A review of your finances before the end of the year is always a good practice, and often assessing tax-saving strategies is part of the process. This year is a particularly challenging year to do this because of the last-minute negotiations taking place around the “fiscal cliff.” This is the combination of tax increases and spending cuts at the federal level set to kick in on January 1, 2013.
We usually know how tax laws will change as we conduct year-end planning, but this year is different since many believe that laws currently scheduled to go into effect at the start of 2013 will, in fact, be altered before or soon after they take effect.
Changes that could happen
Here is a broad overview of some of the key tax changes that are set to take effect at the start of 2013 unless policymakers in Washington agree to a different approach:
• Higher income tax rates will apply to all taxpayers (other than corporations).
• The employee’s share of payroll taxes (in this case, the Social Security tax) will return to the standard 6.2 percent rate from the 4.2 percent rate that applied in 2011 and 2012.1
• Investment income such as capital gains and dividends will be subject to higher tax rates, and for certain higher-income taxpayers, will be subject to a new 3.8 percent tax on net investment income.
• Some tax credits and deductions will disappear or be limited.
• Estate and gift taxes will rise and apply to far more taxpayers.
Consider that the higher your income, the more significant the tax changes are likely to be. There is speculation that Congress and the President will agree on a plan to scale back or postpone many of these tax hikes, but it isn’t clear when or if such an agreement will occur.
Timely opportunities to consider now
Making tax-efficient moves before the end of the year is particularly challenging given the question mark surrounding the tax landscape. But uncertainty doesn’t preclude the importance of considering steps that can help you be as prepared as possible regardless of what comes out of Washington. Keep in mind that the “fiscal cliff” situation may not be limited to 2012 – the following action steps to consider apply to most economic landscapes in which consumers are anticipating a rise in taxes the following calendar year.
Though you should never make financial decisions based only on tax efficiency, here are five potential moves to consider making now if they fit into your overall short-term financial plan:
#1 – Convert retirement savings to a Roth IRA
You can convert some or all of your workplace savings plan dollars, if the plan allows, or traditional IRA assets to a Roth IRA. Dollars in a Roth IRA grow on a tax-deferred basis, and withdrawals can qualify for tax-free treatment if holding period requirements are met. Since a Roth conversion is a taxable event, 2012 may be the best opportunity for those who are considering it since tax rates for many people are likely to be lower in 2012 than they will be in the coming years. Another advantage of converting to a Roth is that you can change your mind, and “re-characterize” the dollars converted back to a traditional IRA before October 15, 2013. In short, any decision made to convert today is not final, but waiting until after the New Year will make the conversion subject to potentially higher tax rates.
#2 – Accelerate income
In most years, individuals try to find ways to reduce taxable income and accelerate deductible expenses. This time, it may make sense to accelerate income as much as possible into 2012 and defer deductible expenses to reduce your 2013 income, if you have the flexibility to do so. One note – higher income people may not want to overdo it on deferring deductible expenses as new tax policies being considered could limit deductions in 2013 and beyond for those reaching certain income thresholds.
#3 – Sell appreciated assets
As the law stands today, the tax rate on long-term capital gains realized when an asset is sold (such as a stock or mutual fund) will rise to a top rate of 20 percent in 2013. In 2012, the top long-term capital gains tax rate is just 15 percent. Investment income could also be subject to an additional 3.8 percent net investment income surtax in 2013 (related to the Affordable Care Act) if you reach certain income thresholds, adding to the tax burden. There is an important caveat to mention – don’t sell an asset simply for purposes of potentially reducing the tax impact of the sale. You must first determine whether selling the asset is a beneficial move for you and makes sense as part of your overall financial plan regardless of the tax consequences.
#4 – Take advantage of gift tax savings
In 2012, the lifetime gift tax exclusion amounts are $5.12 million for individuals or $10.24 million for a couple. These rules have not been extended beyond 2012, so this may be the best opportunity for those with accumulated wealth to reduce their estates in such a tax-favorable environment. Be sure any gifting is consistent with plans you already have and is not done simply due to 2012’s more favorable tax environment.
#5 – Accelerate medical expenses into 2012
If you anticipate costly medical procedures and can get them completed and fully paid for in 2012, there may be a better chance for tax savings. In 2012, taxpayers who itemize deductions can claim unreimbursed medical expenses that exceed 7.5% of adjusted gross income (AGI). Only those expenses that exceed 10 percent of AGI in 2013 will be deductible.
As always, any tax-related decisions should be made only after consulting with your tax advisor. Meeting with a financial professional can help you assess financial strategies that are most suitable for the uncertain tax environment that exists as 2012 comes to a close and 2013 begins with new changes in place.
Jose Vicente, Jr. CFP®, CLTC is a Financial Advisor and CERTIFIED FINANCIAL PLANNER practitioner ™ with Ameriprise Financial Services, Inc. in Saddle Brook, NJ. He specializes in fee-based financial planning and asset management strategies and has been in practice for 7 years. To contact him: http://www.ameripriseadvisors.com/jose.x.vicente 201-221-2700 ext. 2705. Ameriprise Financial Services, Inc. 250 Pehle Ave. Suite 500 Saddle Brook, NJ 07663. Advisor is licensed/registered to do business with U.S. residents only in the states of NJ, GA, NY, FL, SC, VA, PA, CT, DC. Ameriprise Financial and its representatives do not provide tax or legal advice. Consult your tax advisor or attorney regarding specific tax issues. Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services