Paycheck Chronicles

The Fiscal Cliff: Your Taxes, Part II



In The Fiscal Cliff:  Your Taxes, Part I,  I discussed how changes to the Social Security Tax and federal income tax rates could increase your taxes and decrease your take-home pay.  Today, I'm going to talk about the two other major changes that may impact many military families:  the reduction of the child tax credit and the changing of the Alternative Minimum Tax exemptions.

As always, keep in mind that none of these things will definitely happen.  I am explaining what the situation will be if Congress does nothing to address the numerous things currently schedule to occur.  It is likely that Congress will make changes between now and then, and that this information will no longer be be accurate.  I'll keep you up-to-date if this information changes.  Also, remember that I am NOT an accountant, a lawyer, or legislative researcher.  I'm compiling this information from the same resources available to anyone.  And it is complicated stuff, and I could easily make mistakes.

On to the taxes:

Reduction of the Child Tax Credit

Prior to 2001, the Child Tax Credit was $500 per child. Current taxpayers receive a $1000 tax credit for each eligible child, and in most cases, they receive an actual payment if their credits exceed the amount of taxes they owe. The increase to $1000 per child is scheduled to expire on 31 December 2012. In simple math, this means that families will pay an additional $500 more in taxes for each child. It sounds like they are taxing children, but that isn't the case at all. The child tax credit is a random bonus that makes taxpayers feel good, but costs our country lions of dollars each year in lost revenue. This change is just decreasing the amount of credit.

For families who have children but pay little or no federal income tax, this change may result in the loss of that payment that is received when the tax credit exceeds the taxes due.

As always, I am using 2012 pay figures for a fictional person/family who claims no other adjustments or credits. For purposes of this illustration, I'm also assuming that the child tax credit is the only credit this family can claim.

Example one:   no children, no change

Example two: O-3 with six years of service, married with one  child. No other adjustments to income, standard deductions and exemptions.

Item Amount
Income $63,264
Standard Deduction $11,900
Exemptions $11,400
Taxable Income $39,964
Tax Before Credits $5,125
Current Child Tax Credit $1,000
Old/New/Lower Child Tax Credit $500

Example three:  I'm changing example three a bit to show how the refundable part of the child tax credit works.  Married soldier, E-8 with 20 years of  service, five children.  No adjustments to income, and only the regular  exemptions and deductions:

Item Amount
Income $57,192
Standard Deduction $11,900
Exemptions $15,200
Taxable Income $30,092
Tax Before Credits $3,644
Current Child Tax Credit $5000
Old/New/Lower Child Tax Credit $2500

Here is where it gets interesting:  With the current child tax credit, example three will have a credit larger than the tax due before credits.  The credits will bring the tax bill down to $0 taxes paid.  In many cases, including this one, the extra unused credit is then given to the taxpayer as a payment.  In this case, the taxpayer is receiving a payment of $1,356 and paying no federal income tax at all.  It's just a straight up payment.

You don't need to have a lot of kids to fall into this category.  Lower earners, people deployed to tax-exempt combat zones, or people with other adjustments to income can easily fall into this category.

With the reduced child tax credit, fewer people will receive the refundable child tax credit payment.

Example four: O-5 with 20 years of service, divorced with  three children, filing head of household. No adjustments to income, and only the  regular exemptions and deductions.

Item Amount
Income $98,388
Standard Deduction $8,700
Exemptions $15,200
Taxable Income $74,488
Tax Before Credits $13,267
Current Child Tax Credit $3,000
Old/New/Lower Child Tax Credit $1,500

A change in the child tax credit will directly impact all families with children, at the rate of $500 per child.

The Alternative Minimum Tax

Whew - this is a biggie and it is a little confusing if you're not already familiar with the Alternative Minimum Tax (AMT) system.  The AMT is a second set of calculations for certain higher-earning tax payers who have large deductions, such as mortgage interest.  It was enacted in 1969 as a way to make sure that the super wealthy weren't shielding all their income from taxation.  However, it wasn't written with any index for inflation.  As we all know, income figures have changed a LOT since 1969.  Congress has made individual short-term fixes each year, but has never completely changed the underlying laws.  This year, however, the Alternative Minimum Tax fix has gotten caught up in all the other problems.

If Congress does not act to change the Alternative Minimum Tax income figures, then approximately 30 million more taxpayers will be required to pay the Alternative Minimum Tax for the 2012 tax year, with the payments due in April 2013 when we file our 2012 federal income tax returns.  These payments can be large, the average is $3,700 extra tax, and those taxpayers would often also be subject to penalties for under-withholding throughout the year.  This tax, which was designed to target a few very-high-income taxpayers, would affect many middle-class taxpayers, including some people in the military.

There is strong bi-partisan agreement that this needs to be fixed, and I suspect that it will be fixed.  However, when it gets fixed is also important.  Taxpayers who might be affected should not file their 2012 income tax returns until we know for sure what the laws will say.  Then, the Internal Revenue Service (IRS) will need to update their software, website, processes and procedures to reflect the changes.  It could make for a crazy tax year.

In Summary:

If, hypothetically, all of these changes did happen, taxpayers would find their tax bills significantly higher in the future.  I think that some or all of these will be changed, and that the total increase in taxes won't be as large as it could be.  However, I do believe that taxes will increase.

I encourage you to do some rough, back-of-the-envelope type calculation to see how these changes could impact your family, and think about how you would adjust your spending to reflect the decrease in income.  My family would be paying about $6,000 extra each year with all the combined taxes, and that is without even thinking about the Alternative Minimum Tax.  That is $500 per month!

Keep your ears open so that you will know what is happening.  These are not the type of things that you want to be surprises.


Also in this series: 

The Fiscal Cliff:  Your Taxes, Part I

The  Fiscal Cliff:  What Is It?

The  Fiscal Cliff:  Your Pay



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