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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:
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.
Source: Internal Revenue Service.
The type of income that will be affected the most is qualified dividend income. Qualified dividends are generally earned by a taxpayer from his or her investment in an equity fund. If the tax cuts are not extended, the maximum tax rate on dividends from an equity fund will increase to almost three times the current rate, from 15% to 43.4%. Also of note is a new category of capital gains: qualified five-year gains. Gains in this category will be subject to a maximum tax rate of 21.8% (18% capital gain tax and 3.8% Medicare tax). In order to be subject to this rate, the security must be purchased after December 31, 2000, and held for more than five years.
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.
Taxpayers currently have an opportunity to conduct tax planning prior to the upcoming changes. Some items to consider include:
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.
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.
Taxable-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. It does not reflect state and local income taxes or the alternative minimum tax, if any, and will vary based on each investor's tax bracket.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
A conversion to a Roth IRA may involve administrative fees and other costs to the investor.
A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.
A Roth 401(k) is an employer-sponsored investment savings account that is funded with aftertax money. After the investor reaches age 59½, withdrawals of any money from the account (including investment gains) are tax-free. Unlike the Roth IRA, the Roth 401(k) has no income limitations for those investors who want to participate—anyone, no matter what his or her income, is allowed to invest up to the contribution limit into the plan.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.