In Tuesday’s State of the Union address, the President addressed the massive, looming federal budget cuts referred to by many in Washington as the "sequester." Specifically, he noted that “[i]n 2011, Congress passed a law saying that if both parties couldn’t agree on a plan to reach our deficit goal, about a trillion dollars’ worth of budget cuts would automatically go into effect this year.”
Unless Congress acts to prevent them, there will be automatic, across-the-board cuts in both military and domestic spending as a result of the sequester. Absent Congressional action, these cuts will likely take effect at the beginning of March – just over two weeks from today.
Media reports were dominated by a similar story in late 2012 – the looming “fiscal cliff,” a number of sweeping tax changes that were set to take effect on the first of this year. The federal estate and gift tax unified credit, for example, was set to drop from $5.12 million to $1 million, along with a massive increase in the estate tax from 35% to 55%. Congress narrowly averted the fiscal cliff by passing the American Taxpayer Relief Act of 2012 (“ATRA”), which was signed into law on January 2nd, but postponed consideration of the budget cuts that make up the sequester.
As part of the fiscal cliff deal that led to ATRA, taxes increased for the highest earners. For individuals with taxable income over $400,000 (or $450,000 for married couples filing a joint return), the top marginal tax rate increased from 35% to 39.6%, and long-term capital gains rates increased from 15% to 20%. Although many taxpayers below this threshold breathed a sigh of relief, millions of workers earning well below the $400,000/$450,000 threshold got an unpleasant surprise with their first paychecks of the New Year. ATRA prevented a number of drastic tax changes, but did not extend the “payroll tax holiday” many Americans had been enjoying since 2010 (Illinois taxpayers did not enjoy the benefit of the tax holiday as much as other states, since the Illinois legislature increased state withholding by the same 2% in 2010).
As a result of the expiration of the payroll tax holiday, all taxpayers earning income subject to Social Security tax saw a 2% reduction in their paychecks at the start of 2013, as payroll tax increased from 4.2% to 6.2%. For many, this was an unwelcome and unexpected change – the hashtag #WhyIsMyPaycheckLessThisWeek was trending on Twitter in early January, as workers received their first paychecks of 2013. The average worker saw an $83 per month decrease in take home pay as a result. What will this mean for taxpayers annually? An individual earning $50,000 in income per year will pay nearly $1,000 in additional payroll tax this year. For individuals earning $113,700 and above, the increase will max out at an additional $2,274 in payroll tax in 2013.
While ATRA did not prevent the expiration of the payroll tax holiday, it did prevent a number of tax changes that were set to take effect at the start of 2013, for
- The Federal Estate and Gift Unified Credit, which was set to drop to $1,000,000 (a reduction of over $4,000,000 from 2012 levels), has been set at $5,125,000 for 2013 forward.
- The maximum estate, gift, and GST tax rates are 40%, instead of the 55% that would have taken effect without ATRA.
- The tax on long-term capital gains and qualified dividends is 20% for taxpayers over the $400,000/$450,000 threshold. For lower income levels, the tax will be 0% or 15%. Short-term capital gains will continue to be taxed as ordinary income.
- Itemized tax deductions and personal exemptions will be limited for single taxpayers with income over $250,000 ($300,000 for married couples).
- The Alternative Minimum Tax (AMT) exemption has been made permanent and will be adjusted for inflation annually to prevent it from impacting middle-class families.
While we can’t predict with certainty whether Congress will solve the sequester problem in advance of the March deadline, we do know what will happen if they don’t. Mandatory budget and spending cuts are projected to total $1.2 trillion, and will be evenly split between defense spending and “discretionary” domestic spending (spending on wars and entitlements like Social Security and Medicaid are exempt from cuts). The cuts are scheduled to begin in 2013 and end in 2021, evenly divided over the nine-year period.
As with most legal and financial matters, the particular details of your specific situation should be carefully evaluated in making decisions about your tax planning. Due to changes in the law, 2013 is a very important year to consult with a tax preparer or other tax professional, and you may want to make tax withholding changes sooner, rather than later. If you haven’t already done so, contact an attorney or tax professional who can advise you on how best to plan for your specific situation.
Do you have a legal question you'd like to see answered in a future article? Post it in the Comments section below, or email it to me at firstname.lastname@example.org
Disclaimer: This article provides legal information of a general nature and is not intended as legal advice, nor does it create an attorney-client relationship with any person or group of persons. Should you wish to obtain legal advice concerning your particular situation, contact an attorney.