The “fiscal cliff” being discussed by politicians and the media is the collective impact of the expiration of certain temporary tax provisions and the commencement of automatic federal government spending cuts under the laws agreed to by Congress and the president. The concern is that this simultaneous raising of tax rates and spending cuts will harm a fragile economic recovery.
Given this uncertainty, how should one approach year-end 2012 tax planning? Here are a few opportunities your clients might want to take advantage of before the calendar flips.
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Consider accelerating wage income. There will be higher taxes on wage income in 2013. Ordinary income tax rates are scheduled to increase 3 percent for most income levels and 4.6 percent for higher income taxpayers. Also, a temporary reduction in the Social Security tax from 6.2 percent to 4.2 percent is scheduled to expire, and starting in 2013, the health care law will increase Medicare tax from 1.45 percent to 2.35 percent for high-income taxpayers. Even if Congress agrees to hold the ordinary income tax rates at their current rates, the Social Security and Medicare tax increases will raise the tax burden on wage earners. Planning to minimize these taxes is a challenge, but if you have flexibility to accelerate wage income into 2012, that could be a wise plan.
Consider converting retirement assets to a Roth 401(k) or IRA. Roth assets are after-tax and generate tax-free income, subject to holding the account for five tax years and having attained age 59 ½. If you have a traditional 401(k) or IRA, you can convert that asset to Roth form by paying the tax on the gain or before-tax value of the asset. Roth IRA assets are also not subject to age 70½ required minimum distributions or RMDs, which further enhances the power of the tax-free Roth growth. While any conversion tax liability in 2012 will need to be paid with your 2012 income tax return, there could be considerable savings from converting in 2012 and paying the income tax at lower rates.
Consider selling certain capital assets in 2012. In 2013 the top capital gains rate is scheduled to increase from 15 percent to 23.8 percent and the dividends tax rate from 15 percent to 43.4 percent. Even if tax rates are generally extended, the capital gains rate will increase to 18.8 percent when considering the new 3.8 percent tax on investment income for high-income taxpayers. (PPACA created a new 3.8 percent tax on investment income with income thresholds of $200,000 for individuals and $250,000 for joint filers.) As you consider your investment options for the remainder of 2012 and whether you want to sell any assets, you should consider how the current lower tax rates could benefit you. It may be time, while these rates are still in place, to sell the low basis stock that you have, particularly if you are planning to sell it at some point in the near future. If you like the investment and want to retain it, but also want to lock in the tax gain at the current rates, you can sell the investment and simply repurchase the same stock. “Wash sale” rules only apply to disallow losses when purchasing replacement stock.
It may also be time to consider whether you want to sell dividend paying stock, since the after-tax return on dividends will be less if the dividend tax rates increase as scheduled.