Fiscal Cliff And Payroll Taxes: Why Is My Paycheck Smaller?

 

Photo courtesy of StockMonkeys.com

 

 

As most Americans are aware, our legislators in Washington spent the New Year holiday ironing out a deal to avoid going over the dreaded “Fiscal Cliff”. When the deal was reached, many were relieved to learn that taxes would only be going up for the uber-rich; those making nearly half a million dollars a year or more. Yet as the first paychecks of 2013 came rolling in, many average, working-class Americans were shocked to see that their incomes had also taken a hit, leading them to ask, "How did this happen?"   Many were quick to blame the smaller checks on anything from Sandra Fluke’s need for more ‘free birth control’, to the need to pay for more of the First Family’s globe-trotting vacations. Instead of feeding the hype, let’s look at what really happened and how it impacts the income Americans will earn this year.

This Fiscal Cliff Deal (formally named the American Taxpayer Relief Act of 2012) raises tax rates from 35% to 39.6% for those making $450,000 or more annually filing married, or those earning $400,000 annually filing single. This is what most Americans were talking about immediately after the deal, and was the result of a last-minute compromise. Democrats were asking for tax rates to increase on those making more than $250,000 per year, while GOP lawmakers were asking for the increase to start at the $1,000,000 income level. In addition, according to Forbes.com, the maximum rate on long-term capital gains and qualified dividends increased from 15% to 20% on taxpayers with taxable income in excess of the same amounts ($450K married, $400K single).

Photo courtesy of 401 (K) 2013

What many did not know is that additional tax changes are taking place for the not-quite-so-wealthy as well. For example, the Taxpayer Relief Act includes the phase-out of itemized deductions/personal exemptions for taxpayers with adjusted gross income in excess of $300,000 filing married/$250,000 if single. Furthermore, with the implementation of the Affordable Care Act (aka Obamacare), wage earners and self-employed taxpayers will pay an additional 0.9% tax on their earned income in excess of $250,000 filing married/$200,000 filing single. In addition, via the ACA taxpayers with modified adjusted gross income in excess of $250,000 married/$200,000 single will pay an additional 3.8% tax on their net investment income, i.e., dividends, interest, royalties, rents, other passive income and certain gains. Finally, according to BusinessWeek estate taxes are rising, too. The first $5 million in inheritance is still exempt, but after that the tax rate rises to 40 percent, from 35 percent previously.

Image courtesy of RightChange.com

Of course, most Americans do not make $200,000 or more per year, and thus did not anticipate seeing a change to their take-home pay. Yet they have seen a change–in fact, the non-partisan Tax Policy Center estimates that 77% of Americans will be paying more in taxes in 2013 than they did in 2012. So, how did this happen, considering President Obama told reporters on Jan. 1 that under the new law more than 98% of Americans "will not see their income taxes go up”? The answer is simple, but not easy to swallow. Income taxes have not gone up for most Americans–but payroll taxes have.

On December 23, 2011, President Obama signed into law the Temporary Payroll Tax Cut Continuation Act of 2011 (H.R. 3765). The Act included an extension of the reduced employee Social Security tax rate (seen under FICA on pay stubs), maintaining the employee portion of the social security tax rate at 4.2% through February 29, 2012. According to the Act, the employee tax rate for social security would revert to 6.2% on March 1, 2012, unless the federal government chose to further extend the law or change the rate. The employer contribution amount remained 6.2% throughout this time period. Then, on February 22, 2012, a new law, the Middle Class Tax Relief and Job Creation Act of 2012 (H.R. 3630), was signed by President Obama that extended the reduced employee Social Security tax rate of 4.2% through December 31, 2012. This was not extended again at the end of the year, so now all employees are back to paying the higher percentage. Many politicians do not view that as a tax hike, but rather as the expiration of a two-year tax cut that was always designed to be temporary.

Of course, some consider this argument a matter of semantics. Whether it’s called a tax hike or an expiration of a tax cut, the end result is the same–people will be paying higher payroll taxes in 2013. For those earning between $75,000 and $100,000, a group that fits squarely in the President’s definition of middle class, the increase in taxes paid will be roughly $1,200. Households making between $50,000 and $75,000 will face an average tax increase of $822.Those with incomes between $40,000 and $50,000 would pay an additional $574 in payroll taxes in 2013, according to the Tax Policy Center.

 

Revenue from tax increases in green; budget deficit in red.

In a speech given shortly after the Fiscal Cliff deal was reached, the President stated that this agreement would “reduce the deficit”. If that were true, it would make these increases a softer pill to swallow for most Americans. Yet, according to Robert Farley of FactCheck.Org, the deficit will increase by roughly $4 trillion over the next 10 years because of the extension of the Bush tax cuts for all but those in the top 1% of taxpayers. The deal will "reduce the deficit" only compared with what it would have been if the Bush tax cuts had been extended for everyone. Again, like the payroll tax increase, this can be seen as an (imaginary) decrease by some, but as an increase by others.

The bottom line is, virtually everyone who receives a paycheck will see their take-home pay shrink this year, some more than others. Some will be angered by this, feeling as though they were given false promises that their bottom line would not be changed. Some will become apprehensive, wondering if this is a harbinger of things to come; some may feel a resigned sense of acceptance. However we decide to respond to this change, it is most important that we base our reactions on the facts.