Year-end tax planning provides you with an opportunity to develop a good plan of defense during these critical times of uncertainty. As this article is going to press, the election results are in but we are far from certain what tax policies will be implemented and when they’ll take effect. Will the Bush-era tax cuts be allowed to expire, raising taxes for everyone? Will these tax cuts be extended for all taxpayers? Or will a different plan be implemented altogether? This uncertainty makes it even more important to be informed and prepared.
Here are some strategies to be aware of in developing your year-end action plan:
Take advantage of increasing tax rates. In the absence of new tax legislation, higher tax rates will be in effect for 2013. To the extent a taxpayer can control the timing of bonuses, option exercises, and other ordinary income, it may make sense to accelerate this income to 2012 in order to take advantage of the lower tax rates currently in effect. In addition, the Medicare tax on earned income such as compensation and self-employment income is scheduled to increase by 0.9% starting in 2013 (for wages in excess of $250,000 (MFJ)/$200,000 (single)). On the flip side, it may make sense to defer certain deductions until 2013, when the higher rates kick in, to achieve a bigger benefit for them.
Harvest capital gains. Long-term stock sold at a gain in 2012 will be taxed at 15%, versus potentially at 23.8% (20% capital gains tax plus 3.8% Medicare tax for taxpayers with income over $250,000 (MFJ)/$200,000 (single)) in 2013. If you have a particular investment that you don’t want to get out of, it may make sense to capture the current appreciation and pay tax in 2012, and then buy the same stock back again to restart the holding period with a stepped-up basis. The “wash sale” rules do not apply when you sell at a gain.
Accelerate installment sale payments. To the extent it is appropriate and possible to accelerate payments on installment sales into 2012, the gains will be taxed at the current, lower capital gains rate and will avoid the 3.8% Medicare tax.
Harvest capital losses. Consider selling assets in your portfolio with unrealized losses to offset your capital gains. Any excess losses will carry over to 2013, where they will offset gains at a higher rate. Be aware of the “wash sale” rules if you buy back substantially similar shares within 30 days of the disposition.
Convert traditional IRAs to Roth IRAs. Funds invested in Roth IRAs are taxed up front and grow indefinitely without being subject to additional taxation. Converting in 2012 would allow you to benefit from the lower tax rate on the conversion income.
Consider changing your investment allocation. Starting in 2013, the new 3.8% Medicare surtax will be assessed on the net investment income of certain higher income taxpayers whose modified adjusted gross income exceeds $250,000 (MFJ)/$200,000 (single). Net investment income includes taxable interest, dividends, royalties, rents, passive activity income and net gain from the disposition of property (other than property held in a trade or business), as reduced by properly allocable deductions. Heading into 2013, you should factor in the 3.8% tax as part of the analysis of the return on investment of your portfolio, and potentially consider any changes in investment strategy you may want to make.
Gift assets. The lifetime exemption for gift and estate taxes is scheduled to drop from $5.12 million to $1 million in 2013, with the GST exemption set to drop to an inflation adjusted number slightly above $1 million. In addition, the maximum tax rate for estate and gift taxes is scheduled to increase from 35% to 55% in 2013. Even if you’ve already used your lifetime exemption, it may be worthwhile to make additional taxable gifts this year and pay a gift tax at 35% before the gift tax rate increases to 55%. The tax rate savings along with getting future appreciation out of your estate could provide for tremendous savings in the long run.
While these suggestions can help reduce the impact of a potential tax increase, any major changes you consider making should be reviewed in the context of your overall financial goals and objectives. Tax planning should not drive the decision-making process but should be part of the discussion you have with all of your advisors. Planning would be much easier if we knew for certain what changes will take place in the Federal Tax Code. However, given that we may not know what will happen in 2013 until very late this year, it is important to plan now for the various scenarios that might transpire.
Please consult your DGC client relationship representative to discuss ways you can prepare.
Information contained in this article/post was current as of December 1, 2012.