With President Obama and Congress still battling over how to stave off the so-called "fiscal cliff," the fact that Bush-era tax cuts will expire and spending cuts are set to go into effect at the end of the year, the outcome is still unclear. But two top tax experts helped us narrow down the possibilities, and figure out how to handle them.
One possibility is that "we just go over the cliff," says J.D. Foster, senior fellow at the Heritage Foundation. If that were to happen, he says, "just about everybody would pay more in taxes. The payroll tax is going up, income tax rates will go up, dividend and capital gains taxes will go up … the child tax credit is cut in half, so it's affecting families. It's hard to find many folks who wouldn't be paying more," he says.
If lawmakers fail to reach an agreement within the month, then the tax season could be delayed, explains Barbara Weltman, author of J.K. Lasser's 1001 Deductions and Tax Breaks. "Unless we get answers really soon, the tax filing season won't start at the beginning of January, because the IRS can't do tax forms, and tax-prep companies can't prepare anything," she says.
That would mean more work for employers, who will have to readjust payroll taxes after the new rates are announced, and more stress for tax preparers, who will have less time to meet tax deadlines. Because people won't be able to start filing their taxes early, it would also mean delayed revenue for the government and delayed refunds for taxpayers. (Weltman says that while the April 15 deadline has never been changed in the past, there's also never been a significant delay.)
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Lawmakers could opt for a temporary fix to the problem by agreeing on a few things, such as a mix of spending cuts and certain tax-cut extensions, and then address the larger tax policy questions more fully next year, Weltman says. "It's about time for a new overhaul of the tax code," she adds, since the last one was in 1986.
Another possibility, says Foster, is that there will be "some kind of grand deal that occurs in December," which would involve significant changes to entitlement programs as well as tax policy. Such an agreement, though, would be complicated and take time to work through, as well as to explain to taxpayers, he adds. Bigger tax-policy changes could also come next year.
While the major policy changes might be out of taxpayers' hands, there are a few steps Americans can take to prepare for the potential changes. The first is to anticipate how they might affect your own bottom line. "Taxpayers who deal with paid professionals should talk to them now—don't wait," says Weltman. Will your tax rate likely go up? Will deductions that you normally take no longer be available? If so, there might be ways to mitigate, or at least prepare for, some of those effects.
Investors, adds Foster, will need to think about the possibility of different taxes on small businesses, dividends, and estate-tax changes. Lawmakers have also floated the idea of limiting the deduction that homeowners can take for their mortgage interest, a change that would affect many homeowners, especially those with large mortgages.
For those who file their own taxes, there's not much to do other than follow the debate. Once lawmakers reach an agreement, the IRS will release documents that help taxpayers figure out how the changes apply to them. "Taxpayers just need to know that whatever their circumstance in life, their tax rates may go way up, and they'll have to adjust their consumption and savings as a result," says Foster.
The good news is that lawmakers on both sides of the aisle are motivated to reach an agreement and avert the fiscal cliff because of the potential economic impact of allowing the tax increases and spending cuts to occur. "You're talking about the largest fiscal shock in our nation's history—that alone means plans for consumers and businesses alike will be disrupted pretty significantly … It's gonna hurt," says Foster.
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The White House has estimated that if the automatic tax increases proceed, consumer spending could fall in 2013 by as much as $200 billion. Economic growth could fall by 1.4 percentage points, which could have a negative impact on the post-recession recovery.
Barring any changes, the most immediately noticeable impact at the beginning of the new year for many Americans, says Weltman, will be the fact that withholding from payroll checks will jump, because employees will pay more for Social Security taxes. Says Weltman: "That will be felt immediately."