Taxes and death may be inevitable, but now’s the time to reap the benefits of the changing tax laws before 2012 ends. Time is running out on valuable tax savings opportunities that disappear on January 1, 2013. Here’s a recap of the key tax law changes that will lead to a significant increase in tax rates on everything from employment and portfolio income to retirement account distributions. The potential impact these changes will have presents several opportunities.
In a stable tax rate environment, the common tax planning approach is to capture available deductions to minimize current taxation and to defer income as long as possible to let tax dollars remain invested. In a rising tax rate environment, however, the optimal strategy is reversed—wealth is created by accelerating income and deferring deductions.
In today’s tax environment, taxpayers should decide whether it makes sense to recognize income payable in 2013 in 2012, while pushing any available 2012 deductions into 2013 and beyond. With even a modest change in tax rates, significant value can be created. Please consult with a tax professional before implementing any of the strategies discussed here, as everyone’s situation is unique.
Tax increases in 2013
Federal estate and gift tax rates are set to rise while exclusion amounts will go down. The maximum federal estate and gift tax rates (now 35 percent) will increase to 55 percent with the exclusion amounts decreasing from $5.12 million to $1 million.
Planning suggestions : Estate plans should be reviewed in light of the current $5.12 million federal exclusion, recognizing that this threshold could be lowered next year. The end of 2012 is an opportune time to consult with an attorney regarding more complex wealth transfer strategies such as those involving sizable gifts, irrevocable trusts, charitable trusts or grantor-retained trusts.
Higher income tax brackets. If all or part of the Bush-era tax cuts expire, income tax brackets will revert back to a range of 15 percent to 39.6 percent (up from 10 percent to 35 percent).
Planning suggestions: The prospect of rising tax rates in the near future completely reverses traditional tax planning strategies. As a result, investors may want to consider recognizing more income in 2012 via IRA distributions or Roth IRA conversions. Business owners may want to consider increasing their salary or distributions. Income acceleration strategies should be evaluated carefully so as not to accidentally push oneself up to higher tax rates even within the current brackets. Taxpayers may also think about deferring deductions into 2013 if the deduction will result in an increased tax savings over current rates.
Rise in capital gains rates. If the current long-term capital gains tax rate provisions (15 percent for higher-income earners and 0 percent for those in the lowest two income tax brackets) expire at the end of 2012, the rates will revert back to 20 percent for higher-income taxpayers and 10 percent for those in the lowest tax bracket.
Planning suggestions: For investors in lower tax brackets, it will make sense to harvest long-term capital gains (in other words, sell assets with gains) because the transaction will be taxed at 0 percent if you remain in the lowest brackets after the sale. If you plan to sell assets in 2013 for a gain and are in the higher income tax brackets, it will likely make sense to sell these assets in 2012 and pay the tax at potentially lower capital gains rates while possibly avoiding the 3.8 percent Medicare tax as well.
Qualified dividends will no longer be taxed at the historically low level of 15 percent. Dividend rates will revert to ordinary income tax brackets as high as 39.6 percent.
Planning suggestions: Closely held businesses classified as a C corporation that are eligible for qualified dividend treatment should consider making any available dividend distributions before the end of the year.
Income limits on itemized deductions and personal exemptions will be reinstated. These benefits will be phased out for higher-income taxpayers.
Planning suggestions: These phase outs are passive: They either apply, or they don’t, based on income. Little planning can be done to directly mitigate or avoid them. But planning around the assumption of higher rates will be all the more valuable as rates inevitably rise further to account for their impact.
Higher payroll taxes for Social Security. Payroll taxes will revert to 6.2 percent from the current 4.2 percent for company employees, and to 12.4 percent from 10.4 percent for self-employed individuals.
New taxes in 2013
New Medicare tax on unearned income. An additional 3.8 percent tax will be levied on unearned income above $200,000 for individuals and $250,000 for married couples filing jointly.
Planning suggestions : Investors should consider investments that produce income that escapes the tax (such as municipal bonds). Additionally, investors should evaluate whether recognizing capital gains in 2012 (versus 2013) to avoid this tax makes sense from a tax as well as a long-term investment standpoint. Retirement account distributions, taxable at the time of distribution, don’t qualify as “unearned income” for the purpose of the new Medicare tax. But such distributions can increase overall income above the threshold and cause other investment income to become subject to the tax.
New Medicare surtax on wages. An additional 0.9 percent Medicare surtax will apply to wages in excess of $200,000 for individuals or $250,000 for married couples.
Planning suggestions : Given the relatively moderate rate of the new surtax, dramatic tax planning moves should not be based solely on this tax.
Plan ahead now
Although uncertainty remains regarding the specifics of tax policy, significant changes may be on the horizon in 2013. Investors would be wise to consult with their tax and estate professionals to prepare for the risk of higher tax rates and how such changes may affect their personal finances. If taxes rise in 2013, the consequences of not taking advantage of current rates could be significant. As a result, it’s smart to begin end-of-year tax planning now to be well positioned to take advantage of any opportunities.
Bruce Dzieza is CEO of Willow Creek Financial Services in Sebastopol.You can reach him at (707) 829-1146 or (800) 696-8096.
