Happy New Year! We have a deal. A so-called “fiscal cliff” deal, that is.
The backstory on the fiscal cliff: Remember the debt ceiling debate in summer 2011?
It sure seemed like a big deal at the time, and investing pundits debated whether it would destroy your portfolio and possibly the United States itself.
Spoiler: It didn’t.
What it did do was result in a bill that would put into place lots of get-tough budgetary measures (spending cuts and tax increases) set to go into effect January 1, 2013, unless a deficit-cutting “supercommittee” could put its own plan into effect.
Like many things with “super” in the name, the supercommittee fizzled and Congress also gave a bunch of other tax and spending decisions the December 31 deadline.
The federal budget was rigged for explosive pyrotechnics as the ball dropped on New Year’s Eve! (Okay, not really. Most of the provisions would have taken effect in stages, and Congress can always change tax laws retroactively.)
In any case, on New Year’s Day, the President, Senate, and House worked out a deal. Also typical for these high-profile legislative showdowns — not much actually changed.
Here are a few key provisions of the law, which is called the American Taxpayer Relief Act of 2012. The most important item in the law is a modest tax increase for most Americans.
That’s a relief, right?
Payroll tax increase
The portion of your payroll taxes (FICA) that pays for Social Security will increase from 4.2% to 6.2%.
How much more will you pay? Try this calculator from the Wall Street Journal.
Higher taxes for the very rich
If you make more than $450,000 per year (married filing jointly) or $400,000 (individual), you’ll find yourself in a new 39.6% federal income tax bracket.
You’ll also pay 20% capital gains tax on investment gains. But remember that these new rates don’t apply to the taxpayer’s entire income, only the portion above $450,000.
Estate tax increase
Estate taxes are going up to 40% of the amount over $5 million, from 35% of the amount over $5.12 million.
A fix for the AMT
The Alternative Minimum Tax (AMT) was supposed to be a special form of income tax designed to make sure wealthy taxpayers who earn most of their income from investments can’t avoid paying tax.
It’s become a mess that ensnares middle-class taxpayers, and Congress is constantly having to patch it. The new law makes some permanent fixes to the AMT and, for the first time, adjusts its brackets for inflation, just like the regular income tax.
College tuition deductions and Earned Income Tax Credit
For low-income families, the bill extends the Earned Income Tax Credit (EITC), which allows some working-class taxpayers to pay negative tax.
It also restores a little-used college tuition deduction and, more importantly, maintains the American Opportunity Tax Credit (AOTC), the most valuable college tuition credit.
401(k) to Roth 401(k) conversions
If your employer offers a Roth 401(k), you can now convert your existing traditional 401(k) contributions, in whole or in part, to Roth contributions.
This is probably a bad idea, however. It means paying higher taxes upfront so you can avoid lower taxes later, in retirement.
Also, many news outlets and blogs are reporting that the new law allows you to roll over your 401(k) to a Roth IRA. I’ve read the law, and this is wrong. Okay, I didn’t read the whole law, just the part about 401(k)s.
What’s the big deal?
The big deal is there’s no big deal. Most of what this bill accomplishes is common-sense fixes for stuff that’s been broken for a while (the AMT) and stuff that nobody really expected to expire (the AOTC and EITC).
Most families won’t notice anything different except a modest increase in payroll taxes—back to the level you were paying two years ago.
For investors, the lesson is obvious: If everyone is talking about something apocalyptic, the proper portfolio move is to do nothing.
Just like we saw with the debt ceiling in 2011, in the run-up to the fiscal cliff deal, investors saw loads of headlines like, “Don’t Let the Fiscal Cliff Push Your Portfolio Off a Cliff” and “How to Position Your Portfolio for Fiscal Cliff Uncertainties.”
Since it was impossible to know the outcome in advance, however, making any big change to your portfolio would have meant taking a big risk.
And for what?
We had two alleged apocalypses in December, and the S&P 500 was up 0.91% for the month.
Next time Congress decides to pull some last-minute drama, I’m going to remember what I did on December 31, 2012: Drank cocktails and didn’t touch my portfolio.