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With certain tax deductions and credits due to expire at the end of 2012 (sunset provisions) and new higher tax brackets kicking in next year (the end of the Bush-era tax cuts), year-end tax planning is harder than ever.
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?
Example: For income taxed at a higher tax bracket next year, accelerating such income to 2012 results in less taxes being paid. At the same time, deductions and tax credits deferred into next year will become more valuable as they offset income taxed at a higher bracket.
However, life is never that simple. Tax law uncertainty, especially this year, makes for some real guesswork. As discussed below, when it comes to certain deductions that have tax threshold limitations, bunching of deductions to one year may force the timing into a tax year where the tax bracket is lower than the other tax year in question. Year-end tax projections must take into account the maddening Alternative Minimum Tax.
In any event, the following lays out the basic ideas for income acceleration and deduction/credit deferral in a rising income tax bracket environment.
For taxpayers who think that they will be in a higher tax bracket, here are some targeted forms of income to consider accelerating into 2012.
• 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.
• Sell appreciated assets. With capital gains being taxed at a higher rate in 2013, it may make sense to sell such assets before the end of the year.
Example: Mr. Appreciation has low basis stock that has appreciated by $200,000 as of December 2012. He thinks he will need to liquidate his positions either this year or next. His $200,000 gain will generate $30,000 in federal taxes in 2012 (15 percent tax). If Mr. Appreciation waits until 2013, the tax rate may be 25 percent (or more due to the 2013 higher capital gain rate and 3.8 percent surcharge and itemized deduction limitations) with a tax of $50,000 in 2013. As a result, a sale in 2012 may save $20,000.
Note, however, that for an older taxpayer or one in ill health, this strategy may not make sense, since there would be no capital gains (because of the step up in basis rules) if the assets passed through his or her estate.
Planning note: The wash sale rules do not apply when selling at a gain, so taxpayers can cash out their gains and then repurchase the securities immediately afterwards.
• Redeem U.S. savings bonds. Be aware that starting in 2013, a new 3.8 percent Medicare tax on unearned income, including interest, dividends and capital gains, will take effect. So cashing in these bonds may make sense in the proper situation.
• Complete Roth conversions. Taking into income the monies in IRA accounts in a year before your tax bracket is due to rise may make for some significant tax savings.
• Accelerate debt forgiveness income with your lender.
• Maximize retirement distributions. Remember the minimum required distributions are the amounts distributed each year to avoid the draconian 50 percent MRD penalty. However, taxpayers with IRAs can choose to take larger distributions this year to have such income taxed at a lower income tax rate than in 2013.
• Electing out or selling outstanding installment contracts. Disposing of your installment agreement may bring the deferred income into 2012 at a lower tax rate than anticipated in future years. It may be helpful to pay tax on the entire gain from an installment sale in 2012 by electing out of installment-sale treatment under Section 453(d) of the Internal Revenue Code, rather than deferring tax on the gain to later years. Conversely, in certain situations, installment-sale treatment may be a better option, since it allows for spreading of income over multiple years, which may keep taxpayers below the modified adjusted gross income threshold.
• Accelerate billing and collections. If you report income on a cash basis method of accounting, immediately sending out bills to increase collections before the end of the year may result in significant tax savings.
• Take corporate liquidation distributions in 2012. Senior or retiring stockholders contemplating the redemption or sale of their shares of stock in their corporation can save considerable taxes by selling their shares in 2012.
Deductions and Tax Credit Deferrals
• Bunch itemized deductions into 2013 and take the standard deduction into 2012. Note, however, that the AGI limitation rises to 10 percent in 2013 from the current 7.5 percent (except for those over age 65), so this limitation may dictate the opposite strategy in certain taxpayer situations.
• Postpone paying certain tax-deductible bills until 2013.
• Pay the last state estimated tax installment in 2013.
• Postpone economic performance until 2013 if you are an accrual basis taxpayer.
• Watch adjusted gross income (“AGI”) limitations on deductions/credits. For certain expenses such as elective surgery, dental work, and eye exams, it would be better to have it done in the year that you are already above the applicable AGI threshold. However, it may be better to incur these expenses in 2012 where the applicable AGI limit (7.5 percent) is lower than the 2013 limit (10 percent for those under 65). It all depends on the particular tax situation of each taxpayer.
• As mentioned above, watch the AMT. Missing the impact of the AMT can make certain year-end strategies counterproductive. For example, aligning certain income and deductions to cut regular tax liability may, in fact, increase AMT liability. It is very easy to have your tax planning backfire by missing the difference between the regular tax and AMT tax rules.
Example: Do not prepay state and local income taxes or property taxes if subject to the AMT. It will generate no income tax benefit.
• Watch net investment interest restrictions.
• Match passive activity income and losses.
• Purchase machinery and equipment before the end of 2012. The very generous current Section 179 deductions decline in 2013 to $25,000 and there is no 50 percent bonus depreciation in 2013.
Final Thoughts and Warnings
Remember that these are some of the customary year-end income tax strategies and are not all-encompassing. Taxpayers must take into account slated tax law changes for next year and last-minute tax laws enacted before year-end. Accelerating tax payments must take into account the impact on cash flow and the present value of money. This is why it is essential to “run the numbers” to find the best steps to reduce the impact of these new tax laws.
Also keep in mind that recent tax law changes, like the 3.8 Medicare tax that applies to 2013, bear heavily on income tax planning.
Most important, remember that income tax strategies depend on the specific income or expenses of each taxpayer and their overall income, gift and estate tax setting. This discussion offers some but not all tax strategies.
As always, it is quite beneficial for a taxpayer to have a tax professional look at the details of their particular income tax situation to carve out specific tax strategies to cut taxes owed.