Fiscal Cliff Complicates Year-end Tax Planning

The “fiscal cliff” has made year-end financial planning especially daunting this year.

Uncertainty, the saying goes, breeds uncertainty. And it’s up in the air as to whether Congress will take action to head off a significant reduction in federal government spending and the expiration of Bush-era tax cuts that are scheduled to take effect January 1. Nor is there any clarity on what alternatives Congress might decide on.

However, income tax planning must go on, even in this uncertain tax environment. As a result, it is essential to know the customary year-end planning techniques that cut income taxes

It all starts with a tax projection of whether the taxpayer will be in a higher or lower tax bracket next year. Once their tax brackets for 2012 and 2013 are known, there are two basic income tax considerations.

• Should income be accelerated or deferred?

• Should deductions and credits be accelerated or deferred.

 

Capital gains: Take advantage of historically low taxes on long-term capital gains, which apply to stocks and other investments owned for at least a year.

Regardless of what tax bracket you’re in, many expect taxes on capital gains to rise. Currently, individuals with ordinary income above $35,350, or married couples with ordinary income above $70,700, pay 15 percent in capital gains taxes. Those below that level pay no capital gains taxes. Ordinary income includes all income except for income eligible for reduced tax rates, such as dividends and long-term capital gains.

Because of the tax uncertainty, some investment advisers say it makes sense to look at selling stocks that have appreciated significantly before the end of the year to avoid a higher tax bill down the road.

Something else to consider: If you’re selling a stock and taking a gain on it, there are no negative tax implications if you turn around immediately and buy the stock again. That’s different than when you sell a stock for a loss. In that scenario, you can’t claim a loss if you buy the stock again within 30 days

Don’t run out and trigger capital losses to offset capital gains or ordinary income given that this year’s tax rates on both capital gains and ordinary income are likely to look like a bargain compared to the rates that take effect in 2013.

Charitable contributions : Because of the tax uncertainty it might make sense for families to speed up their charitable giving to the end of this year instead of next.

Roth IRA: If you’ve been contemplating converting your traditional IRA to a Roth IRA, the time may be ripe.  With traditional IRAs, you invest pre-tax dollars and pay taxes when you withdraw funds. With a Roth IRA, however, you invest after-tax dollars but pay no taxes when you withdraw funds.  Now could be a good time to convert to a Roth IRA. In future years, your tax rates are likely to be higher.  A conversion is not to be taken lightly, however, because you’ll have to pay taxes on the converted funds.

Income Acceleration:  For taxpayers who think that they will be in a higher tax bracket,  receive bonuses before January 1, 2013. If your employer allows you the choice, this may create some significant income tax savings. Also, be aware that certain high-income earners will pay an extra 0.9 percent in Social Security taxes on earned income above certain thresholds starting in 2013.

AMT - Certain deductions that can be helpful in keeping tax bills low are worthless if you are in the AMT. Among them are deductions you get for paying state income taxes, local property taxes or mortgage interest. In a year when you are going to be in the AMT, it’s best — if possible — to delay paying taxes and mortgages in December and pay them in January.

Get Medical and Dental work done:  Another health care act tax provision will make it more difficult to claim itemized medical deductions. For 2012 taxes, medical deductions must exceed 7.5 percent of adjusted gross income before they can be claimed. In 2013, the expenses must be more than 10 percent of AGI. If there is a chance of exceeding the 7.5 percent floor this year, the individual may want to accelerate into this year discretionary medical expenses, such as prescription glasses and sunglasses, and elective medical or dental procedures not covered by insurance.