As we approach the end of 2012, I would be remiss if I didn't mention the fiscal liff that is looming in 2012. It's been in the news for months now. We have all heard about it but what is the “fiscal cliff”?

As we approach the end of 2012, I would be remiss if I didn't mention the fiscal liff that is looming in 2012. It's been in the news for months now. We have all heard about it but what is the "fiscal cliff"?

Well, the fiscal cliff is a description that has been used to describe the potential situation that will occur at the end of 2012 when a number of US tax and fiscal changes are scheduled to occur. This perfect storm is a combination of the expiration of the Bush tax cuts and the implementation of the mandatory or "sequestration" budget cuts.

A very brief description of some of the Bush tax cuts that are expiring include:

The lowest income tax rate of 10 percent will increase to 15 percent and also increase for the upper marginal tax brackets.Capital gains rates increase for upper tax rates from 15 to 20 percent.Qualified dividend rates increase from the capital gains rate to your income tax rate.Child tax credit will be reduced to $500 per child for qualifying families.American Opportunity Tax Credit expires for post-secondary education.Earned Income Tax Credit changes for low and median income individuals and couples.Reversion of the Alternative Minimum Tax to 2001 levels. This parallel set of tax rules was designed to limit the very wealthy from taking too many deductions. It was never indexed for inflation and so without patches each year, affects more and more folks. Without another patch, it will roll all the way back to 2001 levels, which will now affect folks that it was never intended to.The marriage penalty relief changes.Estate tax exemption decreases from just over $5 million to $1 million.Gift tax lifetime exemption decreases.Top estate (and gift) tax rate increases.Other tax changes include:

An increase in employee social security tax withholding by 2 percent, which is a return to 2010 levels of 6.2 percent.A new 3.8 percent Medicare surtax on investment or unearned income on high income earners.Currently, Medicare withholding is 1.45 percent for both the employer and the employee (totaling 2.9 percent). A new surcharge of .9 percent on employee Medicare withholding for high-income earners will raise that withholding from the standard 1.45 percent to 2.35 percent.The other components of the "fiscal cliff" are the mandatory or "sequestration" tax cuts, which will be implemented in 2013. Discretionary spending for both defense and non-defense spending will be reduced by "sequestration" if Congress is unable to agree on other spending cuts of similar size. Up until this moment, Congress has been unable to reach an agreement with the White House on an alternative plan. Social Security and Medicare are not affected by sequestration.
The effect on both defense and non-defense discretionary spending will be significant if the cliff is not avoided. Cuts totaling $110 billion per year will be applied from 2013 to 2022, split evenly ($55 billion each) between defense and non-defense discretionary spending.

So what's the bottom line for us? Well, a lot of us will pay more in income taxes and payroll taxes are going back up as well. High earners will pay even more in new Medicare surcharges on both payroll tax and investment income.

There is not much we can do about that. However, there is one thing we can do before the end of this year, assuming that the fiscal cliff will happen. You can review your investments. Next year, taxes increase from 15 percent to 20 percent on capital gains. So, review your non-qualified investments for unrealized capital gains, i.e. those investments that have increased in value. If the gain is significant, you might consider cashing in your investments this year while the tax rate is still 15 percent on upper income earners. Why only non-qualified investments? Because the investments in your tax-qualified accounts grow tax deferred until you start to take money out and then you pay income tax on the amount withdrawn. You don't have to worry about capital gains.

Now this whole discussion may be a mute point if Congress and the White House can reach an agreement to an alternative plan to the sequestration cuts by the end of this year. However, I would bet that taxes are going to increase along with some modest budget cuts. There will be lots of bluster on the bigger issues concerning fixes to social security, Medicare, Medicaid and the tax code but nothing much will come of it.

My discussion of the expiring Bush-era tax cuts and is not all-inclusive. For more information you can go to two of my principal sources; Wikipedia, which has an excellent discussion of the fiscal cliff. Another excellent source was an article, "Tax Increases Looming in 2013: Who Pays, How Much and Will They Stick?" by Kelly Phillips in

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Larry Martin is a registered investment advisor offering advisory services through Main Street Advisor, LLC. The opinions expressed in these articles may not represent those of MSA. 1407 Main Street, Hays, KS 67601. The Consultants Financial Services, LLC and MSA are not affiliated.