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What’s the Fiscal Cliff?

How Will the Fiscal Cliff Affect Your Personal Finances?

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What’s the fiscal cliff? How will it affect your personal finances?

The “fiscal cliff” isn’t one single event. It’s a catch-all term that describes a series of spending cuts and tax increases that will go into effect in 2013. There are two components to the fiscal cliff: tax increases and spending cuts. Let’s look at both of these.

Bush Tax Cuts and the Fiscal Cliff

The Bush tax cuts are set to expire in 2013. These tax cuts lowered both the income tax and investment taxes for the majority of middle-class and upper-class people, although the bulk of the benefit went towards the highest-earning households.

(It’s important to note that small businesses that are structured as an LLC or an S-Corp are taxed at the household level. That means that when people discuss “households” that earn more than $250,000 per year, they’re also talking about small mom-and-pop businesses that are taxed as though they’re households.)

If the Bush tax cuts expire, most people and small businesses will pay higher tax rates. Supporters of the Bush tax cuts argue that this might hurt the economy, because people will have less money to spend and businesses will have less money to hire new workers. Opponents of the Bush tax cuts argue that a new round of tax cuts that relieve the tax burden on low-income earners will spur spending more effectively. They also argue that the higher tax revenue can help repay the U.S.’s huge national debt.

One additional note: The Bush tax cuts were originally scheduled to expire at the end of 2010. President Obama struck a deal with Congress agreeing to extend the tax cuts to 2013, in exchange for a 2 percent reduction in payroll taxes and longer unemployment benefits. That payroll tax cut and the enhanced unemployment benefits are also set to expire in 2013.

Spending Cuts and the Fiscal Cliff

The fiscal cliff’s other aspect, the spending arm, refers to two types of cuts. One is a reduction of $1 trillion dollars over the span of 10 years that will affect almost every agency that receives government funding, from the FBI to education to defense.

It also promises that an additional $1.2 trillion in spending cuts will be instituted if Congress can’t legislate its way out of the fiscal cliff before 2013. (Although realistically, if Congress misses its January 1, 2013 deadline, it can always pass a law later in the year and then make the law retroactively apply backwards in time.)

What Does This Mean For You?

This might mean that your tax rate could increase. If that’s the case, you should adjust to living on less. In the worst-case scenario, your tax rate will stay the same, and your quality-of-life adjustment will allow you to have extra savings that you can direct toward your retirement fund or college savings.

This also might mean that businesses slow down their hiring and jobs are tougher to get. If that’s the case, you should build a larger emergency fund, which you can tap in the event that you’re between jobs. Remember, unemployment benefits are scheduled to last for a shorter period of time, which means an emergency fund is more important than ever.

Finally, if you work for a government agency, this might mean that your ability to get a raise or to get funding for a project will be hampered. If that describes your situation, you should reduce your personal spending, save more money, and grow a larger emergency fund. This will help shield you against any potential blows to your income.

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