According to the old proverb, there are only two things we can count on in life – death and taxes. And, when it comes to taxes,we all want to pay as little as possible.
As we approach the end of 2012, taxpayers face certain critical decisions. Current tax law for 2013 will result in income tax rates increasing for everyone. Much of this increase will be caused by the taxing of income at higher rates for all income levels. This includes the tax on Long Term Capital Gains, which will go from 15% to 20%; the elimination of the maximum 15% tax on qualified dividend income; and the increase in the number of taxpayers subject to the Alternative Minimum Tax.
There is strong support for Tax Reform in Congress. However, as we all know, there are major differences between the two parties as to what Tax Reform should look like. Nonetheless, and not knowing for sure what the future holds, taxpayers need to be aware of six key points involving end-of-year tax planning.
POINT #1 –
Uncertainty Surrounding 2013 Tax Rates Makes Tax Planning Difficult.
The past several years have been unprecedented regarding the uncertainty surrounding income tax rates, deductions, credits and exemptions. This year is no different. Many deductions and credits, which expired at the end of 2011, have not yet been reinstated by Congress. As is often the case, Congress does not get around to reinstating many of these deductions and credits until right before the holidays when most people are not focusing on their tax planning. Even those who are, find little time to implement year-end tax strategies as many need to be accomplished by December 31.
This year is especially problematic since it appears to be a tossup as to whether or not the law, as scheduled to go into effect in 2013, will be changed by Congress prior to December 31.
Appropriate Tax Planning is Specific to Each Taxpayer’s Individual Situation.
Tax Planning is not generic. You need to address your own individual tax planning and what effect the changes in the tax law will have on your personal situation, and then act accordingly.
The remaining 4 key points address General Tax Planning Strategies – assuming current 2013 tax law as described above. I recommend that before implementing any of these strategies you consult your tax advisor.
POINT #3 –
Taxpayers who expect to be in a higher income tax bracket in 2013 than in 2012 should accelerate income into 2012 and defer deductions to 2013.
Accelerating income and deferring deductions runs counterintuitive to traditional Tax Planning. Generally taxpayers wish to delay paying taxes as long as possible and minimize current taxes by taking deductions into the current tax year. However, this advice is just the opposite when tax rates are increasing, which is exactly the situation many taxpayers face now.
There are several strategies to accelerate income into 2012 in order to pay tax on that money at lower tax rates. Taxpayers who need to withdraw money from their IRA or 401(k) plans for living expenses may want to withdraw additional amounts in 2012 rather than waiting until 2013.
Employees who receive bonuses or commission checks right after the end of the year may want to ask their employer if they could be paid prior to year end. Employers may not mind if this is only a matter of a few days. Finally, business owners may wish to encourage customers to pay for services prior to year end so they can realize the income in 2012.
Deferring deductions into 2013 – when tax savings for those deductions will be greater for taxpayers in a higher tax bracket – is easier for many taxpayers than accelerating income. Charitable donations, deductions for state and local income taxes, and medical expenses, should be paid at the beginning of 2013. However, with respect to postponing the payment of medical and dental expenses, the scheduled increased in the threshold for deducting such expenses (from 7.5 percent of AGI to 10 percent of AGI for taxpayers under 65) should be considered.
POINT #4 –
Taxpayers who own IRAs and or 401(k)s should consider converting a portion into a Roth IRA and recognizing the conversion income this year.
Roth IRAs are different than Traditional Retirement Plans such as IRAs or 401(k)plans in that distributions from Roth IRA accounts are tax free if the taxpayer has held the Roth IRA account for at least five years and is at least 59 ½ years old. This can be a tremendous tax benefit for taxpayers who expect to be in a higher tax bracket later in life. Unfortunately, until 2010, many taxpayers could not make Roth IRA Contributions because their taxable income exceeded the threshold for which Roth IRA Contributions could be made.
However, at that time, the tax law changed to allow all taxpayers to convert a portion or all of their IRA, 401(k), 403(b), etc. to a Roth IRA. The tax due on the amount converted could be spread over the 2011 and 2012 tax year, thus providing tax deferral of the income tax payments. While the ability to spread the tax over two years is not available for Roth IRA Conversions after 2010, it still might make sense to convert assets to a Roth IRA in 2012 for those who expect to be in a higher tax bracket in 2013 and beyond.
POINT #5 –
Consider your holding period before selling assets with Capital Gains.
The tax rate on the gain on the sale of such assets as stocks, bonds, mutual funds and real estate is dependent upon how long the taxpayer has held those assets. Gains on the sale of assets owned one year or less are considered short term gains and are taxed at the taxpayer’s ordinary income tax rate. Gains on the sale of assets owned for more than one year are considered long term gains and are taxed at long term capital gains tax rates, which are more favorable to the taxpayer than ordinary income tax rates.
Tax planning is quite straightforward for taxpayers contemplating selling assets with short term gains; do not sell the asset until the holding period is greater than one year.
For assets which already have been owned for more than one year, the decision whether to sell those assets and realize the gain in 2012 when long term capital gains are taxed at 15%, rather than at 20% (or higher) in 2013, depends upon how long the taxpayer intends to hold the asset.
I recommend not selling any investment in 2012 if the taxpayer does not need the proceeds from the sale of the asset for at least the next three years.For investments where the proceeds are needed within the next two years, then it makes sense to realize the long term gain now.
There is one exception to the above. For 2012, the tax rate for long term capital gains for taxpayers who are in the 10 or 15% tax bracket is zero. Therefore, taxpayers in this situation may want to realize long term gains and pay zero taxes, even if their intent was to hold the asset for at least three years. Taxpayers who wish to take advantage of this strategy should be cautioned, as the amount of gain that exceeds the 15% tax bracket is taxed at 15% and not zero.
POINT #6 – Do not accumulate capital losses in 2012. Instead, consider accumulating investment losses in 2013 when the value of those losses will be worth more to the taxpayer.
The tax law allows taxpayers to offset capital losses against capital gains. If the amount of losses exceeds the amount of gains in a given tax year, the taxpayer can offset the excess of the losses over the gains, up to a maximum of $3,000 against ordinary income. The balance of any remaining losses can be carried forward into future tax years offsetting future gains. This strategy of accumulating losses to be used against future gains is more valuable to the taxpayer when tax rates are higher. Therefore this strategy should be used in 2013 and not 2012.
The above are just a few of the end-of-year tax planning strategies you should consider in the event tax rates are higher in 2013. Consult a tax advisor to see which if any of the above are right for you.