The media frenzy surrounding the so-called fiscal cliff is
reaching a crescendo, as politicians in Washington argue about how
to handle impending tax cut expirations. Here's everything you need
to know about the current taxes and how they could change.
History of the Tax Cuts
The Economic Growth and Tax Relief Reconciliation Act of 2001,
which was passed by President Bush, made several changes to many
tax rates including income tax, estate and gift tax exclusions, and
retirement plan rules. The act increased the amount of tax
exemption for individual Alternative Minimum Tax (
In 2003, President Bush passed the Jobs and Growth Tax Relief
Reconciliation Act (JGTRRA) which extended tax cuts on AMT, and cut
taxes for investors for individual rates, capital gains, dividends,
and estate tax.
The tax on capital gains were reduced from rates of 8% to 15% to
just 5% for individuals in the 0-15% tax bracket. The highest tax
rate for capital gains was 15%. Under Bush's tax cuts, taxes on
qualified dividends were lowered to capital gain levels.
In December 2010, President Obama put a two year extension on
these policies, which are due to expire January 1, 2013. The
potential expiration of these cuts has been dubbed the "fiscal
Capital Gains Taxes
Capital gains are the profit made from the sale of capital
assets, which can be stocks, bonds, or real estate. This profit is
considered investment income, and is subject to special tax
Bush's 2003 tax cuts reduced the tax rate for capital gains to
0% for the bottom two tax brackets, and 15% to all other tax
brackets. If congress is unable to make an agreement, tax rates
will significantly increase from the 15% tax rate.
The tax rate on capital gains is expected to increase to 20% if
current cuts are allowed to expire, with an additional 3.8%
healthcare tax for individuals who earn more than $200,000 per
year, or a couple who earns $250,000 per year.
Tax on Qualified Dividends
are dividends which are taxed at the same level as capital gains.
This level, which is usually lower than regular income tax, applies
to regular dividends paid by most U.S. corporations.
Investors are required to hold a common stock for more than 60
days during the 120 day period before the ex-dividend date in order
to receive the qualified dividend tax rate. Holders of preferred
stock are required to hold the stock for 90 days during the 180 day
period during the 90 days before the ex-dividend date.
Dividends of foreign corporations may also be considered
qualified dividends if they trade on a U.S. exchange.
The following chart shows the current qualified dividend tax
implications, as well has the potential increases planned for
January if no agreement is made.
Qualified Dividend Taxes
Click image for larger version
Tax on Non-Qualified Dividends
As shown below, non-qualified dividend are taxes equal to an
individual's regular income tax rate. Non-qualified dividends
include payouts from real estate investment trusts (REITs), master
limited partnerships (MLPs), dividends paid by tax exempt
companies, dividends paid on employee stock options, and dividends
paid on savings or money market accounts.
Even if a company is qualified for regular dividends, special
dividends do not qualify for the special tax rate.
Since regular income taxes are expected to increase in January,
taxes on non-qualified dividends will also increase with income
taxes if there is not an agreement.
Non-Qualified Dividend Taxes
Click image for larger version
Possible Tax Reform Scenarios
As we wait for the president and congress to come up with an
agreement, many are wondering what actually may occur after
politicians come to a resolution. The government has essentially
four options to choose from: extending the Bush tax cuts, let the
tax cuts expire and not replace them, tax only the rich, or come to
a compromise. Let's examine these four scenarios.
Kick the Can
- The government approves another extension onto Bush's tax cuts.
This is what Republicans are hoping for - continuing with current
tax rates, and avoid the "fiscal cliff" altogether. Obama already
extended these tax cuts once before in 2010.
Likelihood: Somewhat Likely
- If the government doesn't do anything and simply allows the tax
cuts to expire, all income, capital gains, and dividend taxes
return to the rate that they were prior to Bush's 2003 tax cuts.
This scenario would be the worst choice for everyone involved.
Not acting on this situation would hurt individuals, government,
corporations, and the markets.
Likelihood: Extremely Unlikely
Punish Only the Rich
- Obama is pushing for a policy which would target individuals
earning over $250k, while giving individuals in lower tax
brackets continued tax breaks. Republicans oppose this scenario,
hoping for a compromise to tax more than just the wealthy.
Some Combination of #1 and #3
- Government makes compromise to let all multiple brackets share
the burden, and not just leave it all to the rich. This scenario
would raise taxes somewhat on the rich, but not put all the
excess tax obligations on those individuals.
Likelihood: Very Likely
The Bottom Line
The chance of the Government doing nothing about the fiscal
cliff is highly unlikely. Although there is no way to know for
sure, there is almost zero chance that the government will just
allow the tax cuts to expire. There are plenty of other options to
explore, and letting the cuts expire would be pretty
Even if a resolution is not reached by the end of 2012, don't
panic. Any subsequent changes can always be made retroactively.
"The Myth of the Cliff" makes the public believe that if an
agreement is not made by January 1, an economic catastrophe will
ensue. Although a lack of resolution would certainly hurt the
economy, the deadline to reach a resolution is not actually January
Finally, no matter what the environment, investors must always
invest wisely. It is important that investors do not make
investment decisions based on taxes. Interest rates are still
historically low, making dividends an ideal investment choice. This
fact will not change, regardless of potential tax changes in
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