Traditional tax planning has often been summarized and oversimplified into one phrase: “defer income and accelerate deductions.” Well, in light of the changes scheduled to occur Jan. 1, as well as our politicians acting like lemmings ready to go over the “fiscal cliff,” that may not be the best advice.
Starting next year, and without legislative action, the 2001 and 2003 tax cuts will expire, and new Medicare taxes enacted as part of health care reform will take effect.
The expiration will eliminate several benefits, including:
• Rate cuts across all income brackets
• The full repeal of the personal exemption and itemized deduction phase-out
• The top rate of 15 percent for capital gains and qualified dividends
• Marriage penalty relief and the $1,000 refundable child tax credit
In addition, there are Medicare tax changes and additions. First, the rate of the individual share of Medicare tax will increase from 1.45 percent to 2.35 percent on earned income above $200,000 for single, and $250,000 for joint filers. The 1.45 percent employer share will not change, creating a top rate of 3.8 percent on self-employment income. In addition, investment income such as capital gains, dividends and interest will be subject for the first time to a 3.8 percent Medicare tax to the extent income exceeds $200,000 (single) or $250,000 (joint).
Between rate increases and deduction decreases, the top combined rates on income jump to 24 percent for capital gains, 43 percent for dividends and interest, and more than 42 percent for earned income.
As we can see, it may not make the best sense to defer income into next year in light of these tax rate increases. Alternatively, it may make sense instead to defer deductions and actually accelerate income.
The easiest income to control is capital gains. You can trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. But if much of your net worth is tied up in one asset because you’re deferring the tax bill on a large gain, this might be a good time to reallocate that equity.
You may also be able to affect tax by timing how you exercise options. If you do not plan to hold incentive stock options (ISOs) long enough to qualify for capital gains treatment, you can exercise them and sell the stock before tax rates increase.
You can also consider a conversion from a 401(k) or traditional individual retirement account (IRA) to a Roth IRA now, while tax rates are low. Tax will be owed on the amount of the conversion now in exchange for no tax on future distributions if the conversion is made properly and certain other conditions are met.
You might also consider electing out of the deferral of gain available in an installment sale. Deferred income on most installment sales can be accelerated by pledging the installment note for a loan.
First, determine whether tax increases will apply to you. Tax increases are unlikely to affect any income below the income thresholds of $200,000 (single) or $250,000 (joint), and taxes may not increase at all.
Also, if you’re subject to the alternative minimum tax (AMT), you may not benefit from any acceleration in tax. In addition, economic considerations should always come before any tax-motivated sale. We strongly suggest discussing tax strategies within the context of your overall financial plan.
Lastly, let’s hope our political leaders prove our lemmings metaphor wrong and actually deliver some clarity to taxpayers in 2013.
Ron Tamayo, CFP, is a founder and partner with Moisand Fitzgerald Tamayo, LLC, a wealth management firm based in Maitland. He has been a financial planning practitioner for 25 years and currently serves on the Editorial Review Board of the Journal of Financial Planning. He can be reached at [email protected]