Much like the end-times chaos that some had foreseen with the conclusion of the Mayan calendar on December 21, 2012, "Taxmageddon"—the 2013 expiration of previously enacted tax cuts and other tax provisions—never came to pass. That dreaded event was averted by the passage of the American Taxpayer Relief Act of 2012, which President Obama signed into law on January 2, 2013, as the initial step in avoiding the so-called "fiscal cliff." This article highlights notable features of the act that we believe are most important to mutual fund shareholders.

Extension of the Bush-era Tax Cuts
The act extends permanently the so-called Bush-era tax cuts for most taxpayers and addresses certain other expiring tax provisions. The Bush-era tax cuts contain numerous provisions that reduced the amount of taxes paid by most taxpayers. The passage of the act made these expiring provisions permanent for taxpayers earning less than $400,000 ($450,000 for married taxpayers filing jointly. Taxpayers earning more than the threshold should note the following:

• It could have been worse. The current administration originally proposed the maximum rate to be applied to taxpayers with gross income in excess of $200,000 ($250,000 married). The act, however, provides for a $400,000/$450,000 threshold based on taxable income (inclusive of deductions). The changes to the initial proposal on determining the amount subject to the 39.6% highest tax rate reduce the total number of taxpayers affected by the rate increase.
• All or nothing? A taxpayer with taxable income in excess of the threshold will not be subject to the highest rate on all of his or her income. Instead, only the amount in excess of the threshold will be subject to the highest rate. For example, if a married taxpayer has taxable income of $450,001, only $1 will be subject to the highest tax rate. Higher-income earners will still enjoy the lower Bush-era tax rates on the amount under the threshold.
• What about next year? The Bush-era tax cuts have been made permanent. In addition, the high-income threshold will increase annually in order to account for inflation.

Maximum Tax Rates
In addition, the act featured the following changes to maximum tax rates:

• Ordinary income—The maximum tax rate on ordinary income was increased from 35% to 39.6% on the amount of taxable income in excess of the threshold.
• Capital gains—The maximum long-term capital gain rate increased from 15% to 20% on taxpayers with taxable income over the threshold. Short-term capital gains (i.e., securities held for one year or less) are subject to ordinary income tax rates.
• Dividends—For taxpayers with taxable income over the threshold, the maximum rate on qualified dividend income (QDI) of 15% was increased to 20%. QDI is generally dividends paid by certain U.S. corporations or qualified foreign corporations.

Other Provisions of Interest

• The act permanently fixes the alternative minimum tax (AMT) exemption amount. This fix was necessary because the AMT exemption level was not originally indexed for inflation and, therefore, required Congress to "patch" the AMT exemption amount annually in order to prevent too many taxpayers from being subject to the AMT. The act increases the amount exempt from AMT to $50,600 ($78,750 married) for 2012 and adjusts these amounts annually based on inflation.
• The 2% reduction on Social Security withholding, the so-called "payroll tax holiday," expired December 31, 2012. This means employers will begin to withhold 6.2% instead of the reduced 4.2% on wages up to $113,700 in 2013.
• Itemized deductions will begin to be phased out for taxpayers with adjusted gross income in excess of $250,000 ($300,000 married). The amount of the reduction to the itemized deduction cannot be more than 80%.
• Similarly, a taxpayer's personal exemption will begin to phase out once adjusted gross income exceeds $250,000 ($300,000 married).

Medicare Surcharge
Effective January 1, 2013, the Affordable Care Act (ACA) requires taxpayers with gross income in excess of the $200,000 ($250,000 married) to pay an additional 3.8% in Medicare tax on the lesser of all net investment income or the amount of income in excess of the threshold. The Medicare tax is independent of and in addition to provisions in the recently passed act. Net investment income includes taxable income and capital gains earned from an individual's mutual fund investments.

New Maximum Tax Rates
Table 1 (below) is a summary of the maximum federal tax rates (inclusive of the Medicare surcharge) for each type of income generated from a mutual fund investment.

Conclusion
The tax portion of the "fiscal cliff" was addressed at the eleventh hour. The resulting act helps avoid "Taxmageddon"; however, most taxpayers will be paying more in taxes during 2013 primarily due to the expiration of the payroll tax holiday. In addition, the inclusion of multiple high-income thresholds, some based on gross income and others on taxable income, only increases the complexity of the tax laws. With all these upcoming changes to the tax law, it may be prudent to discuss potential strategies with your financial and/or tax advisor.