Tax rates are near historic lows. However, these rates are only the “temporary” Bush tax cuts that were implemented in 2001 and are scheduled to expire January 1, 2013. There is currently a stalemate in Washington over what to do. According to many commentators, the only possible chance of these rates continuing intact is if the Republicans have a clean sweep of the House, Senate and the White House. This is currently predicted unlikely.
What is likely is that there will be some tax increases that will go into effect in 2013. This makes 2012 tax planning imperative. The following taxes may be impacted:
The top tax rate for ordinary income is set to increase from 35% to an effective rate of 44.6%, thanks in part to a new 3.8 % surtax on investment income and a possible reinstated claw-back of itemized deductions.
Similarly, the tax rate on long-term capital gains could increase from 15% to 20% and the rate on qualified dividends from 15% to an effective 44.6%.
The federal estate tax rate is scheduled to increase from 35% to 55% with the exclusion amount dropping from $5.12 million to $1.0 million.
In today’s column, we will discuss some ways you can avoid or minimize the adverse effects of these changes. Planning for these likely tax changes is a major undertaking. Like many other taxpayers, you may want to start beginning the process now, rather than waiting for the fall elections. This will allow you additional time to implement any tax savings strategies.
Capital Gain Harvesting. It may make sense for you to harvest capital gains in 2012 to take advantage of the current lower rates. You would sell appreciated capital assets and immediately reinvest in the same or similar assets. You would then hold the new assets until you would otherwise have sold them, so there would be no change in your investment strategy.
Deciding whether to use the strategy is not as simple as it might appear on the surface, however, because the lower tax rates must generally be weighed against a loss of tax deferral. By harvesting the capital gains in 2012, you would be paying a lower tax rate, but recognizing the gains earlier. The greater the differential in tax rates and the shorter the time before the second sale the more favorable capital gain harvesting would be.
In some cases, the correct decision will be clear without doing any analysis. If you are currently in the 0% long-term capital gains bracket, 2012 capital gain harvesting would always be favorable because it would give you a free basis step-up. Capital gain harvesting would also be more favorable if you planned to sell the stock in 2013 or 2014 anyway. The time value of the tax deferral would be small compared with the future tax savings.
At the other extreme, if you are currently in the 15% long-term capital gain bracket and plan to die with an asset and pass it on to heirs with a step-up in tax basis, there is no reason to recognize the capital gains now. You would be paying tax now without any offsetting future benefit. Nor would it make sense to harvest losses to create additional capital loss carryovers. These loss carryovers would be better employed to offset capital gains in the future when rates are expected to be higher.
If you are not in one of these specific situations, you will have to do a financial analysis to determine whether 2012 capital gain harvesting would work for you. Your decision could be thought of as buying a future tax savings by recognizing capital gains in 2012.
Planning for the 3.8% Medicare Surtax. For tax years beginning January 1, 2013, the tax law imposes a 3.8% surtax on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount. The applicable threshold amounts are $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for all other individual taxpayers.
NII includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts. MAGI is generally the amount you report on the last line of page 1, Form 1040.
Fortunately, there are a number of effective strategies that you can use to reduce MAGI and/or NII and reduce the base on which the surtax is paid. These include Roth IRA conversions, tax exempt bonds, certain tax-deferred annuities, life insurance, rental real estate, oil and gas investments, timing estate and trust distributions, charitable remainder trusts, installment sales and maximizing above-the-line deductions. These strategies may be able to be used to save you large amounts of the surtax.
Accelerating Ordinary Income into 2012. Another opportunity that you should note is accelerating ordinary income into 2012. One way you can do this would be to convert a traditional IRA to a Roth IRA in 2012, if a conversion otherwise made sense. You can also accelerate ordinary income by selling bonds with accrued interest in 2012 or selling and repurchasing bonds trading at a premium. Finally, you might consider exercising non-qualified stock options in 2012.
Estate/Gift Tax Planning. The estate tax exemption is currently $5.12 million per person and will revert to $1.0 million on January 1, 2013 unless Congress and the President act. The President is suggesting a $3.5 million exemption. The potential reduction in the estate tax exemption is resulting in many taxpayers making large gifts, in trust, for their family. You could set up trusts for your spouse, children and grandchildren or just for your children and younger generations. Most experts would calculate the savings at 35%, 45% or 55% of the amount gifted over $1.0 million.
By doing a little planning and paying a little tax in 2012, you may be able to substantially reduce your overall tax burden in future years.
By: Matthew M. Wallace, CPA, JD
Published edited August 26, 2012 in The Times Herald newspaper, Port Huron, Michigan as: Tax hikes likely in 2013