Income Tax Planning for 2012-2013

It’s time to sharpen your pencils or tighten up your spreadsheets. Income tax planning for 2012 and 2013 is likely to be more important and trickier than in the previous few years. Key provisions expired at the end of 2011. Others expire at the end of 2012. New provisions are kicking in. And Congress could act at any time to extend any of the provisions, create new tax rates after 2012, or both.

Here are the key provisions that expired at the end of 2011:

– The alternative minimum tax (AMT) “patch” that exempted many middle class people from the AMT by increasing the exemption amount.

– The use of some personal tax credits against the AMT.

– The above-the-line deductions for qualified tuition and related expenses and for elementary and secondary school teacher expenses.

– The optional itemized deduction for state and local sales taxes instead of income taxes.

– The deduction for qualified mortgage insurance premiums.

– The higher exemption for employer-provided parking benefits.

– The 100% bonus depreciation and expanded section 179 first-year deduction for business equipment purchases.

– Various energy incentives for businesses and homes and appliance purchases.

– Tax-free distributions for charitable contributions from IRAs of those over age 70½.

Congress could retroactively restore some or all of those tax breaks at any time, or it could take no action.

You probably recall that in December 2010 President Obama and congressional leaders agreed to extend the Bush income tax breaks and increase the estate and gift tax exemptions to $5 million through the end of 2012. If no action is taken by the end of 2012, the pre-Bush income and estate tax laws will be restored. That would mean a top income tax rate of 39.6%, corporate dividends being taxed as ordinary income, and the long-term capital gains tax rate rising to 20%. The estate tax exemption would fall to $1 million.

Coming in 2013 is the new Medicare surcharge of 3.8% on passive income of higher-income taxpayers. It kicks in for married couples with incomes above $250,000. Expect IRS regulations on whether this applies to items such as capital gains from the sale of a first or second home.

Here’s my view of the most likely outcome.

Most of the key expired provisions will be extended for 2012 and 2013. Those not likely to be extended are the business equipment write offs. The Bush tax rates also are likely to be extended. The $5 million estate tax exemption and the portability of the exemption for married couples should be extended, too.

Those are the likely outcomes, but the outcome probably won’t be clear until late in the year, perhaps as late as December. Both parties will use the tax code as part of their political campaigns, so at least one party and probably both won’t find it expedient to make a deal before the election in November.

You need to build a contingency plan and be ready to put that plan into place later in the year once an outcome is clear.

The most logical contingency plan assumes no deal is reached. None of the expiring provisions for either 2011 or 2012 is restored and tax rates will rise in 2013. In that case, the most logical actions are to pack income into 2012 and let deductions slide into 2013 to the extent you can. You don’t want to go overboard, and you should wait to pull the trigger until later in the year when Congress’s action might be clearer. Here are some actions to consider.

Move income forward. When you’re working, look for opportunities to move some 2013 income into 2012, such as early receipt of bonuses and deferred compensation. Others should consider increasing distributions from annuities and retirement accounts.

Take long-term capital gains. When you’re considering the sale of an asset with significant long-term capital gains over the next few years, consider making the sale in 2012. There’s likely to be a lot of year-end selling in 2012 for tax reasons, so don’t wait too long for this one or you’ll receive a lower price. If you’re a high-income taxpayer, remember in 2013 you could face not only the higher capital gains rate but also the 3.8% Medicare surtax.

Reconsider dividend investments. Investors flocked to high-dividend stocks in 2011 because dividend yields were higher than many bond yields, and companies tend to increase dividends over time. If dividends lose their 15% maximum tax rate, the after-tax yield from the stocks will decline dramatically. The stocks might, too.

Delay some expense payments. This year it might make sense to delay paying deductible December bills until January 2013, when the expenses might be deducted against a higher tax rate. Mortgage interest, medical expenses, and real estate taxes are prime candidates for this strategy. Be sure delaying payment doesn’t incur a penalty.

Defer charitable contributions. Your deductions are more valuable in 2013 than in 2012 if your tax rate rises. Charities won’t like it, but it could be to your benefit to make some of your intended 2012 contributions in 2013 along with regular 2013 contributions.

Donate appreciated investments in 2013. You can donate property with long-term capital gains to a charity. You deduct the current fair market value of the property, up to 30% of your adjusted gross income. If capital gains rates rise, it’s a good strategy for 2013.

Conserve capital losses. Losses on capital assets offset capital gains, and any additional losses can be deducted against other income up to $3,000. Unused capital losses can be carried forward to future years. Because of the potential for tax rates on both capital gains and ordinary income after 2012, you might want to wait to hold off selling some losing investments until 2013 so they can offset higher tax rates.

Always beware of the alternative minimum tax. Don’t implement a strategy until determining how your taxes are changed under both the regular tax and the AMT. This is especially important if Congress doesn’t reinstate the higher AMT exemption that kept many people from paying the AMT.

Another potential trap is the limitation on itemized deductions for higher-income taxpayers. This limit has been suspended the last few years but will be reinstated if Congress fails to take action before the end of 2012 or if it decides to reinstate the limit as part of a new tax law. Under it, upper middle income taxpayers lose some of their itemized deductions, losing a greater percentage of them as income rises.

A third trap is to focus too much on the tax law and not enough on good investment and financial strategies. You don’t want to avoid doing the right thing overall to save a few dollars on taxes.

A final trap is Congress could agree to a major tax reform this year that lower rates and reduces deductions. In that case, I’ll be back with an update, but the best plan probably would be the reverse of the advice above.

RW February 2012.