the course of their child's education.

It gets worse: the "payroll tax holiday," a 2% Social Security tax cut on the first $110,000 in wages, is set to end. For the average family, this will mean a tax hike of $1,000 per year. At the same time, the average middle class family will also get hit with the expiration of the "marriage penalty reduction," a break that was included in the Bush tax cuts. Basically, this cut enabled low- to middle-income couples filing together to pay less in taxes than they'd pay if they filed separately. With its expiration, couples will face an increase in taxes if they choose to file jointly.

Moving Beyond the Average

Of course, average families aren't the only ones who will be affected by the fiscal cliff. For lower income households, the loss of the Earned Income Tax Credit will hit hard. This credit encourages poor families to work by partially offsetting their Social Security expenditures. Childless couples making $19,190 or less receive $475 per year, and benefits increase depending on the number of children a family has and the amount of money that it makes. For example, families with three children can receive up to $5,891, even if they make up to $50,270 per year. When all those other sweeping changes hit in 2013, the EIC will be scaled back.

In all likelihood, the average middle class family won't be affected by changes in the estate tax. Currently, survivors have an exemption of up to $5 million on inheritance, and pay 35% on any money above that level. On Jan. 1, the exemption will drop to $1 million and the tax rate will increase to 55%.

At the same time, the capital gains and dividend tax rates will also increase. The capital gains rate, currently 15%, will go up to 20%, while the 15% dividend tax rate will rise to match the income tax rate. These changes will be unpleasant for people who derive most of their income from investments, but will likely not significantly affect the average wage-earning household.

Sweeping Changes

Beyond the direct effects of the tax hikes, Jan. 1 will bring sweeping changes that will affect most of the country. For example, the Defense Department will see its budget cut by 10% across the board, a slash that will likely result in the shuttering or scaling back of hundreds of programs. And that will ripple through the economy in terms of job cuts, fewer workers spending less money, and in turn paying less into the system in taxes.

What's more, when those defense workers lose their jobs, they'll have to scramble for new work. Currently, unemployment benefits last for 99 weeks, but on Jan. 1, the limit will revert to 26 weeks. And that means an already-tight job market is about to get rougher as it is flooded with thousands of new unemployed at the same time that the currently jobless become a lot more desperate.

And there's more bad news: every "discretionary" program -- effectively, every program that doesn't have earmarked funds, will face an 8% cut. Schools, roads, public health, food inspections, homeland security, and almost every other federally-funded program will be scaling back services.

Even some entitlement programs are set to get hit. Medicare rates, for example, will drop by 2%, making it harder for providers to offer the same level of service, and setting the stage for a drop in the number of providers.

'Fasten Your Seat Belts. It's Going to Be a Bumpy Night.'

Given the broadly sweeping effects of the fiscal cliff, it's not surprising that the looming disaster has earned other names, like "Taxmaggedon" and "Taxpocalypse." The expiring tax cuts will hit every worker, and the reduced federal expenditures will ripple across the economy. According to the economic gurus, letting this happen will likely send the country back into recession.

Meanwhile, both parties in Congress are faced off against each other, with neither side willing to budge. Republicans refuse to allow the Bush tax cuts for the wealthy to expire, and Democrats refuse to allow budget cuts to fall inequitably on the heads of the poor. Both groups are hoping to pick up House and Senate seats in November, after which they expect to enact an eleventh-hour solution that will rein in the horses, turn the stagecoach aside, and keep the economy from plunging off the cliff. Both sides are planning to be in the driver's seat when that occurs.

But will that happen? Wall Street, at least, seems to think a last-minute save is unlikely. As The New York Times reported on Monday, manufacturers across the country have decided to delay orders, hold off on capital improvements, and postpone hiring, largely out of a belief that the federal government won't be able to get its act together. What's more, as frightened manufacturers delay investment, the rate of economic growth is slowing, from 4.1% at the end of last year to an anemic 1.5%. In other words, while Congress is waiting for the fiscal cliff to arrive, it may already be here.

CFOs Peer Over the U.S. Fiscal Cliff

Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.

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Erika Bianco

In 2009/10 I tried to explain the post from "americaback12" to a friend (a young girl in her first year of college). We somehow got on the subject and Obama had just come into office. At that time, some of us were aware of his "agenda" but I must admit, at that particular time, the "fiscal cliff" was not even a term that I knew or had crossed my mind.
In trying to explain to her what the "real" world looks like once you've graduated and your out on your own with mom and dad no longer paying for your car, housing, food, insurance, etc., etc., etc., she got defensive. I suppose I would have too. Especially at a young age.
Soon after that, I had another exchange with her and it lead down a path that wasn't, how shall we say, so sugar-coated. Again, she got defensive and shared with her parents what I said.
Thereafter, I became a family friend they no longer considered someone they viewed as such as they felt I personally attacked their daughter. Perhaps I would have felt the same although I must admit, I come from a family of realists that discuss such matters.
Today, we are quickly approaching the "fiscal cliff". Thanksgiving is week after next followed by Christmas/Hanukkah. Obviously a time when we all should be giving "thanks" for what we do have, even if it isn't much.
At Christmas, we spend money on "things" for our children, you know, "a special time of year" that we all look forward to, whether it's to give or to receive. Children have no idea what we as parents are faced with knowing the ramifications will be felt January 1, 2013. At least my kids won't. They are 5 and 3.
I am scared. The unknown has me full of anxiety and I can't imagine how life will pan out for my children as well as their children.
While people have chosen to put Obama back into office, I wonder if they really did the research to fully understand what all of this means to them. I guess we will see come January 1st.
Lastly, there are issues on both sides that need to be worked out so that we can work to fix that of which is broken. However, I'm not confident that will happen. I hope I'm wrong and I hope and pray that at the end of obamas second term, I can see what my college friend (strained friendship) saw at the beginning of Obama's first term. I couldn't see it then and I don't see it now. I wonder if she sees it and wonders how or knows how this will affect her and her family. Again, I hope and pray I am wrong about all of it so someone can say to me, "I told you so"! I will graciously accept the criticism.

November 09 2012 at 9:43 AM Report abuse rate up rate down Reply

Romney / Ryan............................The R Train, Vote out Obama.

August 14 2012 at 12:00 AM Report abuse rate up rate down Reply

We need a change, Nov 6 vote out Obama.

August 13 2012 at 11:54 PM Report abuse rate up rate down Reply

Let me tell you how it works. You are young and in college you don't own a home yet, you have no kids, life is all sunshine and rainbows, because either Mom and Dad are flipping the bill or the Government so you are working in a book store or small coffee shop to pay for the extras and Dad bought you a car for school, so you sign up Democrat thinking, the Government will take care of it all for me or Mom and Dad on their insurance and their dime. Then you graduate, you marry the girl next door. She becomes pregnant, with twins. Oh my we need a bigger place honey then this one room apt. So you go buy a new home, put down very low and expect to have a job all your life to pay for it, because you went to college and the Government will take care of you. You are doing well! One day you wake up, go to work the boss calls you in, Bob I'm sorry, but we are downsizing and have to let you go. Whoops, now Bob begin's to panic. Now he has to pay a mortgage, house taxes, high house taxes already and feed and cloth a wife and twins. Also his medical will run out soon, what will he do. So Bob suddenly sees that now being a Republican is better, he goes down changes his party, because they think more realistic, and life is real people so you better not think that big brother is always going to take care of you. He won't, he doesn't care, and you know why, because it is I'll scratch your back and you scratch mine on the hill and in the house. They all are buddies make millions and don't give a hoot about you. So wake up, Obama is just as bad. You'll be Bob one day, mark my words, and the ones who say they won't are Fools.

August 13 2012 at 3:48 PM Report abuse +2 rate up rate down Reply

I love this, The Libs act like they had absolutely nothing to do with it! They use scare tactics because that is all the party has. They have become so Radical that they are not the party of old. I know I was one for more year's then you can count. Bush made a mess we all know that, but he did some great things also. Obama came in and ran for the job, yet the past 4 years he sunk us to a new low even in the U. S. being downgraded by Standard & Poors to AA Rating of the U. S. Dollar. He spent so much when he first came in instead of worrying about the economy that he forgot about it with all his HC stuff and ran it worse in to the ground. That is where all the country money went people, ANYONE WHO BELIEVES THIS BULL IS WACK! Anyone who votes for Obama again is wack! Fool me once shame on me, fool me twice, then I'm the fool. Obama has pleanty to do with us going over the cliff, and it shouldn't have happen. We elected him not to push it, but to move it back. He didn't he has to go! Second Recession, hell yes! Vote Out Obama 2012 Gas up, Food up, Everything up, this has to stop and stop now.

August 13 2012 at 3:03 PM Report abuse +2 rate up rate down Reply

Maybe we need to let the Bush tax cuts expire. This country needs to cut spending and take in extra revenue. Spending cuts hurt no matter what. We can't keep kicking the can down the road. I for one woundn't mind tax increases if the government really cut spending. I understand that government will always have a deficit but the debt we have now is absurd no matter who's to blame. The super committees recommendations is the best thing that has come out of congress. Both parties want to ignore the recomendions of the super committee. Both parties just want to get relected. One term limits for everybody in the Congress,President and VP.

August 13 2012 at 9:53 AM Report abuse -1 rate up rate down Reply
3 replies to vondeck's comment

Instead of cutting the deficit as promised, Obama and henchman took early advantage of a house and senate majority and pushed trillion dollar programs into the system then turned up the printing presses to full ahead while attempting to turn straw into gold

August 13 2012 at 3:33 AM Report abuse +2 rate up rate down Reply
1 reply to noadmail's comment

Obama came in and wacked up the deficit himself, he took what was there and widen it so much that we went deeper in the hole. 30 Days in hole, that is the lie and deny President. He has to go, even if Romney can't cut it in 4 year's, then will send him out, but I'm willing to try.

August 13 2012 at 3:11 PM Report abuse +2 rate up rate down Reply

There is an election in Nov. well before the Jan. 1 fiscal cliff. Why not put the question to the American people on the ballot?! Do we want tax cuts to continue for those under $250,00.00? Do we want tax cuts to continue for those making over $250,00.00? Simple yes or no questiions. Congress can't do what we eleced them to do but I'll bet the American people can and will make the decision for them!! For that matter the question of a 50 to 75% paycut for Congress should be put on the ballot. As well as voting on taking away FREE HEALTHCARE FOR LIFE!!!! I vote yes on the paycut and no free healthcare! They say we need high pay to get the best and the brightest to run, or work on Wall St. If what we have is the best and the brightest we are in worse trouble than anyone knows!! I don't think we have the best and the brightest, I think we have the greediest and the biggest crooks!!

August 12 2012 at 7:48 AM Report abuse +5 rate up rate down Reply

hey congress, try something new........ do your job

August 11 2012 at 6:22 AM Report abuse +1 rate up rate down Reply
1 reply to reynold1's comment

Democrats Couldn't Do the job in Congress Before, Or did you forget that.

August 13 2012 at 11:56 PM Report abuse +1 rate up rate down Reply

And, if I look up "fiscal cliff" in the dictionary, the only thing I'll find is Mitch McConnell.

August 10 2012 at 6:35 PM Report abuse -1 rate up rate down Reply
1 reply to sandrakaywinter's comment

Forget fiscal cliff, how about second recession................................................that is where we are headed.

August 13 2012 at 11:57 PM Report abuse +1 rate up rate down Reply