Some Tax Tips for Dealing with the Fiscal Cliff

Some Tax Tips for Dealing with the Fiscal Cliff

If the President and Congress do not act before the end of the year, the Bush-era income tax cuts will expire along with the December 2010 transfer tax increases (estate, gift, and generation-skipping transfer [GST] taxes). Here is a list of some of the key changes and some consequent tax planning strategies.

Here are the potential tax increases:

  • The 10% income tax bracket will be eliminated and the rates in the current 25% and higher income tax bracket will all increase.
  • The marginal income tax rate for top earners will increase from 35% to 39.6% together with a Medicare surtax (discussed below).
  • The long-term capital gains tax rate will increase from 15% to 20%.
  • Dividends will be taxed as ordinary income instead of at 15%. For top earners, this means dividends will be taxed at 39.6% plus the Medicare surtax.
  • Lower income bracket taxpayers (those now in the 10% and 15% brackets) will no longer be exempt from paying tax on capital gains and dividends.
  • The estate tax exemption will go from $5.12 million to $1 million. Assets over the exempt amount, currently taxed at 35%, will be taxed at graduated rates starting at 35% and going up to 55%. This means more assets will be taxed at higher rates.
  • The same thing will happen to the gift tax exemption.
  • The generation-skipping transfer tax (GST) exemption will go from $5.12 million to $1 million, adjusted for inflation, and the rate will increase from 35% to 55%.
  • A 0.9% Medicare surtax on a taxpayer’s wages over $200,000 if single, $250,000 for joint filers. Withholding begins when earnings exceed $200,000 regardless of marital status. This additional tax also applies to net earnings from self-employment.
  • A 3.8% Medicare surtax on net investment income for singles with MAGI (modified adjusted gross income) over $200,000 ($250,000 for joint filers. This tax applies to the lower of total net investment income for the year or MAGI over the applicable threshold.
  • Itemized medical expenses will be deductible only to the extent they exceed 10% of AGI. Taxpayers age 65 and older can continue to use the 7.5% AGI floor through 2016. The 10% floor continues to apply for AMT purposes.

On the good side, there will also be the usual cost of living increases to the tax brackets and to exemptions, exclusions, and deductions. However, the itemized deduction phase-out will apply again unless the Bush-era tax cuts are extended. Some notable improvements are higher IRA and Roth contribution limits ($5,500) and a higher annual gift tax exclusion ($14,000).

Here are some tax planning steps you can take in 2012 to mitigate some of the changes:

  • Consider selling assets in 2012 if you will need the proceeds over the next several years. A $100,000 long-term gain in 2012 will generate $15,000 in taxes; but the same gain in 2013 will generate about $25,000 in taxes as a consequence of scaled-back itemized deductions, the 3.8% surtax and a higher capital gains rate.
  • In taxable accounts, sell and then buy-back stocks and mutual funds help more than one year so as to increase the amount of capital gains for 2012 and decrease them for future years when rates go up. Remember that the wash-sale rule does not apply to gains (I wrote about this in a previous blog).
  • Consider selling investment real estate in 2012 (although if you haven’t done so by now, it’s probably too late).
  • Sell vested company restricted stock held more than one year.
  • Pull interest income into 2012 and push interest expense into 2013 where possible, especially if you are in a top tax bracket.
  • Consider converting some portion of your IRAs into Roth IRAs.
  • If you own a business, you should purchase machinery and equipment before the end of 2012 (the Section 179 deduction is set to decline in 2013 to $25,000 and the 50% bonus depreciation to end).
  • If you own a C corporation, you should determine whether to pay more dividends in 2012 if no deal is struck in Washington that will extend their current favorable treatment. In addition, watch for excess accumulations, and authorize charitable contributions before year end (C corporations can deduct them if paid within the first 2 1/2 months of 2013).

There are also a number of estate planning strategies you can follow, but they are too complex and varied to be communicated here. The bottom line: you should already be consulting with your tax consultant or financial planner given the magnitude of the tax changes. They may or may not constitute a fiscal cliff but they are certainly worth preparing for.

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