Year-end tax planning is stressful under ordinary circumstances, and this year is anything but ordinary. Unless Congress reaches an agreement by December 31, tax rates on wages and investments will rise, the exemption from the estate tax will shrink, and dozens of tax breaks will disappear. Without a compromise, nearly 90% of Americans will pay higher taxes next year, and the average household's tax bill will increase by $3,500, according to an analysis by the Tax Policy Center.
The most likely fix is a temporary extension of the current tax rates, but the odds that a lame-duck Congress will reach a deal are fading. With that in mind, focus on year-end tactics that will trim your tax bill no matter what Congress does.
Convert a traditional IRA to a Roth.
If you think your tax rate is going to rise sometime in the future, converting to a Roth makes a lot of sense. Withdrawals from traditional IRAs are taxed at your ordinary income tax rate, while all withdrawals from Roths are tax-free and penalty-free as long as you're at least 59 ½ and the converted account has been open at least five years. You do have to pay taxes on any pre-tax contributions and earnings in your traditional IRA for the year you convert. That's why converting before New Year's Eve is smart: You'll pay taxes at current tax rates, which are unlikely to go any lower.
If you're an upper-income taxpayer -- with modified adjusted gross income(AGI) of at least $200,000 if you're single or $250,000 if you're married filing jointly -- you have an even greater incentive to convert in 2012, because converting next year could trigger a new 3.8% surtax on unearned income. (The surtax was enacted to pay for some of the costs of the health-care reform law.) Withdrawals from an IRA aren't subject to the surtax, but they're counted as adjusted gross income and could lift your AGI above the threshold.
There is a major caveat, though. We think a major tax reform package could be enacted as early as next year that would lower overall tax rates, while eliminating tax credits and deductions. If that happens, you'd be better off converting after December 31.
Fortunately, when you convert to a Roth, you can change your mind, says Kathy Stewart, director of fiduciary research for fi360, a training organization for financial advisers. If it looks like tax reform is going to lower your tax rate, you have until October 15, 2013, to undo the conversion and turn your Roth back into a regular IRA.
Converting to a Roth is rarely a good idea unless you have enough money outside your IRA to pay the taxes. And don't overlook any tax liabilities from previous conversions, says Greg Womack, a certified financial planner with Womack Financial Advisers, in Edmond, Okla. In 2010, Congress allowed taxpayers who converted to split the taxable income over 2011 and 2012. If you still owe taxes on a 2010 conversion, the additional income from a 2012 conversion could push you into a higher tax bracket.