The Obama Tax Cuts: What They Mean For You

Last Updated Dec 7, 2010 10:49 PM EST

We finally know what will happen to the expiring Bush tax cuts -- they won't expire for another two years. In a compromise announced by President Obama last night, the Bush tax rates become the Obama tax rates for 2011 and 2012. And for everyone, not just families making less than $250,000. The compromise? The Republicans will agree to extend unemployment benefits for another 13 months and won't demand that the $60 billion cost be offset by a cut in federal spending.

Not only did the wealthy get a two-year pass on their income tax rate, but they are also going to benefit from two other features of the compromise:

A one-year cut in the payroll tax: To make up for the loss of the expiring Making Work Pay tax credit -- the middle-class tax cut that no one really noticed -- the White House extracted a one-year reduction in the Social Security payroll tax paid by employees from 6.2 percent to 4.2 percent. What's interesting is that Make Work Pay had an income limit: it was completely phased out for individuals making $95,000 or more, and joint filers with income above $190,000. The proposed 2011 payroll tax reduction apparently applies to everyone, at a reported cost of $120 billion in foregone tax revenue. That means an extra $2,172 $2,136 in the 2011 paychecks for all Americans making at least $106,800, the current maximum amount of income subject to the FICA tax. The goal of this tax break is to give a jolt to the anemic economic recovery on the assumption that everyone -- the middle class and the truly wealthy -- will go out and spend that money.

A big break in the estate tax. When we last left off with the estate tax in 2009, it was being levied on estates above $3.5 million ($7 million for married couples) at a top rate of 45 percent. The estate tax has been on hiatus in 2010 and was scheduled to come roaring back next year at its 2001 level: a 55 percent tax on estates above $1 million. No one really expected that to happen, but the deal announced by President Obama sure seems like a huge capitulation to the Republicans. In fact, the President went out of his way in the press conference announcing the deal to clarify that he wasn't too pleased with this outcome. The new estate tax rate will only be levied on estates over $5 million ($10 million for couples), and the 45 percent rate of 2009 dips to 35 percent for 2011 and 2012.

Assuming the framework of the deal announced Monday night makes its way through Congress, here's what you can look forward to in 2011 and 2012 and some tips on how you should respond:

Income tax rates: Nothing changes from today. The top two tax brackets, which President Obama had vowed to raise, will instead remain at 33 percent and 35 percent. Even the millionaires and billionaires will see their tax rate hold steady, not just the middle class.
Strategy: As you would normally, if you have the option of deferring income (and thus, taxes) into next year, go for it. But pull as many deductions as possible into this year so you can benefit from those now. If you've converted a Roth retirement account this year, or plan to by year-end, it certainly makes sense to take advantage of the one-time tax deal being offered for 2010 conversions that allows you to spread the tax bill over the next two years.

Capital gains and dividend taxes: No change here, either. President Obama had wanted the current 15 percent rate to float up to 20 percent for wealthy Americans in the top two tax brackets. But the compromise keeps the rate at 15 percent for everyone.

Strategy: This increases the allure of dividend stocks even more for income-starved investors.

A "patch" for the Alternative Minimum Tax (AMT): A patch that will raise the AMT exemption to account for inflation has been agreed to. According to the New York Times, the threshold for the AMT will be adjusted so that as many as 21 million households would not be subject to it.

Strategy: Relax.

And what happens after 2012? Well, that's going to make for some interesting debates during the 2012 Presidential election cycle. In announcing the compromise, President Obama pushed the notion that leaving rates where they are for the next two years was a necessary interim step to help spur more economic growth, but that long-term we had to make "hard choices." If I were a federal employee, I'd be wondering why I was singled out as a sacrificial revenue lamb for 2011 and 2012. Last week the President announced a pay freeze for most federal employees. Yet today the word is that the rest of Americans, especially the uber-wealthy, won't be asked to make any such sacrifice in 2011 and 2012. But long-term, if we don't eventually bring in more revenues and start reining in the federal deficit, we are all going to be paying an enormous price.

Photo courtesy Flickr user Birmingham Public Library

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