Preparing for the Fiscal Cliff

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I'm not an alarmist on the fiscal cliff. In fact, I figure it's almost a non-issue. But that's no reason not to do a bit of preparation. (See also: Stalemate on the Debt Ceiling)

Under current law, come January first there'll be a bunch of changes to taxes and government spending:

• The Bush tax cuts expire
• The payroll tax holiday expires
• Most government spending (except Social Security) gets cut across the board
• Medicare reimbursements to doctors get cut
• The Alternative Minimum Tax returns in full force
• Extended unemployment benefits expire

Having these changes all happen at once is probably a bad thing. (Although, if you've been worrying about government debt, these changes a long way toward fixing things — a lot further than any other plan that's been put forward.)

Individually, most of these changes are pretty sensible. The tax increases are significant, but would bring the level of revenues reasonably close to providing for the spending that voters seem to want. The spending cuts are pretty harsh, but they're probably the best shot we've had in a generation at cutting expensive parts of government that couldn't otherwise be cut (like defense spending).

The problem is that having them all go into effect at once would probably push the economy into recession.

As I say, I don't think that's very likely. Even if we do "go over the fiscal cliff," I expect Congress will fix things pretty quickly after that. (Because fixing things after will entail cutting taxes and boosting spending — two of Congress's favorite things to do. Fixing things before is less likely, because fixing things before would entail raising taxes and cutting spending, and Congress hates to do that.)

Whether they fix things before or after isn't very important. Even if the rates are allowed to go up, there'll be no immediate effect — paychecks would only be affected after the IRS issues new withholding tables, which would take weeks. Long before that happened, Congress will have reinstated the tax cuts for almost everyone.

Still, if there is no compromise, the tax increases would be significant:

• FICA would go up by 2 percentage points.
• All income tax brackets would go up by 3 to 5 percentage points.
• Tax rates on capital gains would rise.
• Tax rates on dividends would more than double.
• The child tax credit drops from $1000 to $500.
• The marriage penalty would return.

The hardest hit would be two-income couples with children, but everyone would see their taxes go up.

Planning

As a "just in case" measure, here are my tips on what you ought to be doing.

Figure That Your Taxes Might Go Up

If you're making over $250,000 a year, your taxes almost certainly will go up. Maybe you'll be paying a higher rate, maybe you'll just see your deductions get capped or phased out. Either way, you'll be paying more.

If you make less, there's a pretty good chance that the cuts will be maintained. There's no guarantee, though, so you need to find some slack in your budget just in case.

If you're in one of the categories that's especially hard hit (two income couples with kids, people with a lot of deductions that face the AMT), your taxes might go up a lot — so you ought to take some time to do a little research and figure out exactly how bad it might be. Otherwise, just figure that your tax rate will bump up by 5 to 7 percentage points — and make sure that there's enough flexibility in your household cost structure to absorb the hit.

Think About Whether You'll Be Directly Affected by the Spending Cuts

If you're a government contractor, or if your employer is, figure on a 10% cut in revenues. Similarly, if you or your employer is a health care provider, Medicare reimbursements are going to drop by a lot. (Medicare coverage isn't going to fall, but the amount that doctors get paid to provide it will.)

Expect all the things that usually happen when revenues fall — lower profits, smaller bonuses, hiring freezes, layoffs, etc.

Understand That the Whole Economy Will Be Affected

Even if you're not a government contractor, some of your employer's customers (or your customers) are. And, of course, everyone's taxes will have gone up. Everyone is going to have less money; everyone will be buying less.

As I say, I think there's a pretty good chance that we'll "go over the fiscal cliff," but also a pretty good chance that a lot of it will be repealed shortly after.

My best guess is that if you make less than $250,000, the only change you'll see is that FICA will return to its old rates (a 2 percentage point jump). If you make more than that, you'll probably see higher taxes one way or another.

I doubt if we'll see the huge spending cuts currently on the books, but we probably will see spending cuts.

Taking Action

My basic advice is much the same as it always is — be a little extra frugal. Boost your emergency fund a bit. Make sure that you're not locked into paying for stuff that you won't be able to afford if taxes are a little higher.

Once you've done those things, you can pretty much quit worrying about the fiscal cliff.