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Tuesday, November 27, 2012

Expiring Laws, Election Year Complicate 2012 Year-End Tax Planning


Most 2012 income tax rates are scheduled to increase in 2013, and many tax breaks are set to expire. The two presidential candidates have vastly different proposals for addressing these scheduled changes. Whoever wins, there’s no guarantee that his proposal will become law. In fact, unless the winner’s party also controls a majority of seats in the House and at least 60 seats in the Senate, it’s probably unlikely that his proposals will be passed in their current form.

All of this uncertainty complicates traditional year end tax planning. To reduce your current year’s taxes, you generally must implement tax-reduction strategies by the end of the year. But many strategies depend on how your income will be taxed this year vs. next year, as well as on what tax breaks will be available each year.

Timing Strategies Get Complicated
If Congress does nothing, 2013 ordinary income tax rates will be higher for most taxpayers. President Obama has proposed retaining 2012 rates for only the middle and lower brackets — taxable income below $200,000 (singles), $225,000 (heads of households) or $250,000 (married filing jointly; $125,000 for separate filers). Gov. Romney has proposed reducing tax rates below 2012 levels for all taxpayers.

Traditional income and deduction timing strategies depend on what your marginal tax rate (the rate you pay on your next dollar of ordinary income) is this year and what it will be next year. If your marginal rate will go up next year, you’ll likely be better off accelerating income into 2012 (when it will be taxed at a lower rate) and deferring deductible expenses to 2013 (when the deductions will be more valuable). Yet if your rate will stay the same or go down, taking the opposite approach may be better.

Individual income tax rates


2012


2013 – current law

2013 – Obama proposal

2013 – Romney proposal

10%

15%

10%

8%

15%

15%

15%

12%

25%

28%1

25%

20%

28%

31%

28%

22.4%

33%

36%

33% and 36%2

26.4%

35%

39.6%

39.6%

28%

1For married filers, this rate would start applying at a significantly lower income level compared to where the 25% rate started to apply in 2012, because of the expiration of a marriage penalty relief provision.

2Because of the $200,000, $225,000, $250,000 and $125,000 thresholds for tax increases under the Obama proposal, in this bracket only taxpayers exceeding the applicable threshold would see a rate increase to 36% (on the excess until the 39.6% rate applied).

Another consideration this year is the Medicare tax increase under the health care act: Starting in 2013, taxpayers with earned income over $200,000 per year ($250,000 for joint filers and $125,000 for married filing separately) must pay an extra 0.9% (from 1.45% to 2.35%) in Medicare taxes on the excess earnings. If you’ll be subject to this tax, accelerating income into 2012 could be beneficial even if your marginal rate doesn’t go up in 2013.

However, this provision also could be affected by the election. A Republican-controlled Congress could repeal the health care act. The repeal would likely be signed into law if Gov. Romney is elected, because its repeal is one of his goals. If President Obama is re-elected, a repeal would have to have enough votes in Congress (2/3 in both chambers) to override his veto. 

Also keep in mind that President Obama and Gov. Romney have both proposed some changes related to deductions, which also could affect your year end planning. President Obama has proposed limiting itemized deductions to a 28% benefit for higher income taxpayers. Gov. Romney has proposed eliminating or reducing the benefit of some deductions in order to reduce tax rates without increasing the federal debt. However, as of this writing, he hasn’t discussed which deductions would be affected.

With so many different tax scenarios still a possibility, determining how to time your income and deductible expenses is a challenge. So, where possible, consider waiting at least until after the election before making timing-related decisions about such actions as:

  • Taking bonuses,
  • Recognizing consulting or other self-employment income,
  • Taking retirement plan distributions (to the extent not required),
  • Paying 2012 state and local income and property tax bills that aren’t due until 2013, and
  • Making charitable contributions.

But don’t completely put off your income and deduction planning. By working with your tax advisor to project your year-to-date income and deductible expenses now, you’ll be in a better position to act quickly whenever the tax outlook becomes more certain. Before you take any steps to time your income or deductions, it’s also critical to consider the AMT.

The AMT May — or May Not — be a Greater Threat
You must pay the alternative minimum tax (AMT) if your tax liability as calculated under the AMT is higher than your liability as calculated under the regular method. Because certain income items and deductions can trigger the AMT, it’s important to consider the AMT ramifications (for both this year and next) before you accelerate or defer income or deductions. Currently this is complicated not only by uncertainty about ordinary income tax rates but also by uncertainty about whether an AMT “patch” will be extended to 2012 and/or 2013.

The AMT system isn’t automatically adjusted for inflation. This means that, if Congress doesn’t pass legislation to increase the exemption and phaseout ranges (the patch), they’ll be smaller for 2012 than they were for 2011 — potentially making many more people subject to the AMT. President Obama has proposed a three-year patch, while Gov. Romney has proposed the repeal of the AMT.

AMT exemption

 


2011


2012

2013 – current law

Exemption

 

 

 

Single or head of household

$48,450

$33,750

$33,750

Married filing jointly or surviving spouse

$74,450

$45,000

$45,000

Married filing separately

$37,225

$22,500

$22,500

Phaseout range*

 

 

 

Single or head of household

$112,500 – $306,300

$112,500 – $247,500

$112,500 – $247,500

Married filing jointly or surviving spouse

$150,000 – $447,800

$150,000 – $330,000

$150,000 – $330,000

Married filing separately

$75,000 – $223,900

$75,000 – $165,000

$75,000 – $165,000

*The AMT income range over which the exemption phases out and only a partial exemption is available. The exemption is completely phased out if AMT income exceeds the top of the applicable range.

Effectively planning to avoid or reduce your AMT liability is nearly impossible without knowing what regular tax rates will be in effect next year and whether the AMT patch will be extended. Work with your tax advisor to project whether you’re likely to be subject to the AMT under various scenarios, so you can implement the best strategies quickly once the tax picture becomes clearer.

Capital Gains: 0%, 10%, 15% or 20% — Plus 3.8%?
If Congress does nothing, for 2013 capital gains rates will increase. President Obama has proposed retaining the 2012 long-term capital gains rates for only the middle and lower brackets — again, taxable income below $200,000, $225,000, $250,000 or $125,000, depending on filing status. Gov. Romney has proposed retaining 2012’s 0% and 15% rates and expanding the income ranges that qualify for the 0% rate.

Long-term capital gains rates1 

 



2012


2013 – current law

2013 – Obama proposal

2013 – Romney proposal

“Higher-income” taxpayers

15%

20%

20%2

15%3

“Middle-income” taxpayers

15%

20%

15%

0%

Long-term gain that would be taxed at 15% or less based on the taxpayer’s ordinary-income rate

0%

10%

0%

0%

1Different rates apply to certain types of gain, such as gain attributable to certain recapture of prior depreciation on real property, gain on collectibles and gain on qualified small business stock held more than five years.

2Would apply starting at taxable income of $200,000 (singles), $225,000 (heads of households) and $250,000 (married filing jointly; $125,000 for separate filers).

3Would apply starting at taxable income of $100,000 (singles), $150,000 (heads of households) and $200,000 (married filing jointly; $100,000 for separate filers).

Typically it’s tax-smart to hold on to appreciated investments as long as they’re still achieving your objectives. If such investments don’t generate current income (such as dividends), they aren’t taxed until sold. So holding on to them can be an effective tax-deferral strategy. But with the current uncertainty about whether rates will go up or down or stay the same next year, this may or may not be the best strategy.

If long-term capital gains rates go up next year, you may benefit from selling long-term appreciated investments before year end to lock in lower rates on the gain. On the other hand, if rates go down, a sale this year could end up costing you unnecessary taxes.

Further complicating matters is the new 3.8% Medicare tax on unearned income — such as interest, dividends, rents, royalties and certain capital gains — that’s scheduled to go into effect in 2013 under the health care act. The tax will be applied to net investment income to the extent modified adjusted gross income (MAGI) exceeds the same threshold amounts that apply to the additional 0.9% Medicare tax on earned income. Realizing gains by Dec. 31 would allow you to avoid the 3.8% Medicare tax. But, as discussed earlier, depending on the election’s outcome it’s possible the health care act could be repealed.

Again, work with your tax advisor to assess your current situation so you can be prepared to act quickly if it’s looking like you could indeed be subject to a higher tax rate or the 3.8% Medicare tax next year.

Appeal of Dividends may Change for Some
Since 2003, investments that have produced “qualified” dividends generally have been more attractive than other income investments because such dividends are taxed at long-term capital gains rates. Interest from taxable bonds, money market accounts and certificates of deposit, on the other hand, is taxed at higher, ordinary income rates.

But the appeal of dividends might change in 2013 because qualified dividends might once again be taxed at ordinary income rates for some or all taxpayers.

Income tax rates on qualified dividends

 



2012

2013 – current law1

2013 – Obama proposal

2013 – Romney proposal

“Higher-income” taxpayers

15%

36% or 39.6%

36% or 39.6%2

15%3

“Middle-income” taxpayers

15%

28% or 31%

15%

0%

Qualified dividends that would be taxed at 15% or less based on the taxpayer’s ordinary-income rate

0%

15%

0%

0%

1Dividends would be treated as ordinary income, so they’d be taxed at the taxpayer’s marginal rate.

2Dividends would be treated as ordinary income starting at taxable income of $200,000 (singles), $225,000 (heads of households) and $250,000 (married filing jointly; $125,000 for separate filers).

3Would apply starting at taxable income of $100,000 (singles), $150,000 (heads of households) and $200,000 (married filing jointly; $100,000 for separate filers).

Again, keep an eye on the election and Congress. If it looks like no action is going to be taken to extend qualified-dividend tax treatment to 2013, or like such treatment won’t be extended for your income level, you may want to revisit your asset allocation and sell some dividend-producing investments by year end. You might also benefit from locking in a lower long-term capital gains tax rate and avoiding the additional 3.8% Medicare tax. Of course, you first must consider your investment objectives; dividend-paying stock may be attractive even without the tax-favored status.

Expired and Expiring Tax Breaks
Numerous tax breaks expired at the end of 2011 or are scheduled to expire at the end of 2012. Here are just a few that may be relevant to you:

Expired Dec. 31, 2011:
State and local sales tax deduction in lieu of state and local income tax deduction
Direct, tax-free donation to charity from an IRA (up to $100,000) by taxpayers age 70½ or older

Scheduled to expire Dec. 31, 2012:
Repeal of income-based phaseouts on itemized deductions and personal exemptions
Coverdell Education Savings Account (ESA) $2,000 contribution limit and tax-free distributions for elementary and secondary education expenses — limit will be reduced to $500 and only distributions used for qualified postsecondary education expenses will be tax-free

It’s important to work with your tax advisor to determine which ones affect you and to monitor whether any legislation passes before year end.

Watch What Happens
The results of the election should shed some light on what Congress will try to accomplish in the “lame duck session” that starts in November — and what they’ll put off to next year. (In terms of the latter, tax law changes could be made retroactive.) If President Obama is re-elected, Republican leadership might be more likely to strike an agreement with Democrats on the substance of extending tax cuts and there could be a greater chance of tax legislation being passed before year end. If Gov. Romney is elected, Republicans might have less reason to compromise and there could be a greater chance that tax legislation wouldn’t be passed until after the inauguration in late January.

Other election results will also affect legislative action. One is which party will control the Senate and by what margin. As for the House, the Republicans are expected to retain control, but also significant will be how many of the Tea Party members elected two years ago retain their seats.

Given that the House and the Senate will return only briefly after the Nov. 6 elections before recessing again for Thanksgiving, there’s a good chance that the soonest any meaningful tax legislation could be passed would be December, not leaving much time to implement year end tax planning strategies.

Be Prepared
We’ve only touched the surface of the potential impact of various tax law change scenarios on your year end tax planning. If you’re a business owner, you also need to carefully consider business-related tax breaks as well as the impact of your business’s structure on tax planning.

And everyone needs to think about their estate planning strategies, because gift, estate and generation-skipping transfer (GST) taxes will increase significantly in 2013 if Congress doesn’t take action. President Obama has proposed a return to a $3.5 million exemption and 45% top rate, while Gov. Romney has proposed repealing the estate tax.

To be prepared for any situation, it’s a good idea for you and your tax advisor to review your year-to-date income, deductions, gains and losses and project what these amounts may be in 2013. You can then use this information as the 2013 tax landscape becomes clearer to quickly decide what steps to take by year end to achieve your goals.

The second situation involves taxpayer groups that have or had accounts at certain financial institutions that are the subject of U.S. government actions. The IRS may announce that members of these groups will become ineligible for the OVDP on a specified future date.

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