Year-end planning may be a significant challenge for some taxpayers this year because, unless Congress acts, many of the benefits to taxpayers that were established under the Bush administration in 2003 and extended under the Obama administration in 2010, will expire. Unless those rules are extended, tax rates increase on January 1, 2013, the alternative minimum tax (AMT) will impact more taxpayers, various deductions and other tax breaks expire, the estate tax exemption will be reduced and the estate tax rates will increase as a result of the expiring Bush-era tax cuts.
Although Congress could extend these tax cuts for some or all taxpayers, retroactively "patch" the AMT to increase exemptions and availability of credits, revive some favorable tax rules that have expired, and extend those that are slated to expire at the end of this year, which actions, if any, Congress will take remains to be seen. However, even if Congress does act, it is unlikely to extend all of the expiring provisions in light of the lost federal revenue associated with such an extension.
These uncertainties make year-end tax planning challenging. However, they should not be an excuse for inaction.
As noted above, on January 1, 2013, individuals will face higher tax rates on income, including capital gains and dividends, and estate tax rates will be higher as well. These changes are discussed in more detail below.
Expiration of the Bush tax cuts
The 2003 tax cuts resulted in federal income tax brackets applicable to ordinary income ranging from 10% up to a maximum rate of 35%. Those reductions are set to expire after 2012. Beginning in 2013, the federal tax rates on ordinary income will increase from the current 35% to a maximum rate of 39.6% . The special treatment of qualified dividends as capital gains will also expire. Absent Congressional action, qualified dividends will go from being taxed at a preferential 15% rate to being taxed as ordinary income (potentially at up to a 39.6% rate).
Additionally, the 2003 act lowered the tax rate on capital gains to 15% (0% for taxpayers in the lowest income tax brackets). Beginning in January, the federal tax rate on long-term capital gains will increase. The rates will increase to 10% for taxpayers in the lowest income tax bracket and 20% for other taxpayers (there are certain exceptions for property held more than five years and purchased after December 31, 2000).
The 0% and 15% capital gains rates for the AMT will expire along with the offset of the child tax credit and the AMT preference for excluded gain on the disposition of qualified small business stock. As a result, more taxpayers will be subject to AMT.
Certain expensing limitations for depreciable property will be reduced. Currently, the expensing limitation is $139,000 (with a phaseout threshold of $560,000). However, for tax years after 2012, the limitation is reduced to $25,000 and the phaseout threshold is $200,000.00. The availability of an additional 50% first-year bonus depreciation also expires at the end of this year. The current option to elect to accelerate AMT credits in lieu of bonus depreciation also expires this year.
Expiration of payroll tax cut
The reduced 4.2% tax rate for the employees' portion of the Social Security payroll tax expires at the end of this year. The rate beginning on January 1, 2013 will be 6.2%. There has been no indication by the administration that they intend to extend these benefits.
Introduction of 3.8% tax on net investment income
The new 3.8% tax (referred to as the Unearned Income Medicare Contribution) on investment income applies to most joint filers with adjusted gross income above $250,000 and single filers with adjusted gross income above $200,000. The tax is essentially a flat tax at a 3.8% rate on investment income above the $250,000/$200,000 threshold. The tax applies to the following: dividends; rents; royalties; interest, except municipal-bond interest; short and long-term capital gains; the taxable portion of annuity payments; income from the sale of a principal home above the $250,000/$500,000 exclusion; a net gain from the sale of a second home; and passive income from real estate and investments in which a taxpayer does not materially participate. Although the tax applies only to investment income above the threshold, other income (including wages or Social Security) can increase a taxpayer's adjusted gross income above the threshold, exposing the taxpayer to this tax.
Medicare surcharge tax of .9% on higher income households
Beginning after December 31, 2012, the Medicare tax rate will increase by .9 percent (from 1.45 percent to 2.35 percent) on wages for certain employees (i.e., those with wages over $200,000 for single filers, wages over $250,000 for joint filers, and wages over $125,000 for persons who are married but filing separately). According to the Internal Revenue Service's Questions and Answers for the Additional Medicare Tax (issued in June 2012), employers are required to withhold this additional Medicare tax if an employee receives wages of more than $200,000 from that particular employer. Employers are not required to consider a spouse's wages or whether an employee earns wages at a second job. There is no employer match for the additional Medicare tax, and there is no requirement that an employer notify employees when it begins withholding the additional Medicare tax. An employer is required to begin withholding the tax in the pay period in which it pays wages in excess of the applicable threshold to an employee.
The Internal Revenue Service has indicated that it does not intend to add additional boxes to Form W-2 for the additional Medicare tax on wages in excess of $200,000. Employers will report aggregate Medicare wages in Box 5 and the aggregate Medicare tax in Box 6.
Reduction in estate and gift tax exemption
Currently, the estate, gift, and generation-skipping transfer tax rate is 35% and taxpayers have an exemption amount of $5.12 million (adjusted for inflation). As a result, individuals can make a tax-free transfer of a maximum of $5.12 million to reduce their estates. Additionally, if an election is made, the unused estate tax exemption for the first spouse to die can be transferred to the surviving spouse (i.e., the surviving spouse's exemption amount is increased by the deceased spouse's unused exemption amount). Unless Congress acts, the estate, gift and generation-skipping transfer tax rules in place in 2000 will return. Under these rules, the maximum exemption amount will be reduced to $1 million on January 1, 2013. Additionally, the maximum estate tax rate will increase to 55%.
The likelihood of higher tax rates beginning in January makes it even more important to undertake year-end tax planning. Although specific actions for any taxpayer must be determined after careful consultation and planning, the following provides thoughts on actions that may help save tax dollars if action is taken prior to the end of the year.
Year-End Tax Planning Considerations for Individuals
- "Increase the amount you set aside for next year in your employer's health flexible spending account (FSA) if you set aside too little for this year. Keep in mind that beginning next year, the maximum contribution to a health FSA will be $2,500. And do not forget that you can no longer set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids.
- "If you become eligible to make health savings account (HSA) contributions late this year, you can make a full year's worth of deductible HSA contributions even if you were not eligible to make HSA contributions for the entire year. This opportunity applies even if you first became eligible in December. In brief, if you qualify 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. "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 large gains, such as stock, or a vacation home, try to complete 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 as noted above. And if your 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) will be exposed to an extra 3.8% tax (the so-called "unearned income Medicare contribution tax").
- "If you are in the process of selling your primary home, and expect your long-term gain from selling it to substantially exceed the $250,000 home-sale exclusion amount ($500,000 for joint filers), try to close before the end of the year (again, with due regard to market conditions). This can save capital gains taxes if rates go up and can save the 3.8% tax for those exposed to it.
- "You may want to lock in a 15% tax rate on the gain with respect to stock that has appreciated, but you think the stock still has room to grow. In this situation, consider selling the stock and then repurchasing it. You will pay a maximum tax of 15% on long-term gain from the stock you sell. You also will wind up with a higher basis (cost, for tax purposes) in the repurchased stock. If capital gain rates go up after 2012 and you later sell the stock at a profit, the total tax on the 2012 sale and the future sale could be lower than if you had not sold this year and had just made a single sale in the future. This move will reduce your tax bill after 2012 if you are subject to the extra 3.8% tax on unearned income.
- "Consider making contributions to Roth IRAs instead of traditional IRAs. Roth IRA payouts are tax-free and not impacted by higher tax rates, as long as they are made: (i) after a five-year period, and (ii) on or after attaining age 59-1/2, 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 Roth IRAs this year to avoid a possible hike in tax rates next year. Also, although a 2013 conversion will not be hit by the 3.8% tax on unearned income, it could trigger that tax on your non-IRA gains, interest, and dividends. Reason: the taxable conversion may bring your modified adjusted gross income (AGI) above the relevant dollar threshold (e.g., $250,000 for joint filers). But conversions should be approached with caution because they will increase your AGI for 2012. And if you made a traditional IRA to Roth IRA conversion in 2010, and you chose to pay half the tax on the conversion in 2011 and the other half in 2012, making another conversion this year could expose you to a much higher tax bracket.
- "Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70-1/2. Failure to take a required withdrawal can result in a penalty equal to 50% of the amount of the RMD not withdrawn. If you turn age 70-1/2 this year, you can delay the first required distribution to 2013, but if you do, you will have to take a double distribution in 2013—the amount required for 2012 plus the amount required for 2013. Think twice before delaying 2012 distributions to 2013—bunching income into 2013 might push you into a higher tax bracket or bring you above the modified AGI level that will trigger a 3.8% extra tax on unearned income such as dividends, interest, and capital gains. However, it could be beneficial to take both distributions in 2013 if you will be in a substantially lower bracket in 2013, for example, because you plan to retire late this year or early the next.
- "This year, unreimbursed medical expenses are deductible to the extent they exceed 7.5% of your AGI, but in 2013, for individuals under age 65, these expenses will be deductible only to the extent they exceed 10% of AGI. If you have a shot at exceeding the 7.5% floor this year, accelerate into this year "discretionary" medical expenses (including elective procedures not covered by insurance) you were planning on making next year.
- "Consider using a credit card to prepay expenses that can generate deductions for this year.
- "Take an eligible rollover distribution from a qualified retirement plan before the end of 2012 if you are facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won't sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2012. You can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2012, but the withheld tax will be applied pro rata over the full 2012 tax year to reduce previous underpayments of estimated tax.
- "You may want to pay contested taxes to be able to deduct them this year while continuing to contest them next year.
- "You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
- "Make gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. You can give $13,000 in 2012 to each of an unlimited number of individuals but you can not carry over unused exclusions 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% tax in the hands of the donor.
Year-End Planning Considerations For Business Owners
- "If your business is incorporated, consider taking funds out of the business through a redemption of stock if you are in the position to do so. The redemption of the stock may result in a long-term capital gain or a dividend (subject to a number of factors). However, either way, the maximum rate will be 15% if it is done this year. Beginning on January 1st, long-term capital gains and dividends will be taxed at a higher rate, unless Congress acts. Additionally, if your 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 after December 31, 2012 (along with other types of unearned income, such as dividends and interest) will be subject to an additional 3.8% tax (the so-called "unearned income Medicare contribution tax").
- "Make expenses that qualify for the business property expensing option. The maximum amount you can expense for a tax year beginning in 2012 is $139,000 of the cost of qualifying property placed in service for that tax year. The $139,000 amount is reduced by the amount by which the cost of qualifying property placed in service during 2012 exceeds $560,000 (the investment ceiling). For tax years beginning in 2013, unless Congress makes a change, the expensing limit will be $25,000 and the investment ceiling will be $200,000. As a result, if you anticipate needing property in 2013, you may want to accelerate the purchase of that property into 2012 to obtain the benefits of the higher expensing deduction (if you are otherwise eligible to claim it). Property acquired and placed in service in the last days of 2012, rather than at the beginning of 2013, can result in a full expense deduction for 2012.
- "Put new business equipment and machinery in service before year-end to qualify for the 50% bonus first-year depreciation allowance. Unless Congress acts, this bonus depreciation allowance generally will not be available for property placed in service after 2012. (Certain specialized assets may, however, be placed in service in 2013.)
- "If you need a business vehicle, and a large heavy vehicle (those built on a truck chassis and rated at more than 6,000 pounds gross (loaded) vehicle weight) makes sense, consider buying it in 2012. Due to a combination of depreciation and expensing rules, you may be able to write off most of the cost of the vehicle this year.
- "Establish a self-employed retirement plan if you are self-employed and have not yet done so.
- "If you are thinking of adding to payroll, consider hiring a qualifying veteran before year-end to qualify for a work opportunity tax credit (WOTC). Under current law, the WOTC for qualifying veterans will not be available for post-2012 hires. The WOTC for hiring veterans ranges from $2,400 to $9,600, depending on a variety of factors (including the veteran's period of unemployment and whether he or she has a service-connected disability).
- "Increase your basis in a partnership or S corporation if doing so will enable you to deduct a loss from it for this year. A partner's share of partnership losses is deductible only to the extent of his partnership basis as of the end of the partnership year in which the loss occurs. An S corporation shareholder can deduct his pro rata share of an S corporation's losses only to the extent of the total of his basis in (a) his S corporation stock, and (b) debt owed to him by the S corporation.
Note: Rules that expired at the end of 2011 include, for example, the research credit for businesses, the election to take an itemized deduction for State and local general sales taxes instead of the itemized deduction permitted for State and local income taxes, and the above-the-line deduction for qualified tuition expenses. Rules that will expire at the end of this year include generous bonus depreciation allowances and expensing allowances for business, and expanded tax credits for higher education costs.
These are just some of the year-end steps that can be taken to reduce tax liability. By contacting us, we can tailor a particular plan that will work best for you.
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For more information contact the Tax Group at Lowndes, Drosdick, Doster, Kantor & Reed P.A.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.