With less than half the year left and a presidential election in November, we again face an uncertain tax environment.
The so-called "Bush tax cuts," which include income tax rates ranging from 10 to 35 percent, a top capital gain and dividend rate of 15 percent, favorable estate and gift tax rules, and other provisions, are set to expire at the end of 2012. If Congress takes no action, overall tax rates in 2013 will increase and a variety of tax-related provisions will change:
- The top income tax rate, currently 35 percent, will increase to 39.6 percent.
- Long-term capital gains and qualified dividends will no longer be subject to a maximum 15 percent tax rate. Instead, long-term capital gains will be taxed at 20 percent and qualified dividends will be taxed at ordinary income tax rates (as high as 39.6 percent).
- Income limits on itemized deductions and personal exemptions will be reinstated, which means these benefits will be phased out for higher-income taxpayers.
- The so-called "marriage penalty" will return.
- The maximum federal estate and gift tax rates will increase to 55 percent, with the exemption amounts decreasing to $1 million.
Additionally, there are two new taxes that will be levied on higher-income taxpayers starting in 2013 resulting from the healthcare overhaul that passed in 2010:
- A Medicare surtax of 3.8 percent on investment income such as interest, dividends and capital gains for individuals with a modified adjusted gross income (MAGI) of more than $200,000 ($250,000 if married and filing jointly).
- A 0.9 percent Medicare tax on wages and self-employment income over $200,000 or single individuals and $250,000 for married couples filing jointly. This additional tax applies only to the employee share of Medicare tax and the employee portion of the Medicare tax within the self-employment tax.
Because 2012 is an election year, there is no consensus as to what will happen next. President Obama is currently in favor of increasing tax rates only for higher-income taxpayers and extending much of the current tax law; Presidential candidate Mitt Romney is proposing a reduction in all tax rates, with a top ordinary income tax rate of 28 percent, and the elimination of the estate tax.
How should this uncertainty impact your tax planning for 2012 and after? In light of these and other potential developments, below are some tax-smart strategies to consider now:
- Accelerate Ordinary Income
With tax rates currently at historically low levels, it may make sense for some taxpayers to recognize more income in 2012, either by receiving it prior to year end and/or by deferring deductions into 2013. Some strategies to consider include:
- Converting a traditional Individual Retirement Account (IRA) to a Roth IRA. Taxes on the amount converted are generally due in the year of the conversion. However, after that investment earnings compound tax free and can be distributed tax free during retirement.
- Realize long-term capital gains. By selling appreciated stock in 2012, you'll be able to take advantage of the 15 percent long-term capital gains rate. You'll also avoid the 3.8 percent Medicare surtax that is slated to become effective in 2013.
- Make dividend payments. If you're the owner of a C-Corporation or an S-Corporation with prior C-Corp earnings, consider making dividend payments this year rather than next. Starting in 2013, qualified dividends will be taxed at ordinary income tax rates.
- Accelerate Deductions
Because itemized deductions may be phased out for higher-income taxpayers come 2013, it may make sense to take any deductions you have available in 2012, subject to your alternative minimum tax (AMT) status. These may include:
- Prepaying mortgage interest or property taxes
- Making charitable contributions
- Scheduling elective medical procedures if they entail significant out-of-pocket cost
- Consider Lifetime Gifts
Currently, there is a $5.12 million exemption amount for transfers made during life or at death. What the estate, gift and generation skipping transfer (GST) tax rules will be after 2012 remains to be seen. As a result, now may be a good time to consider shifting significant wealth from your estate through lifetime gifting. Gifting assets in 2012 removes those funds, as well as any future appreciation, from your estate, avoiding potentially higher estate taxes and lower exemption amounts in the future.
Between now and the end of the year, individuals can also make tax-free gifts up to $13,000 per individual ($26,000 for married couples) per recipient without eroding the lifetime exemption amount. Those who want to add funds to a child's or grandchild's 529 college savings plan can do so to optimize lifetime transfers. A contribution of as much as $65,000 can be made gift-tax-free in a single year under a special rule.
- Review Estate Plans
Regardless of whether lawmakers extend the current gift and estate tax exemptions or allow them to lapse, adding flexibility to your estate plan is important. For many, 2012 may be an opportune time to consult with an attorney, accountant and wealth management advisor to make sure all elements of your estate plan are in place and up to date.
Depending on the outcome of the November 6 election, significant changes may be on the horizon for 2013. Regardless of what happens next, there are still many strategies available to help you diversify your tax risk and prudently manage your assets. To learn more, contact a Northwestern Mutual Wealth Management Advisor. He or she can help you explore your options and create an integrated plan that encompasses your needs and objectives for your family and future generations.