Year-end tax strategies for 2012 are complicated due to the ongoing uncertainty around the “fiscal cliff.” However, one fact is definite: An effective tax plan is specific to a taxpayer’s individual situation. Without the extension of the Bush tax cuts, one can be sure that tax rates will increase in 2013. Being armed with knowledge is the best defense in the present environment of uncertainty, and year-end tax planning need not be one’s worst nightmare.
An informed taxpayer should be aware of several 2012 year-end tax moves before meeting with a tax advisor. Some of these year-end tax tips involve increasing “above-the-line” deductible items, those subtracted towards AGI, and timing expenses to increase “below-the-line” deductions. Other strategies involve the timing of income recognition, if possible.
Increase Above-the-Line Deductions
As stated, these deductions are subtracted directly from gross income to reach AGI. Many itemized deductions are “phased out” based on the AGI figure. Therefore, by taking advantage of above-the-line deductions, a taxpayer may be able to increase the amount of itemized deductions. Reducing AGI is particularly important for higher-income taxpayers, as many itemized deductions can be reduced or even eliminated based on AGI.
One common tactic is to fund, to the permitted maximum, retirement accounts that allow the contributor to deduct the contribution. A taxpayer can make a 2012 contribution to fund a Traditional IRA up until the filing deadline in 2013 and still take the deduction on the 2012 tax return. Individuals over age 50 can make “catch up” contributions to increase their deduction. By making a deductible IRA contribution along with a deductible contribution to an employer-sponsored retirement plan, an individual could subtract an impressive amount directly from gross income. The combined deductible amounts could total $22,000 for those under age 50 and $28,500 for those age 50 and above.
Also, fund health savings accounts to the maximum allowed. Remember too that self-employed individuals can deduct the premiums for high-deductible health insurance as an above-the-line deduction.
Pay Below-the-Line Expenses
These are the itemized deductions and include medical and dental expenses, mortgage interest expense, sales tax or state income tax, real estate taxes, charitable contributions and various miscellaneous deductions. In many instances, it is possible to time the payment of below-the-line expenses.
Interest on mortgage debt is deductible when paid, so a taxpayer can make additional mortgage payments prior to the end of 2012. Real estate taxes can also be paid in advance and deducted. Another 2012 year-end tax move is to pay medical expenses before December 31. In 2013, these expenses will be more difficult to deduct, as they will need to exceed a higher percentage of AGI.
One can also make year-end charitable contributions to increase itemized deductions. If the tax rates do increase in 2013, it may be more beneficial to make these contributions next year and take the benefit to reduce 2013 taxable income. However, if a taxpayer loses part of a 2012 contribution deduction due to AGI limitations, the remaining contribution amount can be spread, carried forward, for five more years.
What About Income?
In addition to increased Medicare taxes on earned income for higher-income taxpayers, a Medicare tax of 3.8 percent will also be assessed on unearned income at higher-income levels. This means that interest, dividends and capital gains will be subject to Medicare tax. The 3.8 percent Medicare tax applies to joint taxpayers who have unearned income exceeding $250,000 and single taxpayers with unearned income over $200,000.
Given this, it may be advisable to sell appreciated stock, or other appreciated capital assets, and take the capital gain in 2012 when capital gain rates are lower. In 2012, the top capital gains rate is 15 percent. In 2013, the maximum capital gains rate could be 20 percent for stock held more than one year and 18 percent for assets with a holding period over five years. Combining the increased capital gains tax and the Medicare tax on unearned income, one’s tax on capital gains could be as high as 23.8 percent.
Alternatively, one can avoid paying capital gains tax on appreciated items held more than one year by donating them to charity. The taxpayer can take an itemized deduction for the fair market value of the asset.
If it is beneficial to convert a pre-tax retirement fund to a Roth IRA, it is wise to do so before year-end given the 2013 potential tax rate increases. In a Roth IRA conversion, taxpayers are trading the benefit of tax-deductible contributions now for the benefits of tax-free distributions at retirement. At conversion, the funds are taxed, and it is probably best to have them taxed in 2012.
Consult a tax advisor for more information about appropriate 2012 year-end tax moves.
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