Do you keep hearing the phrase “Fiscal Cliff,” but don’t know exactly what it means?  Well, get ready to impress your friends at the next cocktail party, because here’s a short cheat sheet on what it is as well as a few thoughts on how it might affect retirees.

The Fiscal Cliff is a combination of tax increases and spending cuts that will automatically occur on December 31 unless Congress and the White House come to some sort of compromise.

The tax increases include:

• An increase in Federal income taxes.  We will go from six brackets to five, and the rates will go from 10%, 15%, 25%, 28%, 33% and 35% to 15%, 28%, 31%, 36% and 39.6%.
• The maximum long-term capital gains tax rate will go from 15% to 20%.
• Dividends will go from being the same as long-term gains (usually 15%) to being taxed as ordinary income (up to 39.6%)
• The temporary 2% reduction in the FICA payroll tax will go away.
• Itemized deductions and dependency deductions will be phased out for high wage earners.
• The earned income tax credit, child tax credit and Hope tax credit will revert to their old (and less generous) limits.
• People with student loans will no longer be able to deduct loan interest beyond the first 60 months of repayment.
• Estate and gift tax provisions will change drastically.  The amount that can be excluded from an estate will drop from $5.12 million to $1 million and the top tax rate will increase from 35% to 55%.
• The alternative minimum tax (AMT) exemption amounts will fall significantly, subjecting many more people to this tax.
• In addition to the above, high wage earners will see a 0.9% increase in the Medicare portion of their payroll tax as well as a new 3.8% tax on some or all of their net investment income.

The spending cuts include:

• The failure of the “Super Committee” to reach a deal to cut spending in 2011 means across the board cuts will happen automatically in 2013.  The cuts will total about $1.2 trillion ($109 billion of that in 2013) and will be spread evenly between defense and non-defense spending.

What this means for you:

There’s good news and bad news if all of these things are allowed to happen.  The good news is that, according to the Congressional Budget Office, the deficit will be significantly reduced (i.e. We will go into debt more slowly).  The bad news is that the country will likely go back into recession.

I’m assuming that Congress and the White House will come to some sort of agreement to avoid at least some of the things outlined above.  That will grab the headlines and cause the markets to rally, but don’t let that obscure the larger point.

Our country has promised and spent far beyond its means for many decades.  That cannot go on forever.  If you filter out the “noise,” the major themes of the next decade or two will likely be higher taxes, more reserved spending and less generous benefits (think Medicare, Social Security, etc.).  That’s not doom and gloom, it’s just reality.  Keep that in mind as you plan for retirement and do your best to build a margin of safety into your planning.

~ Joe

Photo by Victoria.  Used under Creative Commons License.