As the New Year approaches, we are in the midst of a highly uncertain period from a tax planning perspective. The “Bush-era tax cuts,” which I am sure everyone has heard of at this point, are set to expire on January 1, 2013. This means that everyone’s effective tax rates will increase. This newsletter is intended to help you mitigate the uncertainty surrounding these looming changes.
Changes Set to Occur on January 1, 2013
• An increase in the tax rate for the top income tax bracket from 35% to 39.6%.
• Marriage tax penalty relief for those in the 15% tax bracket will expire.
• An increase in the long term capital gains tax from 15% to between 18% and 20%.
• The preferential 15% tax rate for qualified dividends is set to expire, which means that they will be treated as ordinary income and taxed at each person’s marginal income tax rate.
• A decrease in the expense limit for new equipment purchases under Section 179 from $139,000 to $25,000. The 50-percent first-year bonus depreciation deduction is also set to expire for most types of assets.
• A reduction in itemized deductions, a phase-out of personal exemptions, and numerous other changes to deductions, credits, etc., including:
– Education expenses. The American Opportunity Tax Credit is set to expire. In 2012, the credit can be up to $2,500.
– Flexible Spending Arrangements. Contribution limits on FSAs under a cafeteria plan will be decreased to $2,500.
– Medical expenses. The threshold for deducting unreimbursed medical expenses will increase from 7.5% to 10% of adjusted gross income.
• The extremely favorable gift tax laws are scheduled to expire. The lifetime gift exclusion is set to decrease from $5.12 million to $1 million.
• An increase in the top estate tax rate from 35% to 55%, coupled with a decrease in the exemption amount from $5 million to $1 million.
• A new Medicare contribution tax which imposes a 3.8% surtax on certain unearned income (including interest, capital gains, and dividends) for those with adjusted gross income above $200,000 ($250,000 for married filing jointly). In addition, an additional 0.9% tax will be imposed on wages in excess of $200,000 ($250,000 for married filing jointly). These items are part of the Patient Protection and Affordable Care Act (commonly referred to as “ObamaCare”). Please note that ObamaCare will be enacted regardless of whether the Bush-era tax cuts are extended.
How You Can Prepare
• Adjust Your Income Tax Withholding. One strategy to avoid being surprised in 2013 is to adjust your income tax withholding. If the tax rates go up, so should your withholding. Keep in mind that the current 2% payroll tax (Social Security and Medicare) holiday is also scheduled to expire.
• Consider Recognizing Income Now, Rather Than Deferring to 2013. For most taxpayers, this should NOT be done until it is certain that no new legislation will be enacted prior to year-end. Taxpayers may want to recognize income in 2012 when lower tax rates are available, rather than deferring it to a future year. Also, higher income taxpayers should consider delaying deductions until 2013.
• Employee Bonuses Should Be Paid Prior to Year-end. To avoid increases in income tax and payroll tax and the additional Medicare taxes imposed by ObamaCare, employers should consider paying annual bonuses, as well as allowing the recognition of income on stock compensation plans, prior to December 31, 2012.
• New Equipment. Businesses should consider accelerating equipment purchases into 2012 to take advantage of the still generous Code 179 expensing and the bonus depreciation deduction.
• Harvesting Losses. Now is also a good time to consider loss-harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may be taxed at a higher rate). Also, do not forget about the wash-sale rules.
• Gifts. The annual gift tax exclusion is $13,000 for 2012. Married couples may make combined tax-free gifts of $26,000 to each recipient. Use of the lifetime gift tax exclusion amount ($5.12 million for 2012) should also be considered.
• Charitable Giving. Taxpayers should consider accelerating any anticipated charitable contributions into 2012, prior to the return of the “Pease Limitation,” which generally requires higher income individuals to reduce their tax deductions for charitable contributions.
• Medical Expenses. While many medical expenses cannot be timed for tax deduction purposes, batching expenses into 2012, when the deduction threshold is still 7.5%, may make it more likely that the expenses will exceed that threshold.
• State Taxes. Many states are increasing their income tax rates in 2013. For example, New York has approved a supplemental tax beginning in the New Year. Fortunately, there are also several potential new tax credits for 2013. In New York, there is talk of a tax credit for angel investments into start-up companies.
• Mortgage Refinancing. This is not really a tax issue, but it’s still good advice: consider refinancing the mortgages on your primary and secondary homes. Even if you refinanced in the last 6-12 months, there may be an opportunity to lower your monthly payments as interest rates have dropped significantly in 2012.
Although President Obama has claimed that he is “not wedded” to any particular provision in his most recently proposed tax plan, an actual compromise before year-end appears unlikely. Nevertheless, we can still take steps to prepare ourselves for the New Year.