What the 'Fiscal Cliff' Means for Typical Pocketbooks

Nov. 8, 2012— -- The fiscal cliff is nigh! But what does it all mean for your pocketbook?

In short, before the end of the year, Congress has to determine whether and how it will extend the tax cuts that most Americans have enjoyed for years. Lawmakers will also try to avert hundreds of millions in spending cuts that are expected to go into effect Jan. 2, per the terms of the Budget Control Act of 2011.

The worst-case scenario for the typical American is that just about every taxpayer will see their taxes go up next year, meaning the average household will owe the government $3,500 more a year, according to the Tax Policy Center.

The most likely scenario, however, is that Congress will step in to prevent that from happening, even if the solution is only temporary. At the same time, even if lawmakers come up with a solution, it might still mean that some taxes will go up.

Here's what you need to know:

Bush Era Tax Cuts

Most Americans are used to paying taxes at the rates that were established during George W. Bush's administration. For about a decade now, people making between $40,000 and $65,000 have paid an average of $888 less in taxes a year than they did before the Bush tax cuts went into effect.

Democrats and Republicans agree that the Bush-era tax rates should not expire for average-income Americans

For the top-earning Americans, however, there is a dispute between the two sides in Washington about whether their taxes should increase. If they do, it might mean that for the highest earners -- the top 5 percent -- taxes might increase dramatically.

Payroll-Tax Holiday

Congress also decides the fate of a 2 percent payroll tax cut that the employed have gotten used to for several years now.

It accounts for a substantial chunk of money. If it expires, people making between $40,000 and $65,000 a year will see an average $672 increase in what they pay in taxes each year. People making between $65,000 and $109,000 will see their taxes increase by an average of $1,135.

This one might hurt a little because Democrats and Republicans agree that the payroll t-ax holiday was intended to be a temporary form of stimulus during the worst of the economic recession. What they don't agree on is whether now's the time for it to expire.

Alternative Minimum Tax

That's AMT, for short.

Here's a simple explanation: On tax day (or whenever you pay your taxes), you have to calculate what you owe the government two ways. Then, if you are subject to the AMT, you pay the higher amount.

Most people aren't aware that this has been a feature of the tax code for decades because Congress has repeatedly exempted millions from having to pay the higher amount.

Only about 5 million households are subject to the AMT's higher tax liability right now, but about 30 million households would pay if Congress doesn't extend the exemption, Tax Policy Center Director Donald Marron said.

On the bright side, Congress has passed an AMT "patch" roughly every year or every other year for more than two decades in an effort to minimize the number of tax payers affected.

If it expires, however (or a deal isn't sealed in time) a person or couple making between $40,000 and $65,000 a year could see an average $104 increase in their tax bill.

Tax Credits

Quite a few tax credits for individuals and businesses are expected to expire at the end of the year.

For most individuals and families, however, there are a few that might matter most.

Some education, child and an adoption-tax credit that were put in place as a part of President Obama's stimulus bill in 2009 might expire if they are not extended.

One common tax feature that won't expire: the mortgage deduction. That one is a permanent feature of the tax code.

How Did We Get Here?

Congress is dealing with a potpourri of tax problems borne from several temporary tax measures, including 2001 and 2003 tax cuts enacted during the Bush administration, 2009 tax cuts enacted during Obama's administration and several short-term tax cut extensions Congress passed between 2010 and now.

On top of that, some lawmakers in Washington want to revisit tax cuts as a way to raise revenue and reduce the deficit. And the impending $800 billion in cuts to domestic and defense spending is a consequence of Congress' failure to reach an agreement on long-term deficit reduction last year.

It's unclear whether deficit reduction will play a big or small role in how Congress addresses the expiring tax cuts between now and Jan. 2.

"A lot of people view the fiscal cliff as an opportunity to have some leverage to do a medium-term budget deal," the Tax Policy Center's Marron said.

A desire to address bigger issues, such as the deficit and entitlements, also means a deal might not be fully reached until next year.

"There are a lot of people who are thinking about strategies to do that," Marron said, "designing a four-month or six-month package to give them more time to put together a more thoughtful fiscal arrangement."