2012 Tax Strategies

The Bush-era tax cuts may expire at the end of 2012... or they may be extended...or they may be extended, but modified... or they may expire, and then be extended or modified in 2013. It is all up to Congress, which most likely will not do anything until after the election.  So what is a person to do?

Despite the uncertainty, there are steps you can take to help reduce taxes—regardless of what Congress ultimately does—plus strategies to consider should there be higher taxes next year or down the road.

We divide those strategies into two groups: first, things to do assuming tax rates rise on January 1, 2013, and second, things to do no matter what happens with rates.

Here are some strategies to consider prior to the end of 2012 which could result in significant benefits if Congress doesn't pass new legislation to extend the lower tax rates.  
1. Convert retirement savings to a Roth IRA.
If you’ve been considering a Roth conversion for all or part of your traditional IRA, think about acting before the end of this year. You’ll have to pay income tax on the amount you convert, but the bill could be higher if you convert next year if tax rates go up. And if Congress extends the lower tax rates, you can undo a 2012 conversion up until October 15, 2013, and get back the taxes you paid.

It is always wise to run a variety of scenarios to evaluate the impact of different options.  You may want to enlist the assistance of a fee-only financial planner with expertise in tax matters.

2. Maximize personal gifts.

Estate and gift tax provisions also face major increases in 2013. For 2012, the estate tax and the lifetime gift tax exemptions are each $5,120,000 per person and $10,240,000 per couple, with a 35% top tax rate. Beginning in 2013, however, unless further legislation is enacted, the exemptions will drop to $1 million per person and $2 million per couple, with an effective 55% top tax rate.

If you've been considering a major gift, 2012 is the time to make that gift.  There are several trust strategies than can enable to you retain control over the assets or property for a period of time. Implementing some of these strategies can take time, so don't wait until the last minute to discuss with an independent and objective financial advisor.

3. Harvest capital gains.

If you are holding significantly appreciated stocks or other assets that you are thinking about selling, consider acting this year while the top capital gains rate is only 15%. Next year, it is scheduled to increase to 20%. Moreover, the new Medicare tax that takes effect next year imposes an additional levy on capital gains, other investment income, and modified adjusted income for high earners.

4. Postpone capital losses.

On the flip side of harvesting capital gains, if you were considering using capital losses to offset your capital gains in 2012, you might consider waiting until next year to sell stocks or mutual funds at a loss. If capital gain rates do rise, the losses could have a greater tax benefit.

5. Pull in income.

In a typical year, taxpayers try to reduce taxable income and increase deductions. But reversing those strategies in 2012 could be more advantageous if tax rates rise next year.

For example, if you’re self-employed, you could accelerate income into this year. If you work for a company, you could talk to your employer about having your 2012 bonus paid before the end of the year. Or, if you’re retired and know you’ll be making a withdrawal from your retirement plan early next year, you could take it before the end of this year.

6. Take advantage of 2012 deduction certainty.

When tax rates go up, deductions become more valuable. So if you believe tax rates are going up in 2013, you might consider pushing annual charitable contributions you would normally make at the end of 2012 into 2013, and then doubling up with another contribution at year’s end. Also, you could pay state and property tax bills after the first of the year. Before you implement this strategy, however, be sure to investigate its potential impact on your exposure to the alternative minimum tax (AMT).

There is uncertainty around deductions. For example, one of the tax proposals would limit the value of itemized deductions, including charitable deductions, by capping the eligible rate at 28% for couples with incomes over $250,000 and for individuals with incomes over $200,000. Also, the limitation on certain itemized deductions (known as Pease, named for the congressman who helped create the legislation) and the phaseout of personal exemptions (known as PEP, personal exemption phaseout) are currently suspended, but they will come back in 2013 for high income earners unless Congress acts. So consider taking advantage of the certainty of 2012 deductions, possibly linking a larger charitable gift in 2012 to help offset the impact of a Roth IRA conversion.

The outcome of the elections may determine deductions in 2013, which could make maximizing deductions in 2012 more beneficial. Consider speaking to a tax advisor to see what may be right for you depending on your tax situation.

7. Donate appreciated stock.

When you give appreciated stock to a charity, you get to deduct the full current value of the stock as a charitable contribution. This can be more favorable than cash donations. You don’t have to pay tax on any capital gain, as you would if you sold the stock and then contributed the cash. That could be a nice tax break this year, but it would look even better if tax rates increase next year. High-income earners should keep in mind the potential 28% cap on itemized deductions in 2013, including charitable contributions, which could make donating in 2012 more favorable.

8. Beware of the AMT wild card.

One of the biggest unknowns for the 2012 tax year is what Congress will do about the AMT. Typically, it passes a last-minute “patch” that helps tens of millions of middle and upper middle income taxpayers avoid being caught by the tax that was originally targeted at the wealthy.

Taxpayers most vulnerable to owing extra tax because of the AMT are those with large deductions such as high state, local, and property taxes; those with large charitable contributions; and those with many dependents. Also vulnerable are people who exercise incentive stock options (ISOs). Managing ISOs to minimize their AMT impact is best done with the help of a tax professional.

Being subject to the AMT has the potential to affect your tax strategies across the board, so take some time to evaluate your AMT exposure before you make any major moves, or contact a tax professional.

Regardless of what Congress does or where taxes end up, here are three strategies to consider now.

9. Maximize tax-deferred savings.

Contributing to tax-advantaged savings accounts such as a tax-deductible traditional IRA (if you qualify), 401(k) or similar workplace plan, Simplified Employer Pension (SEP), or a health savings account (HSA) is a reliable way to help reduce taxes. Contributions generally are not included in your taxable income for the year, meaning that your tax liability could be reduced by your marginal tax rate, multiplied by the amount of your contributions.

You have until April 15, 2013 to make a 2012 contribution to an IRA or HSA, but you must act before the end of the year to max out your 401(k) contribution for 2012.

10. Get all the deductions you’re entitled to.

The timing might not be right to pull as many deductions as possible into the current year, but you still don’t want to overlook those you already have coming. Large charitable contributions are easy to remember and track, but the little items add up, too. Go through your checkbook or debit statements to track the amounts you gave to people soliciting door-to-door, through the mail, or online.

Also make sure you’re keeping track of all your eligible medical expenses. You can deduct only the amount that exceeds 7.5% of your adjusted gross income, but given the cost of health care, your expenses might reach that threshold quicker than you think. Remember that you can deduct the cost of your health insurance (if you pay it yourself in after-tax dollars), long-term care insurance, dental work, and mileage to and from medical appointments.

11. Make the most of annual gifting exclusions.

Remember that the law allows you to gift $13,000 in 2012 to as many people or entities as you want, without incurring gift tax or using up a portion of your lifetime gift exclusion. Also, you can pay college tuition bills or health care providers directly for another person (a child or grandchild, for example) without the payment being considered a gift.

Always remember, you never want to let tax concerns overwhelm your investment and financial planning goals.

We know that tax strategizing will never make the top-ten list of fun things to do. But particularly this year, spending a little time before year-end to assess your options could be time well spent!