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What the Republican Mid-Term Win Means for Your Taxes

In all likelihood, the Republican party triumph in Tuesday's mid-term elections means no American household -- not even those with income above $250,000 -- will see their federal income tax rates and investment tax rates change in 2011, and possibly not in 2012, either. With the shift in Washington's balance of power, it's expected that the current tax rates that are scheduled to expire at the end of this year will be extended for everyone, regardless of income, for at least a year. But getting the tax debate resolved could end up being a messy process that will give us all some tax headaches along the way. Here's a cheat sheet on how a split Congress will affect your 2011 tax bill:

The Obama administration will punt -- for now -- on its plan to raise taxes for the wealthy. A centerpiece of the president's tax plan was to permanently extend the Bush tax cuts for what he deemed to be the middle class: families with income below $250,000 and individuals bringing in $200,000, while bumping up income and investment tax rates for everyone else a bit. But the Republicans have long held that the wealthy should get a permanent extension of the current rates as well.

So with the Republicans taking over control of the House, you knew they would be ready for a fight on this issue. But that fight won't happen, at least not right now. In the past few months, more than a few Democrats and economists have been suggesting that given our weak economic recovery, now is not the time to raise taxes. The upshot is that no one's tax rates will change in 2011, and possibly not in 2012, either.

Longer term? Well, that's where the wrangling is going to get interesting. The administration is reportedly angling to carve the tax debate into two separate issues by making the tax cuts permanent for the middle class, while also passing separate legislation to give the wealthy a temporary tax cut for a year or two. When this temporary extension for the wealthy ends, it would force a straight up vote in Congress on how to tax the wealthy, something the Republicans would probably prefer to avoid, especially if it occurs right in the heart of the 2012 election cycle. Stay tuned on this one.

There could be a short-term hiccup of higher taxes for everyone in January. What's not so clear is when exactly we would get the deal to extend these tax cuts. Congress returns for a lame duck session beginning on November 15th, and you'd think that nailing down an agreement on taxes would be a priority. Think again. There is some murmuring that the Republican leadership might just decide to sit tight through the lame duck session and wait until it is back in control of the House in January to tackle all of the Bush tax cuts. If that happens, get ready to see a smaller paycheck come January 1; if Washington hasn't cut a new deal by December 31, the IRS will have to roll out new withholding tables based on the income tax thresholds in place in 2001. Even if, as expected, Congress eventually made the extension of the cuts retroactive to January 1, it still could be a few weeks of having to deal with that lower paycheck until you get rebated. And take pity on the poor folks in your payroll department; what a headache they will face.

The definition of "middle class" could change. President Obama's $250,000 cutoff is likely heading higher. Vice President Biden pretty much conceded as much in late October when he said the administration was open to talking about the right threshold. That's partly a bargaining chip now that the Republicans have a bigger seat at the negotiating table, but even some Democrats have been musing that $250,000 is too low a cutoff, at least for now. A few weeks ago, $500,000 was floating around as a possible new threshold, but in the past week, more talk of a "millionaire's tax" has emerged.
Taxes on investment gains likely aren't going anywhere. The current 15 percent maximum rate on long-term capital gains and the 15 percent rate on qualified dividends are also scheduled to phase out at the end of this year, but they appear safe for another year or two. Longer-term, any change would probably be incremental at best (worst?). Republicans will do their utmost to keep those rates right where they are, while the Obama administration is already on record saying that it merely wanted to raise the rates from 15 percent to 20 percent for anyone above its definition of middle class.

One change Congress will likely address is the estate tax. Yes, Washington just let this disappear for 2010, allowing the Steinbrenner clan and other wealthy families dodge any estate tax bill. But don't think for a moment that the Republicans will let the current 2011 law see the light of day -- the tax is scheduled to return on estates above $1 million at a top rate of 55 percent. That's a whole lot worse than what we had in 2009, which was a top rate of 45 percent levied on estates above $3.5 million ($7 million for married couples.) Republicans would love to see this completely disappear; Dems wouldn't. The likelihood is that we will see a compromise in the vicinity of taxing estates above $3.5 million or $5 million (that's where the debate will be) at a top rate of 45 percent.

The short and long view for you and your taxes. Obviously, retaining the status quo on income and investment tax rates for the next year or two mitigates any need to get extra strategic with your year-end 2010 tax moves. Now that rates aren't heading higher in 2011, there's no rush to accelerate income into this year or cash out a big capital gain. And for those of you who were considering paying your Roth conversion tax in full this year, you might want to huddle with your tax advisor and think about spreading it out over the next two tax bills (this is available only on conversions made in 2010) given that you don't have to worry about rates rising in the near-term.

Longer-term there is plenty to be worried about. While there seems to a growing consensus that the economy is too fragile to impose tax hikes at this juncture, what might be good for the patient over the next year or two could kill it 10 years down the line via gaping budget deficits. Douglas Elmendorf, director of the Congressional Budget office, recently noted that a permanent extension of the Bush tax cuts without future increases in taxes or reductions in federal spending would roughly double the projected budget deficit in 2020. He concluded that "if policymakers then wanted to balance the budget in 2020, the required increases in taxes or reductions in spending would amount to a substantial share of the budget -- and without significant changes of that sort, federal debt would be on an unsustainable path that would ultimately reduce income."

Alas, I am not holding my breath that this newly divided Congress will be up to the task of coming up with a sustainable long-term policy. But I'd love to be dead wrong about that.

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