President Obama signaled on election night that he’s willing to work with leaders in both parties on deficit reduction and tax reform. And House Speaker John A. Boehner said a day later that Republicans were open to new revenue.
Is compromise possible?
It’s definitely needed. The country is headed for the so-called fiscal cliff because of steep spending cuts that automatically kick in next year on top of huge tax increases from the expiration of the Bush-era tax cuts next month. Without an agreement to pull the country back from the edge, the economy is expected to fall back into a recession.
Nearly all taxpayers face a personal fiscal cliff next year if no deal is struck. Taxes next year are expected to go up by more than $500 billion, with the average household picking up nearly $3,500, according to the Tax Policy Center.
Despite these high stakes and the conciliatory tone in Washington last week, many tax experts and financial advisers are not optimistic that politicians are ready to work together.
“The reason people are more pessimistic about compromise is we haven’t seen one for the last two or three years,” said Tim Steffen, director of financial planning at Robert W. Baird in Milwaukee.
But sooner or later, financial experts agree, the White House and the Republicans in Congress will have no choice but to reach a deal.
“The thing that will force the compromise is the dire consequences of not compromising,” said Roberton Williams, a senior fellow at the Tax Policy Center.
Here’s what a compromise could look like for taxpayers’ finances:
ORDINARY INCOME TAX RATES
Obama has long argued for the return of the Clinton era’s top two tax rates for singles making more than $200,000 and joint filers with income exceeding $250,000. If he gets his way, the top tax rates next year would rise to 36 percent and 39.6 percent from today’s 33 percent and 35 percent.
One possible compromise is to allow tax rates to go up for the wealthiest Americans but raise the income threshold much higher than the president has proposed, said Michael Mussio, portfolio manager with FBB Capital Partners in Bethesda, Md. Higher tax rates, for instance, could apply to those earning more than $500,000 or $1 million.
But Republicans so far have been adamant about not raising rates — even on millionaires.
A more palatable scenario for Republicans would be to keep tax rates as they are, but cap deductions for the wealthy, Williams said. That would raise revenue and allow Republicans to say they’ve kept their pledge not to raise taxes, he explained.
DIVIDENDS AND CAPITAL GAINS
For most investors, dividends and long-term capital gains are taxed at a rate of 15 percent.
Starting next year, dividends will again be taxed as regular income, with the rate as high as 39.6 percent. And the rate on gains from investments held for at least one year will go up to 20 percent.
The news gets worse for high-income investors.
As part of the Affordable Care Act, singles with income exceeding $200,000 and married couples making more than $250,000 will pay an added 3.8 percent tax on investment income, which includes dividends, interest and capital gains. Additionally, they will pay an extra 0.9 percent of their wages in Medicare taxes.
The president’s victory and Democrats’ retaining control of the Senate guarantee that health care reform is here to stay, tax experts said. And the tax increases to support the expansion of health care won’t be on the bargaining table.
But there might be room for negotiations elsewhere.
Instead of having different rates for dividends and capital gains, legislators could agree to tax them both at a rate of 20 percent, said Mike Townsend, vice president of legislative and regulatory affairs in Charles Schwab’s Washington office. The Senate passed such a bill last summer, a sign that Democrats are on board with this, he said.
(That would work out to a rate of 23.8 percent for high-income investors once the health care tax is added on.)
ALTERNATIVE MINIMUM TAX
If Congress doesn’t act soon, about 25 million people next year will experience this arcane tax for the first time, requiring them to pay more to Uncle Sam.
“That has to be a top priority,” Steffen said.
The AMT was created decades ago to catch wealthy tax avoiders but was never adjusted for inflation, so even middle-class families now can owe the tax. Congress usually provides a temporary fix to protect the middle class, but the latest patch expired last year.
Many expect a deal to be worked out on the Alternative Minimum Tax by year’s end. But if a retroactive fix isn’t passed until early next year, that would delay the filing of returns by millions of taxpayers while the IRS updates its system, said Edward Karl, vice president of taxation for the American Institute of CPAs. And that would also delay any refunds those taxpayers are owed.
A last-minute compromise two years ago raised the amount of money that can be exempt from federal estate taxes and reduced the tax rate. An individual now can shelter up to $5.12 million from the estate tax, and amounts over that are taxed at a rate of 35 percent.
Once this expires at year’s end, an individual will be able to shelter only $1 million — not hard to reach with a house, insurance and a 401(k). Estates above that limit would be taxed at a rate as high as 55 percent.
There’s plenty of chatter about returning to the $3.5 million limit of 2009 with a top tax rate of 45 percent, Steffen said.
Still, Steffen noted, the country “never had a situation where the exemption falls from one year to the next,” which could complicate estate plans. For simplicity, he said, Congress might keep the current exemption limit.
Wealthy households, though, aren’t taking any chances, experts say. They currently can make gifts totaling $5.12 million without triggering gift taxes, and some are doing so quickly to reduce the size of their estates in case the law changes.
Workers for the past two years have contributed 4.2 percent of their wages up to a certain level for Social Security — down from the traditional 6.2 percent. This tax break, which disappears next year, saved workers an average of $1,000 a year.
Until a few weeks ago, this was one tax break that neither side seemed interested in keeping, said Schwab’s Townsend. Now some Democrats have been raising concerns about the loss of this tax break for the working class.
One suggestion, he added, is to ease the transition by raising Social Security contributions by 1 percentage point next year.
Still, among the tax cuts politicians will fight to retain, this one remains a long shot.
Next year, workers can set aside up to $17,500 on a pre-tax basis in a 401(k). Those 50 and older will be able to salt away an extra $5,500. That’s potentially $23,000 in income that workers will be able to postpone paying taxes on.
Changes to this tax-friendly plan are unlikely to occur next year, said Craig Rosenthal, a partner in Mercer’s retirement, risk and finance business. But as Congress looks for ways to raise revenue and slash the deficit, it could lower contributions to this retirement account, he said.