Although there is much uncertainty regarding future tax rates, as of January 1, 2013 a number of taxes are scheduled to change. Let’s review the changes and examine which year-end tax strategies may be worthwhile to pursue. Although there is much uncertainty regarding future tax rates, as of January 1, 2013 a number of taxes are scheduled to change. Let’s review the changes and examine which year-end tax strategies may be worthwhile to pursue.
Federal Marginal Income Tax Brackets
Even though these changes are scheduled to take place on January 1, taking action now may be premature, especially for those in lower tax brackets. There seems to be political support for maintaining tax rates for single taxpayers making less than $200,000 MAGI (Modified adjusted gross income) and $250,000 MAGI for married taxpayers filing jointly. For simplicity sake, let’s refer to those making more than $200,000 (single) and $250,000 (married filing jointly) as “high earners” going forward. As you will see below, high earners may be wise to accelerate income in 2012 and defer deductions until 2013.
There is a fair amount of uncertainty regarding capital gain rates as well, but those who are in the 15% marginal tax bracket or lower have an opportunity to harvest capital gains at 0%. Just remember the harvested gains will add to your 2012 income, so you want to examine how much you can harvest before jumping to the 25% marginal tax bracket. High earners may also want to harvest capital gains, but they need to consider how long they plan to hold the asset. When taking into account the lost opportunity cost of the taxes paid for harvesting in 2012, they may be better off keeping the asset, even with higher capital gain rates if they plan to hold the asset for more than 10 years. For assets that will be sold in the near term to rebalance, diversify, or satisfy cash needs, recognizing the gain in 2012 makes sense.
The Medicare taxes only impact high earners and are another reason to accelerate income in 2012. If you have large IRA accounts, your distributions do not count as investment income; however, your distributions will increase your income. If your future IRA distributions will push you over the income threshold and you have other sources of investment income, you may want to make ROTH conversion in 2012. By converting your Traditional IRA to a ROTH IRA, future withdrawals will not be included in your income. If you are on the bubble of being considered a high earner, take steps to reduce your MAGI by increasing contributions to tax deductible accounts such as your 401k, 403b, traditional IRA, or health savings account (HSA). If you own your business, you might be able set up or modify your retirement plan to maximize your tax deductible contributions. Investing in tax-exempt municipal bonds in taxable accounts is another strategy for minimizing Medicare taxes. Interest earned from tax-exempt bonds is not taxable at the federal level which lowers your MAGI, and the interest isn’t subject to the Medicare surtax.
Estate, Gift, and Generation-Skipping Taxes
There is a good chance the exemption amount will be increased above the $1 million, so most estate plan modifications should wait until this is resolved. For those with very large estates that are comfortable with completely giving away assets a unique opportunity exists. By giving away the full exemption amount of $5.12 million in 2012 they can avoid paying any gift tax now and remove further appreciation of the assets from the estate. Assuming the $5.12 million gift appreciates at 6% per year for 30 years the assets would be worth $29.41 million at the grantor’s death. If the exemption is $1 million at the time of death $4.12 million dollars of the original gift would be taxable to the estate, but the remaining $25.29 million in appreciation would not be subject to the estate tax. Assuming a 55% estate tax rate this would save $13.91 million.
For those under 65 years of age the floor for medical expense deductions will rise from 7.5% to 10%. If you will be able to itemize on your taxes and will meet the 7.5% floor accelerating medical expenses in 2012 is a smart move.