How Will the Fiscal Cliff Affect Paychecks?

With just one day to go before the United States goes over the "fiscal cliff," employees and employers are left to wonder how the lack of a tax legislation agreement between the White House and Congress will affect paychekcs.

Employees will notice an immediate reduction in take home pay due to the expiration of the 4.2 percent Social Security tax rate on Dec. 31. The tax rate will revert to 6.2 percent in 2013.

Other changes may not be noticeable for a few weeks.

In the short term, the IRS will allow employers to continue withholding at the 2012 rates. However, should those rates change due to a failure in negotiations in Washington, any deficit in collection will be made up later in the year, CNBC reports.

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• ‘Taxmageddon’: $500 Billion Tax Increase Approaching

A Tax Policy Center (TPC) analysis predicts taxes will rise by an average of $3,500 per household -- or $500 billion overall in 2013 -- if the existing tax cuts are allowed to expire. 

Almost 90 percent of Americans would experience a tax increase, the TPC report states. Most of that increase would be a direct result of the expiration of the temporary cut in Social Security taxes and the end of the 2001 and 2003 Bush-era tax cuts.

"Average marginal tax rates would increase by 5 percentage points on labor income, by 7 points on capital gains, and by more than 20 points on dividends," the report warns.

Another potential problem for tens of millions of taxpayers is the failure of Congress to pass a "patch" for the Alternative Minimum Tax (AMT). The AMT was initially passed to make sure higher income earners paid their "fair" share of taxes. The problem lies in the fact that the income level at which the AMT comes into play has never been indexed for inflation. Instead, Congress regularly passes a "patch" to keep the AMT in line with its original intent. The last patch expired on Dec. 31, 2011. If Congress does not act in time for the 2012 tax filing season, the Tax Institute at H&R Block estimates a family earning $85,000 with two children in college could go from a tax refund of $1,056 to owing $1,400.

But wait, there's more bad news for your bottom line.

Numerous tax breaks are set to expire if no action is taken and several other new taxes related to the Affordable Care Act (also known as Obamacare) are set to go into effect:

• A new medical device tax will impose a 2.3 percent excise tax on every medical device valued over $100. As the American for Tax Reform website explains, "In addition to killing small business jobs and impacting research and development budgets, this will increase the cost of your health care – making everything from pacemakers to artificial hips more expensive."
• Flexible Spending Accounts (FSAs) will be capped at $2,500. The Americans for Tax Reform website notes this cap will be “particularly cruel and onerous” for parents of special needs children who currently take advantage of the unlimited FSA to fund special needs education expenses.
• The Obamacare investment surtax will result in the capital gains rate increasing from 15 to 23.8 percent in 2013 and the dividends tax will rise from 15 to 43.3 percent.
• The threshold for medical itemized deductions will increase from expenses exceeding 7.5 percent of adjusted gross income to 10 percent of adjusted gross income.
• The Medicare payroll tax will increase from 2.9 to 3.8 percent for all wages and profits exceeding $200,000 for individuals and $250,000 for married couples.

While the impact on family budgets could be profound, the broader economic implications are also cause for concern. ABC News reports the spending cuts and tax increases could, "stifle the US economic recovery and send the country back into recession, spelling bad news for the global economy as well."

Do you think political leaders will be able to reach an agreement in time to avert a fiscal disaster? Let us know in the comments.