Countdown to 'Taxmageddon': What's Next?

Mark your calendars: Jan. 1, 2013, could be one of the biggest tax disaster days in recent memory. Or not.

That's the day when current tax rates, compliments of the Bush tax cuts, are slated to expire. That's also when the employee payroll tax rate, now 4.2 percent, is scheduled to go back up to 6.2 percent. More estates will face higher taxes in 2013. And don't forget about the 70-plus temporary tax breaks known as extenders that haven't yet been renewed for 2012 or 2013.

The convergence of these tax events has been dubbed taxmageddon, taxopocalypse or likened to standing on the edge of a fiscal cliff. But it's possible that the tax catastrophe, whatever it's called, might be averted.

It's unlikely any tax deal will be cut before November. Both Democrats and Republicans see it as a good election issue.

But after Nov. 6, a lame-duck Congress and President Barack Obama could reach a deal similar to the one agreed to in late 2010 that put off the tax decisions until now. Or not.

That uncertainty is almost as troubling as the expiring tax breaks. And both are making life very unsettling for taxpayers and their financial advisers.

Lots of higher tax rates

If 2013 arrives without Capitol Hill taking action on the Bush tax cuts, tax rates will rise for all, not just the top tier of taxpayers. The 10 percent rate will disappear, meaning that everyone will see at least some of their income taxed at 15 percent.

Income ranges for the tax rate brackets also will change, meaning the marriage tax will return for more couples. With the so-called marriage tax penalty, a husband and wife pay more in taxes when they file jointly than they would as single taxpayers.

Below are some key provisions that, without further legislative action, will change dramatically next year. Most of these tax law changes took place when President George W. Bush was in office. Known as the Bush tax cuts, they were enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA.

Fiscal cliff: A heap of tax laws set to expire

Investments also would face a major tax hit.

"The scariest thing of all for investors is what could happen to dividends," says Brooks Mosley, president of and client adviser at Security Ballew Wealth Management in Jackson, Miss. Low rates on traditional fixed investment vehicles such as CDs prompted many people "desperate for better returns" to turn to high-dividend-paying stocks, says Mosley.

Qualified dividends are taxed the same as capital gains -- at a 15 percent rate for most investors. If that tax treatment isn't continued, they will once again be taxed as ordinary income, which could be as high as 39.6 percent in 2013.

A tax provision of the health care law could make the tax situation even costlier. An added 3.8 percent Medicare tax will begin in 2013 on unearned income (interest, dividends, capital gains, royalties and rents) of higher-income investors.

"They're accustomed to getting a very large dividend taxed at 15 percent, and the tax could go up to 43.4 percent," said Mosley. "That's got people on edge. They're wondering, 'When do I get out of these stocks?' In addition to tax concerns, there's the fear that the (dividend-paying) stocks will drop in value if nothing changes."

Less confidence in Congress

Adam Sherman, CEO of Firstrust Financial Resources in Philadelphia and a Certified Financial Planner, says in addition to potential tax worries, he's seen confidence in Congress shaken as the tax debate drags on.

"Nobody thought that some of these laws would sunset without some sort of bipartisan tax bill," says Sherman. "The need to address expiring taxes is starting to gain some traction as political rhetoric intensifies over the summer."

Sherman says most of his firm's clients are still willing to wait and see how things shake out in Washington, D.C. "Personally," he says, "I don't think things will get resolved until 2013. I don't think a lame-duck Congress is going to have the wherewithal to make changes."

If that prediction is correct, taxpayers and their tax professionals will have to deal not only with 2012's uncertainty but also with the complications of retroactively applied tax laws.

Who wants to suggest a catchy name for that situation?