While some people are fretting about the end of the world on December 21, 2012 (according to the Mayans), mutual fund investors may be better served worrying about "taxmageddon" at the dawn of 2013. That's a humorous term for a serious matter: the convergence of the expiration of the Bush-era tax cuts and other tax legislation, coupled with the implementation of new investment taxes under the Patient Protection and Affordable Care Act. The very real possibility of congressional inaction in addressing provisions expiring on December 31, 2012, could result in higher taxes for practically all taxpayers.

This article will highlight some of the notable provisions and focus specifically on the potential impact of these changes to mutual fund shareholders.

1) Expiration of the Bush-era tax cuts
The Bush-era tax cuts were put into place primarily by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Provisions contained in these acts, which were originally scheduled to sunset after 2010, were instead extended by two years, and are currently scheduled to expire on December 31, 2012. Some of the notable provisions include:

• Reduction of the maximum income tax rate, from 39.6% to 35%;
• Elimination of the "marriage penalty";
• Reduction in the long-term capital gains rate, from 18% on securities purchased after December 31, 2000, held longer than five years, and 20% for other long-term gains to the maximum of 15%;
• Implementation of qualified dividend taxes at the maximum rate of 15%, instead of 39.6%;
• Increase in the child care, dependent care, and earned income credits;
• Reduction in estate tax rate to as low as 0%, down from 55%;
• Elimination of the phase-out rule for personal exemptions and itemized deductions; and
• Increase in annual educational IRA contribution amount, from $500 to $2,000.

2) Expiration of the payroll tax holiday and the AMT patch
The reduction in Social Security withholding—the so-called "payroll tax holiday"—and originally part of the 2010 compromise to extend the Bush-era tax cuts—is scheduled to expire at the end of 2012. The 12.4% tax on wages up to a ceiling of $110,100 (for 2012) is paid half by the employer and half by the employee. The payroll tax holiday reduced the employee's portion of the tax, from 6.2% to 4.2%. Beginning on January 1, 2013, the employee's portion is scheduled to revert to 6.2%.

When the alternative minimum tax (AMT) was enacted in 1970, the provision did not factor in inflation. Therefore, since 2001, Congress has increased the AMT exemption level on a temporary basis (usually one year) in order to prevent too many taxpayers from being subject to the AMT. The 2011 "patch" increased the exemption level for married filers, from $45,000 to $74,450. The patch for 2012 has not yet been approved.

3) The Patient Protection and Affordable Care Act
Effective January 1, 2013, the new Patient Protection and Affordable Care Act will require high-income earners (married taxpayers earning more than $250,000 per year, or $200,000 for single taxpayers) to pay an additional 3.8% in Medicare tax on investment income (typically, interest, dividend, capital gains, rental income, etc.). The additional Medicare tax is based on the lesser of the total investment income or the amount in excess of the threshold. For example, a married taxpayer earning $275,000, which includes $50,000 of investment income, will be required to pay an additional $950 in Medicare tax ($25,000 x 3.8%).

High-income earners also will be subject to an additional 0.9% in Medicare tax on wages. The current Medicare tax of 2.9% is paid half by the employee and half by the employer (1.45% each). The additional 0.9% will be paid exclusively by the employee on the amount of wages in excess of $250,000 for married couples. This brings the total amount of Medicare tax on wages over the threshold to 3.8% (1.45% paid by the employer and 2.35% paid by the employee). The self-employed will be required to pay the entire amount.

It should be noted that, similar to the AMT, the high-income earner threshold of $200,000/$250,000 is not indexed for inflation. Therefore, more taxpayers may be subjected to the supplemental Medicare tax as time goes by.

4) The potential impact on mutual fund investments
Taxpayers who own mutual funds, other than in a tax-advantaged account (e.g., IRA, 401(k), Roth IRA) may generate taxable income by receiving distributions from the fund or selling a fund at a price greater than its cost. Table 1 indicates the type of income generated by a mutual fund investment, its current maximum tax rate, and the maximum tax rate assuming the tax cuts are not extended.

The potential outcome
The upcoming elections and subsequent lame-duck congressional session, the current economic environment, the deficit, and many other factors, make predicting the outcome of future tax policy nearly impossible. It seems as though Congress would like to extend the Bush-era tax cuts; however, there is disagreement on who should be eligible for the extension. Republicans would like to extend the provisions for all taxpayers, while Democrats would like to extend the provisions for all taxpayers except high-income earners. One thing is for certain: If the two sides of the aisle cannot compromise, taxes will increase for all taxpayers.

Planning considerations
Taxpayers currently have an opportunity to conduct tax planning prior to the upcoming changes. Some items to consider include:

• Will you be considered a high-income earner? If so, does acceleration of income to 2012 make sense?
• How are your current investments allocated between tax-advantaged accounts and taxable accounts? Consider holding more tax-efficient investments in taxable accounts.
• Do you have built-in capital gains on current investments? If you own securities with unrealized gains and are considering selling them in early 2013, you may want to sell these securities in 2012 instead. Holding periods should also be factored into the decision-making process.
• What is your fixed-income security mix? Unlike income from taxable fixed-income funds, dividends paid by tax-exempt funds are generally not included in investment income when determining the supplemental 3.8% Medicare tax. This should be factored in when determining the taxable equivalent yield of a tax-exempt fund.
• Are you maximizing your contribution into the appropriate tax-advantaged account?

The supplemental Medicare tax on investment income for high-income earners does not include distributions from a tax-advantaged account. However, the determination of whether you are a high-income earner includes distributions from IRAs and 401(k) plans. In contrast, distributions from Roth IRAs and Roth 401(k) plans are not included because they have been previously taxed. Consideration should be given to converting an IRA into a Roth IRA and contributing to a Roth 401(k) instead of a traditional 401(k) plan, if available.

Conclusion
The convergence of expiring Bush-era tax cuts, the new Medicare tax, the expiration of the payroll tax holiday, and the lack of a current-year AMT patch is fast approaching. Congressional inaction will cause taxes to increase for all taxpayers. At a minimum, high-income earners will be paying more in taxes due to the new Patient Protection and Affordable Care Act.

The tax cost of the status quo may be high. However, legislative inaction should not prevent an individual from taking action. With all these upcoming changes to the tax law, it may be prudent to discuss potential strategies with your financial and/or tax advisor.