Year-end tax planning is stressful under ordinary circumstances, and this year is anything but ordinary, according to financial expert Mark Lamkin from Lamkin Wealth Management.
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.
1. Convert an 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. 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. 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.
2. Max out on your tax-deferred retirement savings plans.
This year, you can contribute up to $17,000 to your 401(k) or other employer-based plan; if you're 50 or older you can contribute up to $22,500. This is a smart strategy if you plan to convert to a Roth this year because it will lower your taxable income. You have until April 15 to contribute up to $5,000 ($6,000 if you're 50 or older) to an IRA; contributions to traditional IRAs may be tax deductible.
3. Make gifts before year-end.
Barring action by Congress, the estate tax and lifetime gift tax exemption will drop to $1 million, from $5.12 million. Plus, the maximum estate tax rate will jump to 55% from 35%.
That doesn't mean you should start handing out big checks to your children and grandchildren (see Protect Your Estate From Greedy Heirs <http://www.kiplinger.com/magazine/archives/3-keys-to-protect-your-assets-from-greedy-heirs.html%20>). Gifts must be irrevocable (otherwise, the IRS doesn't consider them gifts), so you can't ask for the money back if you come up short. But if you have more than $1 million in assets, review your estate plan before year-end. Talk to an estate-planning attorney about setting up trusts and other vehicles that will allow you to take advantage of the current exemption to transfer wealth to your children or grandchildren, tax-free. You could also take advantage of this exclusion to forgive family loans that the borrowers may be unable to repay.
Even the less well-heeled should consider taking advantage of the annual $13,000 gift tax exclusion. You can give $13,000 to as many individuals as you like, tax-free; if you're married, you and your spouse can give $26,000 per recipient. This exclusion will be available next year -- and will likely rise to $14,000 -- but if you fail to take advantage of it by year-end, your 2012 exclusion disappears.
4. Boost your income.
Deferring discretionary income, such as year-end bonuses, is a popular tax strategy when tax rates are expected to remain the same or decline. This year, though, high-income taxpayers may want to accelerate discretionary income to avoid another tax hike created by the health-care reform law. Starting in 2013, taxpayers will pay an additional 0.9% Medicare tax on income from wages over $200,000 ($250,000 for married couples.) Of course, if tax reform leads to lower rates, deferring income would still make sense. But that may not happen right away: rate cuts in the Tax Reform Act of 1986 didn't take effect until 1987 and 1988.
5. Sell your losers!
Allowing taxes to dictate your investment strategy is rarely a good idea . But if you're already considering selling appreciated securities or other assets -- even if you don't have losses to offset them -- cutting them loose by year-end could save you money (you can harvest losses to offset investment gains, plus shield up to $3,000 of ordinary income from taxes).
Unless Congress extends the Bush tax cuts, the top rate on capital gains will rise to 20%, and the top rate for dividends will jump to 39.6%. Even if Congress extends current rates, the new 3.8% surtax on unearned income will boost the top rate for long-term capital gains and dividends to 18.8%.
If you think you're going to need to sell some of your investments to raise cash next year, do it before December 31.
If you're an investor in the two lowest income tax brackets, 2012 is the last year you will pay zero tax on capital gains and dividends. That could be a boon to retirees, who have a higher standard deduction than younger taxpayers and who are not taxed on some or all of their Social Security benefits, and the unemployed, who may have had to tap their investments to make ends meet.
To take advantage of the 0% capital-gains rate for 2012, your taxable income can't exceed $35,350 if you are single; $47,350 if you are a single head of household with dependents; or $70,700 if you are married filing jointly. Note that this is taxable income. That's what's left after you subtract personal exemptions -- worth $3,800 each in 2012 for you, your spouse and your dependents -- and your itemized deductions or standard deduction from your adjusted gross income.
Lamkin Wealth Management
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