It’s that time of year where we should think about preparing an estimate of your current year tax liability and see if there isn’t some way we can reduce that liability. There are several things to consider when doing year-end tax planning: taking advantage of expiring tax provisions, deferring income into the following year or accelerating income into the current year, and accelerating expenses into the current year or deferring them into the following year. The proper strategy depends on whether or not you anticipate a significant change in income or expenses next year.
We’ll also need to consider the impact of possible changes in tax rates/rules in the wake of the presidential and congressional elections.
There are some very favorable tax provisions that are scheduled to expire at the end of 2012 and some potentially unfavorable provisions that become effective in 2013. For example, individual tax rates are scheduled to rise on January 1 to a top rate of 39.6 percent, and the limitations on both itemized deductions and the personal and dependency exemptions are scheduled to return for high-income individuals. Also, the maximum capital gains rate that applies to sales or exchanges for most capital assets is scheduled to increase to 20 percent (10 percent for taxpayers is in the 15 percent income tax bracket). Further, a new .9 percent tax on earned income and a 3.8 percent tax on investment income take effect in 2013 for certain high-income individuals.
Depending on your projected income for 2013, we may need to revise your withholdings or increase your estimated tax payments for 2013 to take these changes into consideration.
While the following are some of the actions we should consider, the focus should not be entirely on tax savings. These strategies should be adopted only if they make sense in the context of your total financial picture.
Accelerating Income into 2012
While we don’t yet know if the tax rate increases scheduled to take effect on January 1, 2013, will actually occur, we need to allow for the possibility that they will. 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, with respect to deferring the sale of stock or other property, the scheduled increase in capital gain rates after December 31, 2012, should 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, 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.
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, there is a change in the threshold for deducting medical expenses in 2013 for taxpayers under 65. Thus, accelerating medical expenses into 2012 to the extent possible is especially important for individuals under age 65 because the threshold increases from 7.5 percent to 10 percent of AGI in 2013. Also note that after 2012, the amount reimbursable under a health flexible spending arrangement for each 12-month coverage period is limited to $2,500 (subject to indexing 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 we anticipate that you will 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, as 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. For example, if you spent less than 14 days at the home, it may make sense to spend a couple more days and have the house qualify as a second residence, with the interest being deductible. As a rental home, rental expenses, including interest, are limited to rental income.
(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. Noncompliance carries stiff penalties.
Please call me at your convenience so we can set up an appointment and estimate your tax liability for the year and discuss any questions you may have.
Murray Tax Services
*CIRCULAR 230 DISCLOSURE: Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.