Fiscal Cliff and 2012 Year-End Tax Planning
The final days of 2012 are one of the few times taxpayers can make decisions affecting their 2012 or future year income tax liabilities. This year, however, the differences in possible outcomes are more extreme than at any time I can remember. Let’s look at the 2012 income tax rules and proposed rule changes that may take effect after 2012, and discuss key tax planning strategies.
Taxes for 2012 and beyond
Tax rates for 2012 are divided into six brackets. Those with taxable income above $388,000 will be in the highest income bracket at 35 percent. The 10 percent bracket for the lower income taxpayers will be eliminated in 2013.
Capital gains taxes are levied on the sale of assets held more than one year. For 2012, those in the 10 and 15 percent tax brackets pay no capital gains tax. All other taxpayers pay 15 percent on capital gains. Capital gains tax rates will go up for all taxpayers for 2013 unless the law is changed.
Of great importance will be the change in tax rates for qualified dividends. Under 2012 rules, qualified dividends are taxed at a maximum of 15 percent (the same rate as capital gains). If these rates expire (as they are scheduled to do on December 31, 2012), dividends will be taxed at ordinary income tax rates.
|Ordinary Income Tax Rates||Capital Gains Rates|
Another big change is the employee portion of social security taxes on compensation, which has been 4.2 percent in 2012. The rate returns to 6.2 percent in 2013. An additional 0.9 percent Medicare tax will be levied on combined earned income above $250,000 for married couples filing jointly and $200,000 for single taxpayers.
Impact of the Affordable Care Act
Effective for 2013, taxpayers may be subject to a new 3.8 percent surtax on net investment income. The surtax will apply to those taxpayers whose income is over a “threshold amount” called Modified Adjusted Gross Income (MAGI). For single taxpayers, MAGI is $200,000; for other taxpayers, MAGI is $250,000. Income subject to the surtax includes taxable interest income, dividend income, rental income, royalties, annuities, capital gains from the sale of investment assets, and income from businesses where the taxpayer is not active in the business. Income not subject to this surtax includes salary and wages, income subject to self-employment income, business income where the taxpayer is active in the business, pensions, social security income, and distributions from IRAs and other qualified plans.
Here is an example:
- Warren, a single taxpayer, has $170,000 of investment income and received a $65,000 required minimum distribution (RMD) from his traditional IRA in 2013.
- The RMD is not “net investment income,” but it is included in MAGI, increasing MAGI to $235,000.
- The surtax applies to the lesser of: 1) net investment income (i.e., $170,000) or 2) the excess of MAGI over the $200,000 threshold amount for single taxpayers (i.e., $235,000 minus $200,000 or $35,000).
- Thus, $35,000 is subject to the surtax and the amount payable is $1,330 (.038 x $35,000).
Beware of the fiscal cliff
The fiscal cliff is the convergence of several laws that are set to take effect on January 1, 2013. These laws include the expiration of the tax cuts of 2001 and 2003, and the more recent cuts from 2009 and 2010; expiration of the 2 percent payroll tax cut; the addition of new taxes from the Affordable Care Act, and government spending cuts required by the Budget Control Act of 2011. The estimated impact of the fiscal cliff includes a tax increase of $500 billion in 2013 (Tax Policy Extender Study). This is an average of $3,500 per household and will be felt by 90 percent of Americans. Average marginal tax rates will increase by 5 percent on labor income, 7 percent on capital gains, and more than 20 percent on dividends.
Assume that a taxpayer has wages of $400,000, interest income for $100,000, qualified dividends of $100,000, and long-term capital gains of $100,000. Under 2012 tax laws, the federal income tax liability (including FICA) would have been $190,000. Under the 2013 laws (unless Congress and the president act to change them), the income tax increases by $60,000 to $250,000. This is roughly a 31.5 percent tax increase. The primary increases relate to the increase in tax rates, compression of the tax brackets, the taxing of qualified dividends at ordinary tax rates, and the Medicare surtax on passive income.
Perhaps a more typical example would be a married couple with three children, “normal” itemized deductions, and income of $100,000 from a sole earning spouse. In this example, the gross income tax owed for 2011 was $7,779. After a $3,000 child tax credit and a $1,500 education credit, the final tax amount was $3,279. For 2012, the couple’s tax is currently scheduled to increase to $4,860 unless Congress extends the increased exemption amount in the alternate minimum tax (AMT) patch. If the patch is extended (which should happen, but may not), the actual tax owed would be $3,184.
For 2013, this family’s total tax bill under the same facts is estimated to be $5,860 — an increase of almost $2,600 from 2011 (a 79 percent increase). In addition, their FICA tax would increase by $2,000. Although a much smaller number than the first example, this is a much higher percentage increase in tax. The primary reason for the large increase is the child credit being reduced from $1,000 per child to only $500 per child.
A third example is a sole earning spouse with income of $150,000 and a $50,000 long-term capital gain resulting in the total federal tax bill going from $26,625 in 2011 to $34,375 in 2013 — an increase of $7,750, or about 29 percent.
Planning opportunities for 2012
This might be the year to accumulate income, especially capital gains and dividends. Consider selling property or securities in 2012 to maximize capital gains. Generally, the strategy is to delay recognition of gains and accelerate capital losses. Capital gains are taxed at 15 percent in 2012. Rates in 2013 might be 20 percent, plus the new net investment income tax of 3.8 percent for an effective capital gains rate of 23.8 percent.
Accelerating capital gains at a lower tax rate can produce an "investment return.” Assume there is a taxpayer who has held XYZ stock several years, and the stock has a basis of $50,000 and fair market value of $100,000. If the taxpayer sells the stock in 2012, the tax due on the long-term capital gain is $7,500 (15 percent). If the taxpayer repurchases the stock the next day, and the stock value grows at five percent per year (under the scheduled 23.8 percent capital gains rate), this chart shows the taxpayer’s potential “return on investment” (ROI) on the $7,500 tax investment, depending on the year of the second sale. ROI here reflects the benefit of the income tax saved by paying the capital gains taxes at the 2012 federal rates.
Naturally, gain harvesting isn’t always the best option. Here are some rules of thumb to use as guidelines for when best to consider.
|Rules of Thumb — Gain Harvesting|
|Situation||Favorability of gains harvesting|
|Taxpayer in the 0% long-term capital gains bracket in 2012 recognizes additional gain, but keeping taxable income below the level at which the 25% tax rate applies.||Gain harvesting will always be favorable from a tax perspective because it gives you a free basis step-up.|
|Taxpayer plans to die with assets and pass them on to heirs with a stepped-up basis.||Gain harvesting unfavorable because any gain would have been wiped out at death.|
|Taxpayer has realized loss carryovers from prior years.||Losses would be better used to offset gains in later years when long-term capital gains rates are higher.|
Selling a business in 2012
For business owners that are selling or have sold their business in 2012, consider electing out of the installment sale rules to accelerate capital gains at the lower 2012 rate. Installment sales collected in later years are likely to be taxable at the higher capital gain rates applicable in the year of collection.
Other strategies include:
- Capture 15 percent capital gains tax rate in 2012 by selling appreciated assets to other family members.
- Consider disposing of existing installment sale obligations to trigger the deferred gain in 2012.
- Maximize dividends to exploit favorable tax rates. Extract liquidity from closely held C corporations including redemptions treated as dividends.
S corporations might consider electing to treat distributions as dividends of former C corporation earnings and profits. Consider exercising non-qualified stock options in 2012 to avoid the 0.9 percent Medicare tax and higher tax rates in 2013.
There are a number of methods available to accelerate the taxation of ordinary income including: accelerate the collection of receivables for cash basis taxpayers; year-end bonus timing; exercise incentive stock options (exercise and dispose of stock); IRA or retirement plan distributions can be accelerated in some cases; and elect to report income from EE U.S. Bonds in 2012.
Individual taxpayers are on a "cash basis" for the timing of payment for deductible expenses. Charitable contributions are deductible in the year the gift is made. If tax rates are increasing in 2013, deductions in 2013 will have more value in saving taxes. For example, if a taxpayer gave $1,000 to charity in 2012 and was in the top federal tax bracket, the tax savings is $350 ($1,000 x 35 percent). If the same taxpayer is in the 39.6 percent bracket in 2013, the tax savings increases to $396 ($1,000 x 39.6 percent).
How we can help
This year, perhaps more than ever, it is important to review your income tax situation and plan wisely for those transactions you can control. The tax cost savings can be significant.