[The following article was published in the Wall Street Journal November 24, 2012 and written by Laura Saunders.]
The annual scramble to make smart tax moves before Dec. 31 is proving especially vexing this year.
Congress still hasn’t settled 2013 tax rates on income, investments, large gifts and estates. Deductions and other breaks are also in doubt, now that politicians from both parties are calling for cutbacks—although in different ways.
And huge questions remain unanswered even for the 2012 tax year. For example, the Internal Revenue Service on Nov. 13 warned lawmakers that if they don’t act soon, the alternative minimum tax, which reduces the value of some tax breaks, will apply to 33 million households for 2012 rather than four million. More than 60 million people might not be able to file returns or receive refunds until late March, the IRS says, because it would have to reprogram computers.
Yet despite the uncertainties, advisers say year-end tax planning is possible. The best move this year, says Paul Gevertzman, a tax specialist at accounting firm Anchin, Block & Anchin in New York, is to avoid “crystal-ball planning”—or thinking it’s possible to know exactly what will happen. Instead, taxpayers should focus on what is known, maximize breaks while they still exist, reduce vulnerability to unknowns without acting rashly and, above all, stay flexible, he says.
“We know Congress has to reach a compromise, but we can’t know what it will be,” he says.
We do know that 2013 will mark the debut of the 3.8% flat levy on net investment income for joint filers with adjusted gross income of $250,000 or more ($200,000 for singles). Congress passed this levy, plus a 0.9% increase in Medicare tax for affluent earners, to help fund the massive 2010 health-care changes. The tax introduces new layers of complexity into investors’ planning. (For more details, see box.)
Big unknowns include the top rates on long-term capital gains and qualified dividends, both now 15%. The rate on gains could hit 23.8% or more, and the rate on dividends could be as high as 43.4%.
Because of the new 3.8% tax and possible higher rates, some tax specialists are again recommending that taxpayers seriously consider converting their taxable individual retirement accounts to tax-free Roth IRAs. The switch is the ultimate flexible tax move, because converters have until Oct. 15, 2013 to reverse the conversion. (For more details, see box.)
Meanwhile, there are few ways taxpayers can shrink 2012 taxes after Dec. 31, other than contributing to some retirement accounts or health savings accounts. Here are moves to consider before year end, plus a few to avoid.
Make charitable gifts. The best value often comes from donating appreciated assets, because donors can get a full deduction while skipping capital-gains tax on the asset’s growth. Cash donations to charities are often deductible up to 50% of adjusted gross income, while the limit for gifts of other assets is often 30%. Disallowed portions usually carry over to future years.
If you aren’t sure whether the group is eligible to receive tax-deductible gifts, American Institute of CPAs tax specialist Melissa Labant recommends checking “Select Check” at www.irs.gov, a master list of qualified charities.
Are you concerned that the charitable deduction could shrink next year? If so, make a large donation to a “donor-advised” fund and qualify for a full write-off this year. Assets can then grow tax-free in the fund until donors specify tax-free recipients, sometimes years later. There’s no deduction at that point.
If you want to donate IRA assets to charity, wait a bit longer. Since 2006, IRA owners 70½ and older have been able to give up to $100,000 of the required payout directly to a charity. There’s no deduction, but no taxable income either. This wildly popular provision expired at the beginning of 2012, but lawmakers might yet reinstate it—as they did in 2010.
Until lawmakers clarify the issue, would-be donors should “leave room” for their donations because the first dollars out of an IRA count as the required payout. For example, if your required payout is $20,000 and you want to give $3,000 of that directly to your church, withdraw no more than $17,000 until this year’s rules are clear.
Make an extra mortgage payment, or pay down principal. Usually taxpayers can’t accelerate more than one month of mortgage interest, but that helps a bit if you think the mortgage-interest deduction will be curbed next year. Or find cash to pay down principal, which reduces overall interest.
Bloomberg NewsThe Internal Revenue Service building
Don’t fret about the alternative minimum tax “patch” for 2012. If Congress doesn’t fix the AMT, eight times as many households will be subject to the tax as in previous years, and there will be severe disruptions to next spring’s tax-filing season. So it probably will get done, tax experts say.
Maximize contributions to employer-sponsored retirement plans. Unlike with IRAs, the deadline for 401(k) contributions is Dec. 31. This year, the employee limit is $17,000, or $22,500 for workers 50 or older. This pretax contribution has two benefits: It bolsters savings and reduces adjusted gross income that might qualify the taxpayer for benefits that phase out at higher incomes.
Evaluate stock options and restricted stock. This is a highly complex area because some elements of these benefits are taxed as ordinary income and some are capital gains. Next year, the new 3.8% investment income tax and the 0.9% Medicare tax hike will further complicate decisions.
For some investors, it will make sense to exercise options before year end or accelerate taxes on restricted stock into this year. Such decisions depend heavily on expected investment growth, notes Grant Thornton benefits specialist Eddie Adkins.
The bottom line: if you have these benefits, get expert help soon.
Think twice before harvesting gains. Yes, the capital-gains tax will be higher next year. But Katherine Nixon, chief investment officer for wealth at Northern Trust in Chicago, is telling clients to resist the urge to sell long-term holdings willy-nilly to qualify for this year’s lower rate on gains. “That shrinks invested capital, and therefore future wealth,” she says.
Accelerating a sale into this year can make sense, she says, for investors who were planning to divest within the next two years—either because a holding no longer fits a portfolio or cash will be needed, say for tuition.
Harvest capital losses, up to a point. Investment losses can offset investment gains plus up to $3,000 of ordinary income, both for single and joint filers. This year, tax specialist Joel Dickson at Vanguard Group cuts the Gordian knot of rate-change dilemmas with a simple recommendation: “Take enough losses to offset your gains, plus $3,000 and perhaps a bit more,” he says.
Note that “wash sale” rules penalize buyers who acquire the same asset within 30 days of selling at a loss.
Use up funds in a medical flexible-spending account. They often don’t carry over, although some employers will allow workers to spend 2012 funds in the first weeks of 2013. Next year, the contribution limit will be $2,500, less than some employers now allow.
Accelerate medical expenses. The threshold for deducting these expenses, now 7.5% of adjusted gross income (10% for AMT payers), rises to 10% next year for most taxpayers.
People who are 65 and older, however, can use the 7.5% threshold through 2016. This phase-in will be useful, say advisers, because most taxpayers claiming large medical deductions are in the final years of life.
Note that the IRS’s list of what’s deductible is far broader than what insurance typically reimburses, extending to contact-lens solution, assisted-living costs and even special education. For details, seeIRS Publication 502.
Set up a health savings account for 2012. Qualified taxpayers can make 2012 contributions to HSAs as late as April 15, 2013, but the account has to exist by year end.
Write next semester’s tuition checks before year end. The American Opportunity Tax Credit allows qualified taxpayers to get a benefit this year for next spring’s tuition if the payment is made before year end—even though the credit is set to expire for 2013. For more information, see IRS Publication 970.
Prepay state taxes. Deductions for state and local income, sales and property taxes are already disallowed by the alternative minimum tax, and they might shrink further next year, even if Congress reinstates the expired sales-tax deduction for 2012. Consider accelerating next year’s state tax payments if they don’t throw you into the AMT, in which case you’ll lose the write-off altogether.
Make gifts up to $13,000 to relatives or friends. Such gifts are tax-free, and the number of recipients isn’t limited as long as the value of each gift doesn’t exceed $13,000. Cash is often the best gift, as presents of assets such as stock carry their “cost basis” with them.
For example, if an aunt gives her niece shares worth $13,000 that were purchased for $5,000, then the niece will owe tax on any gain above $5,000 when she sells the shares.
It’s also possible to forgive $13,000 of a loan instead of giving assets outright. Payments of tuition and medical expenses are tax-free as well, but the giver must write the check to the provider.
Contribute to 529 education savings accounts. Assets in these accounts enjoy tax-free growth, and withdrawals from them are tax-free when used for tuition and other qualified expenses. Some states also provide tax benefits to givers.
These accounts also offer a rare benefit: Contributions leave the giver’s estate, yet he or she can take back the principal without penalty if the money is needed. Contributions do count toward the $13,000 gift limit, however.
Have a closely held business pay a dividend. With the dividend-tax rate in flux, firms that are organized as C corporations or were C corporations but now are in Subchapter S format should consider paying dividends before year end, says Chris Hesse of accounting firm CliftonLarsonAllen in Minneapolis.
Buy depreciable equipment for a closely held business. Both “bonus” and “Section 179” depreciation deductions are set to drop sharply in 2013. According to Jason Cha, a tax specialist at the American Institute of CPAs, the combined depreciation on $190,000 of qualified purchases of furniture, fixtures and equipment is about $168,000 this year but less than $49,000 next year.