Congress appears headed toward an epic battle over sun-setting tax rules, already expired tax breaks and soon-to-expire tax breaks, and it looks as if the dust won’t settle until late this year or possibly next year. While many pundits believe a reasonable scenario might be for Congress to buy itself time to cobble together a comprehensive tax reform plan by extending core expired or expiring tax provisions for one more year, in today’s highly charged political environment, such a reasonable solution may not prevail. This uncertainty makes year-end tax planning for 2012 an even bigger challenge than in past years.
The uncertainty, however, is no excuse for taxpayer inaction. Indeed, the prospect of higher taxes next year makes it even more important to engage in year-end planning this year. To that end, we have put together a brief background on the significant sun-setting federal tax rules and expiring federal tax breaks, as well as the new 3.8% Medicare surtax, along with a non-exhaustive list of potential federal tax planning ideas for individual taxpayers to consider.1 Note that many of these ideas may benefit taxpayers regardless of what Congress does on the major tax questions of the day. In addition, while not all ideas may apply in a taxpayer’s particular situation, most taxpayers will benefit from discussing these tax planning ideas with their tax advisors.
Background Of Significant Sun-Setting Tax Rules, Expiring Tax Breaks And The New Medicare 3.8% Surtax
Changing Tax Rules. In 2010, Congress acted to extend the tax cuts passed in 2001 and 2003, including cuts to the ordinary income and capital gain rates (commonly known in the press as the “Bush” tax cuts) through the end of 2012. So unless Congress acts, the tax rates for individuals in 2013 will revert to their prior and higher levels. Noteworthy changes include:
- Higher Tax Brackets. For 2013, the 10% bracket will disappear (lowest bracket will be 15%); the 15% tax bracket for joint filers and qualified surviving spouses will be 167% (rather than 200%) of the 15% tax bracket for individual filers; and the top four tax brackets will rise from 25%, 28%, 33% and 35% to 28%, 31%, 36% and 39.6%.
- Reduced Standard Deduction. The standard deduction for married taxpayers filing jointly (and qualified surviving spouses) is 167% (rather than 200%) of the standard deduction for single taxpayers.
- Reduction/Phase-out Of Itemized Deductions And Personal Exemptions. Most itemized deductions of higher-income taxpayers are reduced by 3% of adjusted gross income above an inflation-adjusted figure, but the reduction can’t exceed 80%. A higher-income taxpayer’s personal exemptions are phased out when adjusted gross income exceeds an inflation-adjusted threshold. CCH recently estimated that, projected for inflation, these “phase-out” amounts would start for personal exemptions at $267,200 for joint filers and $178,150 for single filers and a phase-out range for itemized deductions would start at $178,150 for all filers except married couples filing separately whose phase-out range for itemized deductions starts at $89,075.
- Increased Tax On Capital Gains And Qualified Dividends. For 2012, most long-term capital gains are taxed at a maximum rate of 15%, and qualified dividend income is taxed at the same rates that apply to long-term capital gains. For 2013, unless Congress acts, most long-term capital gains will be taxed at a maximum rate of 20% (18% for certain assets held more than five years) and dividends paid to individuals will be taxed at the same rates that apply to ordinary income.
Alternative Minimum Tax (AMT). Far more restrictive AMT rules are in effect for 2012 than 2011, and will remain so unless Congress passes a “patch” that amends the rules effective retroactively as of January 1, 2012. For individuals, the AMT exemption amounts for 2012 fall to $45,000 (joint filers and surviving spouses), $33,750 (unmarried individuals), and $22,500 (marrieds filing separately). By contrast, the AMT exemption amounts for 2011 were $74,450 (joint filers and surviving spouses), $48,450 (unmarried individuals), and $37,225 (marrieds filing separately). In addition, for 2012, individuals can no longer use most nonrefundable personal credits to offset the AMT.
New 3.8% Medicare Surtax. Pursuant to the health care reform law that was signed into law by President Obama on March 23, 2010, for 2013 and beyond, a new 3.8% Medicare surtax applies to the lesser of: (1) a taxpayer’s net investment income, or (2) the excess of a taxpayer’s modified adjusted gross income over the following threshold amounts: $250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case.
Tax Planning Ideas
- In 2012, unreimbursed medical expenses are deductible to the extent they exceed 7.5% of a taxpayer’s adjusted gross income, but in 2013, for individuals under age 65, these expenses will be deductible only to the extent they exceed 10% of the taxpayer’s adjusted gross income. If a taxpayer is close to the 7.5% floor this year, the taxpayer should consider accelerating into 2012 “discretionary” medical expenses the taxpayer was planning on making in 2013, such as prescription sunglasses, and elective procedures not covered by insurance.
- Consider using a credit card to prepay expenses for 2013 that can generate deductions for this year.
- Increase the amount set aside for next year in an employer’s health flexible spending account if too little was set aside for this year. Note that beginning next year, the maximum contribution to a health flexible spending account will be $2,500 and that amounts can no longer be set aside to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids.
- If a taxpayer becomes eligible to make health savings account (HSA) contributions late in 2012, the taxpayer should consider making a full year’s worth of deductible HSA contributions even if the taxpayer was not eligible to make HSA contributions for the entire year. If a taxpayer qualifies for an HSA, contributions to the account are deductible (within IRS-prescribed limits), earnings on the account are tax-deferred, and distributions are tax free if made for qualifying medical expenses.
- Losses on stock holdings may be realized while substantially preserving the taxpayer’s investment position. There are several ways this can be done. For example, a taxpayer may be able to sell an original holding, then buy back the same securities at least 31 days later. Taxpayers should consult their investment/tax advisors before executing this strategy.
- If a taxpayer is contemplating selling assets that are likely to yield large gains, such as inherited, valuable stock, or a vacation home in a desirable resort area, the taxpayer should consider trying to make the sale before year-end, with due regard for market conditions. In 2012, long-term capital gains are taxed at a maximum rate of 15%, but the rate could be higher next year as noted above. And if the taxpayer’s adjusted gross income (as specially modified) exceeds certain limits ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 for all others), gains taken next year (along with other types of unearned income, such as dividends and interest) may be exposed to the extra 3.8% Medicare surtax.
- If a taxpayer is in the process of selling his or her main home, and expects the long-term gain from selling the home to substantially exceed the $250,000 home-sale exclusion amount ($500,000 for joint filers), the taxpayer should consider trying to close the sale before the end of the year (again, with due regard to market conditions). This may save capital gains taxes if rates go up and may save the 3.8% Medicare surtax for those exposed to it.
- A taxpayer may own appreciated-in-value stock and want to lock in a 15% tax rate on the gain, but thinks the stock still has plenty of room to grow. In this situation, the taxpayer could consider selling the stock and then repurchasing it. The taxpayer would pay a maximum federal tax of 15% on long-term gain from the stock that is sold. The taxpayer would also wind up with a higher basis (cost, for tax purposes) in the repurchased stock. If capital gain rates go up after 2012 and the repurchased stock is sold down the road at a profit, the total tax on the 2012 sale and the future sale could be lower than if there had been no sale in 2012 and there had just been a single sale made in the future. This move may also reduce a taxpayer’s tax bill after 2012 if the taxpayer is subject to the extra 3.8% Medicare surtax on unearned income.
- If eligible, consider making contributions to Roth IRAs instead of traditional IRAs. Roth IRA payouts are tax-free and thus immune from the threat of higher tax rates, as long as they are made (1) after a five-year period, and (2) on or after age 59½, after death or disability, or for a first-time home purchase.
- If a taxpayer believes a Roth IRA is better than a traditional IRA, the taxpayer might consider converting traditional IRAs to Roth IRAs in 2012 to avoid a possible hike in tax rates next year. Conversions should, however, be approached with caution. For example: (1) while a 2013 conversion may not be hit by the 3.8% Medicare surtax on unearned income, it could trigger that surtax on a taxpayer’s non-IRA gains, interest, and dividends in that the taxable conversion might bring the taxpayer’s modified adjusted gross income above the relevant dollar threshold (for example, $250,000 for joint filers); and (2) a 2012 conversion will increase the taxpayer’s adjusted gross income for 2012, and if the same taxpayer made a traditional IRA to Roth IRA conversion in 2010 and chose to pay half the tax on the conversion in 2011 and the other half in 2012, making another conversion this year could expose the taxpayer to a much higher tax bracket.
- Consider taking required minimum distributions (RMDs) from an IRA or 401(k) plan (or other employer-sponsored retired plan) if the taxpayer has reached age 70½. Failure to take a required withdrawal can result in a penalty equal to 50% of the amount of the RMD not withdrawn. If a taxpayer turns age 70½ in 2012, the taxpayer can delay the first required distribution to 2013, but if this option is chosen, the taxpayer will have to take a double distribution in 2013, the amount required for 2012 plus the amount required for 2013. A taxpayer should think twice before delaying 2012 distributions to 2013; bunching income into 2013 might push the taxpayer into a higher tax bracket or bring the taxpayer above the modified adjusted gross income level that may trigger the 3.8% Medicare surtax on unearned income such as dividends, interest, and capital gains. However, it could be beneficial to take both distributions in 2013 if the taxpayer will be in a substantially lower bracket in 2013, for example, because the taxpayer plans to retire late this year or early the next.
- Taxpayers facing a penalty for underpayment of federal estimated tax should consider increasing their withholding; doing so may reduce or eliminate the penalty.
- Consider making gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. An individual can give $13,000 in 2012 to each of an unlimited number of individuals but unused exclusions cannot be carried over from one year to the next. The transfers also may save family income taxes where income earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax. Savings for next year could be even greater if rates go up and/or the income from the transfer would have been subject to the 3.8% Medicare surtax in the hands of the donor.
While the above list of tax planning ideas is by no means exhaustive, it should provide taxpayers with a starting place to work with their tax advisors to help develop contingency plans for both best and worst case scenarios, and then settle on a course of action once the legislative picture begins to clear.
1 For guidance regarding planning for potential changes to the federal estate and gift tax laws in 2013 and beyond in the event Congress fails to extend/modify the current federal estate and gift tax laws, please see the previous articles which appeared in our August/September 2012, July 2012 and February 2011 Newsletters, as well as our December 2010 Alerts: “2010 Tax Relief Act: Key Income Changes” & “2010 Tax Relief Act: Key Estate, Gift and Generation Skipping Transfer Tax Changes”. In addition, while applicable state income taxes may also be affected in 2013, the focus of this article is on 2013 federal income taxes.