TO: ALL CLIENTS
RE: PLANNING FOR THE FISCAL CLIFF
Normally this time of year we are thinking about your current year income tax and determining what measures can be taken to reduce it!!! Among the things to normally consider are: deferring income into the following year and accelerating expenses into the current year. This is the strategy we’ve followed for years, but in the wake of the recent presidential and congressional elections, it just may not fit for this particular year end. We find ourselves in a rather unique position of knowing (with as much certainty as one can have when dealing with congress) tax rates are scheduled to rise and deductions are scheduled to decline with the start of the new year.
Some very favorable tax provisions are scheduled to expire at the end of 2012 and some potentially unfavorable provisions that become effective in 2013 are: individual tax rates will rise on January 1 to a top rate of 39.6 percent, and the limitations on itemized deductions and personal/dependency exemptions are will return for high-income individuals. Additionally, maximum capital gains rates for sales or exchanges of most capital assets will increase to 20 percent and a new .9 percent tax on earned income (along with a new 3.8 percent tax on investment income) will also take effect in 2013 for certain high-income individuals.
These facts dictate we must seriously consider whether we should accelerate income and defer deductions to take advantage of scheduled changes for next tax year. We know paying more tax in 2012 sounds foreign to everything we have ever said, but wouldn’t you rather pay 10% on a sale in 2012 rather than waiting to 2013 and having the same transaction cost you 25% or more in tax?
Depending on your projected income for 2013, we may also need to revise your withholdings or increase your estimated tax payments to take these changes into consideration.
We have been approached by others wanting to know just what we mean when we talk about accelerating or deferring anything. Well, here is a short list of examples to consider. If you recognize anything that could apply to you, we probably need to have a tax planning session with you, by phone, by email or by snail-mail as soon as possible – and certainly prior to year end. Failure to do so could result in your paying considerable additional taxes that might be avoided.
Oh yea…If you consider any of these actions, you should consider them in terms of not only the potential tax savings, but taking them only if they make sense in the context of your total financial picture………
Accelerating Income into 2012
While we don’t yet know if congress will act to stop the tax rate increases scheduled to take effect on January 1, 2013, we need to plan as though they will and hope they don’t!! Depending on your projected income, it may make sense to accelerate income into the 2012 tax year to lock into favorable rates. Besides harvesting gains from your investment portfolio, other options for accelerating income include:
(1) if you own a traditional IRA or a SEP IRA, converting it into a Roth IRA and recognizing the conversion income this year;
(2) taking IRA distributions this year rather than next year;
(3) selling stocks or other assets with taxable gains this year;
(4) if you are self employed with receivables on hand, trying to get clients or customers to pay before year end; and
(5) settling lawsuits or insurance claims that will generate income.
Deferring Income into 2013
There are also scenarios (for example, if you think that your income will decrease substantially next year) in which it might make sense to defer income into the 2013 tax year. Some options for deferring income include:
(1) if you are due a year-end bonus, asking your employer to pay the bonus in January 2013;
(2) if you are considering selling assets that will generate a gain, postponing the sale until 2013;
(3) delaying the exercise of any stock options you may have;
(4) if you are selling property, considering an installment sale;
(5) consider parking investments in deferred annuities;
(6) establishing an IRA, if you are within certain income requirements; and
(7) if your employer has a 401(k) plan, consider putting the maximum salary allowed into it before year end.
However, when contemplating a deferral of stock or other property sales, the scheduled increase in capital gain rates after December 31, 2012, must be taken into account.
Deferring Deductions into 2013
Once again, if we expect tax rates to increase next year, or if you anticipate a substantial increase in taxable income, we may want to explore deferring deductions into 2013 by looking at the following:
(1) postponing year-end charitable contributions, property tax payments, and medical and dental expense payments until next year; and
(2) postponing the sale of any loss-generating property.
However, be careful!!, postponing the payment of medical and dental expenses could be disastrous with the threshold for deducting such expenses increasing from 7.5 percent of AGI to 10 percent of AGI for taxpayers under 65 next year.
Accelerating Deductions into 2012
If you expect your income to decrease next year, and if we expect tax rates to stay the same for your tax bracket, we should accelerate what deductions we can into the current year. Some options include:
(1) consider prepaying your property taxes in December;
(2) consider making your January mortgage payment in December;
(3) if you are going to owe state income taxes, consider making up any shortfall in December rather than waiting until your return is due;
(4) since medical expenses are deductible only to the extent they exceed 7.5 percent of your adjusted gross income (AGI), if you have large medical bills not covered by insurance, bunching them into one year may help overcome this threshold;
(5) making any large charitable deductions in 2012, rather than 2013;
(6) selling some or all of your loss stocks; and
(7) if you qualify for a health savings account, consider setting one up and making the maximum contribution allowable.
As previously noted, the medical expense threshold increases from 7.5 percent to 10 percent of AGI in 2013 for taxpayers under age 65. Thus, accelerating medical expenses into 2012 to the extent possible could result mean the difference in having a tax deduction or not. Also note after 2012, the amount reimbursable under a health flexible spending arrangement for each 12-month coverage period is limited to $2,500 (indexed for inflation after 2013).
Alternative Minimum Tax
If you are subject to the alternative minimum tax (AMT), your deductions may be limited. While Congress has generally increased the AMT exemption each year, it has not yet done so for 2012. As a result, more individuals may be subject to the AMT than in prior years. Thus, if you may be subject to the AMT, we need to consider the timing of deductible expenses that may be limited under AMT.
Expiring Tax Provisions or Reductions in Credits
Besides the expiration of the reduced capital gains rates, the increase in the top tax rate, the return of the limitations on itemized deductions and personal and dependent exemptions for high income individuals mentioned above, the following are some important tax provisions that are scheduled to expire at the end of 2012:
(1) the 10 percent individual income tax rate;
(2) the American Opportunity tax credit;
(3) the increase of the standard deduction for married filers;
(4) the exclusion from income of the discharge of debt on a principal residence;
(5) certain advantageous student loan interest deductions; and
(6) the taxation of qualified dividends at capital gain rates.
Certain life events can also affect your tax situation. If you’ve gotten married or divorced, had a birth or death in the family, lost or changed jobs, or retired during the year, we need to discuss the tax implications of these events.
Some additional miscellaneous items to consider:
(1) If you have a health flexible spending account with a balance, remember to spend it before year end (unless your employer allows you to go until March 15, 2013, in which case you’ll have until then).
(2) If you own a vacation home that you rented out, we need to look at the number of days it was used for business versus pleasure to see if there is anything we can do to maximize tax savings with respect to that property.
(3) We should also consider if there is any income that could be shifted to a child so that the income is paid at the child’s rate.
(4) If you have any foreign assets, there are reporting requirements and a tax form to fill out with stiff penalties for non-compliance with those regulations.
If you have any doubts as to your status or course of action, we are here to help. A little money spent to adequately plan for these scheduled changes could result in tremendous savings for you and help you eliminate that dreaded phrase….”If only I had…….”