EDITOR'S NOTE: This article was originally published in the November 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.
It's a tricky time for taxpayers engaging in the annual ritual of year-end tax planning. Unless Congress intervenes, the Bush-era tax cuts expire when 2013 arrives. Also at risk if lawmakers don't act before December 31 are many popular tax breaks that expired at the end of 2011 that have long been considered sure-shots for revival. Those breaks include the authority to make direct contributions from traditional IRAs to charity.
Election Day and the beginning of the lame-duck session of Congress are yet to come. Still, despite the wide differences between the political parties over tax policy, Kiplinger's believes Congress will extend current tax rates at least temporarily and probably for all taxpayers.
And you still can engage in many tax-trimming strategies that should hold up no matter what happens. Many tax proposals being debated won't hike tax rates for married couples with adjusted gross income of less than $250,000 and individuals with AGI of less than $200,000. "For those folks, the status quo is the likely scenario," says Rande Spiegelman, vice-president of financial planning for Charles Schwab.
Prepare for a new surtax. One of the biggest changes on the books for 2013 is a 3.8% surtax on investment income for married couples with modified AGI of more than $250,000 (singles, $200,000). As part of the new health care law, the tax applies to the smaller of net investment income or the amount by which taxable income exceeds the thresholds. Investment income includes dividends, interest, capital gains, annuities, royalties and rents. Investment income does not include distributions from IRAs or other retirement accounts.
Let's say a couple has $200,000 in wages and $150,000 in net investment income. Taxable income exceeds the threshold by $100,000, which is less than the $150,000 in investment income. The couple would pay a surtax of $3,800.
To lower the potential tax bite, you could give away income-producing assets, such as stocks or investment property, to adult children whose income is far below the threshold, says Bob Scharin, senior tax analyst with Thomson Reuters, a publisher of tax and business information. "They would not be affected by that extra tax," he says. This is a particularly good year to make large gifts because of a change in the federal gift tax law (see a later section of this article).
If you are thinking of selling appreciated assets, doing so before year-end would guarantee the profit won't be hit by the surtax, Scharin says. A potential bonus: A 2012 sale protects you from the possibility that the rate on long-term capital gains could rise to 20% next year if the Bush-era cuts expire. Of course, you should never allow taxes to determine investment decisions.
You could also consider accelerating plans to convert part of your traditional IRA to a Roth. Although IRA distributions are not investment income under the surtax law, they could boost your taxable income above the threshold to make otherwise protected investment income vulnerable. Plus, because tax-free Roth distributions are not included in AGI, they would not count toward the surtax threshold in future years.
Before converting, Scharin warns, "make sure the conversion itself will not put you in a higher tax bracket this year." Also, if you converted a traditional IRA to a Roth in 2010 and decided to defer the tax bill, the tax tab on the second half of that conversion comes due in 2012. That 2010 conversion income plus the income from a new 2012 conversion could push you into a higher bracket. And be sure you have money outside the IRA to pay the tax tab.
A great thing about doing a Roth conversion in 2012 is that you will have until October 15, 2013, to change your mind. You might want to undo the conversion if, for example, efforts at tax reform gain serious traction and it appears that tax rates may go down -- not up -- in 2013 or 2014.
Also, perhaps it is time to boost holdings in municipal bonds, which are exempt from the surtax. "I would not invest in municipal bonds simply to avoid the 3.8% tax," says Melissa Labant, director of tax advocacy at the American Institute of Certified Public Accountants. "But a lot of people have not invested sufficiently in fixed income as they prepare to retire, and taxes are an added reason to be invested in municipal bonds."
Other investment moves. Whether or not you're subject to the 3.8% surtax, your investment portfolio can be a treasure trove of opportunities. Unless Congress intervenes, this will be the last year that taxpayers who are in the 10% and 15% tax brackets -- joint filers with taxable incomes up to $70,700 and individuals with incomes up to $35,350 -- can enjoy a 0% tax rate on long-term capital gains. However, the 0% rate only applies until your income breaks through the 15% ceiling. If you're a married couple with income of $60,000 and sell a stock for a profit of $20,700, you'll pay 15% capital-gains tax on $10,000.
Scharin suggests this strategy for these low-bracket taxpayers who have appreciated stock that they like: Sell the stock at a gain and pay no capital-gains tax. Then buy back the shares. "This will help in the future if they do finally sell," he says. That's because only the appreciation on the current higher value of the shares would be taxed.
Much depends on your personal situation and your political forecasting, Spiegelman says. For example, if you have a high income this year and expect to retire with an income next year of below $200,000 for a single filer and $250,000 for joint filers, you could decide to defer the gain even if you think rates are going up. (President Obama would keep the 15% rate for taxpayers below those income thresholds and raise it to 20% for those above, while Republican Mitt Romney would drop it to 0% for those below those thresholds and keep it at 15% for those above.) "Even if the rate goes to 20% for those above $250,000, it won't affect you," he says.
Congress has yet to extend a tax break that enables IRA owners who are 70 1/2 and older to send a tax-free distribution of up to $100,000 directly to charity. Don't wait past mid December to direct your IRA custodian to withdraw your minimum distribution.
Give, and you'll receive a break. No matter what happens with the federal estate tax next year, you can still give an unlimited number of individuals up to $13,000 each this year without worrying about federal gift tax. Your spouse can give another $13,000 each to the same people. Higher-income parents could consider giving appreciated stock to adult children in the 0% capital-gains bracket, Spiegelman says. "An adult child in a lower bracket would pay a lot less in capital gains on a sale than if you sold the stock," he says.
If you want to help grandchildren with college tuition bills, you can send a tuition payment directly to the college and the amount won't count toward the $13,000 gift-tax exclusion. Or you may be able to get a state tax deduction or credit by opening a state-sponsored 529 college-savings account. The money in the account grows free of federal and state tax, and it can be used to pay expenses at nearly any college your grandchild chooses. To see the tax breaks for your state plan, go to www.savingforcollege.com.
Because of temporary changes in the federal estate-tax law, you can maximize your tax-free giving. For 2011 and 2012 only, the gift-tax exemption has been "unified" with the estate-tax exemption. In 2012, the unified exemption is $5.12 million. The gift-tax exemption is scheduled to drop to $1 million in 2013 -- meaning that you will be able to give away no more than $1 million above the annual $13,000 gift-tax exclusion in your lifetime without paying the tax. This year, owners of large estates can move up to $5.12 million out of their estate free of gift tax.
If you are considering giving away a vacation home, business interests or appreciating stock, this may be the time to do it either directly or through a trust. See an estate-planning lawyer for advice. The lifetime gift-tax exemption may never be this high again.
Boost medical expenses. Under the health care law, there's a higher hurdle between you and medical expense deductions starting in 2013. Currently, write-offs are permitted only to the extent your qualifying bills exceed 7.5% of your adjusted gross income. Next year, the threshold rises to 10%. However, for the 2013 to 2016 tax years, the 7.5% threshold applies if either spouse turns 65 before the end of the year.
New retirees who see a big drop in income could benefit from this year's lower threshold. So can taxpayers who are making big charitable contributions and other moves that will reduce adjusted gross income.
Consider accelerating the timing of planned elective surgery, dental work or other medical procedures. "If you have the option to get some procedures done now, you may want to take care of those things" before the year ends, says Kathy Pickering, executive director of H&R Block's Tax Institute. Other expenses that could push you above the threshold: the cost of transportation to a medical facility and certain medically related home improvements.
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