Despite The Uncertainty, Year-end Tax Planning Still Makes Sense
Planning is a challenge this year because, unless Congress acts, tax rates will go up next year, many more individuals will be snared by the alternative minimum tax (AMT), and various tax breaks expire.
These adverse consequences are by no means a certainty. Congress and the President are negotiating now on possible solutions, but as of this writing it remains to be seen just what happens.
While uncertainty makes year-end planning challenging, it is not an excuse for inaction. Indeed, the prospect of higher taxes next year makes it even more important to plan.
Here are some actions that can help you save if you act before year-end. Many of these moves benefit you regardless of what happens. Not all actions will apply in your situation, but you could benefit from many.
- Increase the contribution for next year to your employer's health flexible spending account (FSA) if you set aside too little for this year. Keep in mind that next year, the maximum contribution to a health FSA will be $2,500. And don't forget that tax-free reimbursements for over-the-counter drugs are no longer allowed.
- If you are eligible to make health savings account (HSA) contributions, maximize them prior to year-end. If you qualify for an HSA, contributions are deductible (within IRS-prescribed limits), earnings on the account are tax-deferred, and distributions are tax free if made for qualifying medical expenses.
- Realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later.
- If you are thinking of selling assets that are likely to yield gains (including a home whose gain will exceed the tax-free amount), try to make the sale before year-end, with due regard for market conditions. This year, long-term capital gains are taxed at a maximum rate of 15%, but the rate could be higher next year. And if your adjusted gross income (AGI) exceeds certain limits, gains taken next year will be exposed to an extra 3.8% tax (the so-called "Medicare surtax").
- You may own appreciated long-term stock and want to lock in a 15% tax rate on the gain, but you think the stock still has plenty of room to grow. In this situation, consider selling the stock and then repurchasing it. You'll pay tax at the lower rate now, and wind up with a higher cost basis in the repurchased stock. If capital gain rates go up after 2012, you will have saved the extra tax on the gain you harvested. This move will reduce your tax bill after 2012 if you are subject to the Medicare surtax on unearned income.
- 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 attaining age 59-½, after death or disability, or for a first-time home purchase.
- If you believe a Roth IRA is better than a traditional IRA, consider converting traditional IRAs to Roths this year to avoid a possible hike in rates next year. Also, although a 2013 conversion won't be hit by the Medicare surtax, it could trigger that tax on your non-IRA unearned income. The reason: it could increase your AGI enough to subject you to the tax. But conversions should be approached with caution because they will increase your AGI for 2012.
- Take required minimum distributions (RMDs) from your IRA, 401(k), or other retirement plans if you have reached age 70-½. Failure to take a required withdrawal can result in a penalty equal to 50% of the amount of the RMD not withdrawn.
- This year, medical expenses are deductible to the extent exceeding 7.5% of AGI, but in 2013, for individuals under age 65, these expenses will be deductible only to the extent exceeding 10% of AGI. If you have a shot at exceeding the 7.5% floor this year, accelerate "discretionary" medical expenses into this year.
- Consider using a credit card to prepay expenses that can generate deductions for this year.
- Increase your withholding if you are facing a penalty for underpayment of federal estimated tax. Doing so may reduce or eliminate the penalty.
- If you expect to owe state income taxes when you file, consider asking your employer to increase state withholding (or make estimated tax payments) before year-end to pull the deduction of those taxes into 2012 if doing so won't create an AMT problem.
- Make gifts sheltered by the annual gift tax exclusion before year-end to save gift and estate taxes. You can give $13,000 each in 2012 to an unlimited number of individuals. The gifts also may save income taxes where income-earning property is given to family members in lower income tax brackets. 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% tax in the hands of the donor.
