Can you remember a time when year-end tax planning was more difficult? I can’t.
Normally, year-end tax advice is straightforward and goes like this: Look for ways to pay additional tax-deductible expenses in December (so they’ll lower this year’s tax bill) and push to January income you’re expecting to receive soon (so the money won’t raise your taxable income this year).
That makes sense when you’re confident that your tax bracket and the write-off rules will be the same in the year ahead.
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The Fiscal Cliff Creates Confusion
But uncertainties about the outcome of the "fiscal cliff" negotiations mean that no one knows the following about taxes in 2013: what the tax rates will be; how dividends, interest and capital gains will be taxed; which deductions will be capped or eliminated, if any; and how large gifts and estates can be before they’re taxed.
In this topsy-turvy environment, you might be better off turning the conventional year-end advice on its head if your bracket will be higher next year, says John Hewitt, chief executive of Liberty Tax Service, a national tax preparation firm based in Virginia Beach, Va. Such a scenario seems likely for upper-income taxpayers, who could see their tax rate rise from 35 percent to as high as 39.6 percent.
In that case, you’d want to declare all potential income this year, when it will be taxed more lightly, and postpone deductible expenses until 2013, when write-offs would be more valuable. Hewitt says individuals with incomes over $200,000 and couples with incomes exceeding $250,000 may want to accelerate income into 2012 because they’ll be socked with a new 3.8 percent tax on investment income next year, due to a provision in the Obamacare law.
“The fiscal cliff does make year-end tax planning harder,” says Lisa Greene-Lewis, TurboTax’s blog editor, who is based in San Diego. “But there’s nothing on the table for things like investing in a 401(k) in 2012.”
8 Year-End Tax Moves To Consider
She’s right on both counts. That’s why given everything we don’t know, I’m restricting my year-end tax planning recommendations to eight strategies that make sense based on what we do know:
1. Rough out your 2012 taxes to see whether you’re likely to owe the IRS money or get a refund. This estimate will let you see how year-end moves could help lower your tax bill. Turbotax has a nifty free online tax calculator called TaxCaster (there's also a free TaxCaster app for the iPhone, iPad and iPod Touch).
The TaxCaster even lets you run your numbers depending on whether Congress does or doesn’t “patch” the Alternative Minimum Tax, or AMT. The AMT is a special set of rules that could ensnare millions of unwitting taxpayers unless legislators step in to prevent that. “Congress has passed the AMT every year since 1969,” Greene-Lewis says.
2. If you have a flexible spending account, or FSA, for health expenses at work, use every penny of it before January. Otherwise, the tax-free money you’ve put into the account will disappear, since FSAs operate on the “use it or lose it” principle.
Keep in mind, as Lani Luciano wrote in “Flexible Spending Account Tips for 2013,” that FSA contributions will be limited to $2,500 next year.
3. Load up on charitable contributions by Dec. 31 if you expect to itemize deductions on your 2012 return. For anyone who’s not in a top bracket, you needn’t worry that your tax rate will rise next year. So there’s no point in saving this write-off for 2013.
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And if you’re in one of the higher brackets, you may well find that Washington limits your charitable contributions starting in 2013. So you may want to claim the tax break in 2012 while it’s still a sure thing. Concerns over a curb in charitable deductions have led to a run on donor-advised funds, a tax-favored way to donate, as detailed in a recent Next Avenue article.
4. Try to put more money in your 401(k) plan before year’s end. The maximum contribution for these tax-deferred retirement savings plans in 2012 is $17,000 if you’re under 50 and $22,500 if you’re 50 or older. If you haven’t hit that limit and can afford to sock away a little more this year, ask your benefits department if you can make a lump-sum contribution before January. You’ll lower your 2012 taxable income this way.
5. If you’re self-employed, look into opening a tax-deductible Solo 401(k) plan before Jan. 1. Unlike an IRA and other self-employment retirement plans, you need to open a Solo 401(k) by December 31 to qualify for tax-deductible contributions in 2012. You can invest up to $50,000 ($55,500 if you’re 50 or older); if you employ your spouse full-time, each of you can contribute that amount. You have until the date you file your tax return to make your 2012 contributions. But you can’t have a Solo 401(k) if you have any employees aside from a spouse.
6. Consider converting your traditional IRA to a Roth IRA if you’re confident your tax rate will rise after 2012. You’ll have to pay taxes on the regular IRA’s earnings and pre-tax contributions, but future earnings won’t be taxed when you withdraw money from the Roth IRA and you’re in a higher bracket.
Paul Palazzo, managing director for the Altfest Personal Wealth Management financial planning firm in New York City, says converting to a Roth IRA this month could be a smart move if you’re in a low tax bracket in 2012 but expect that status to change.
“For example, if you have retired but are not yet receiving Social Security benefits or distributions from IRAs or other tax-deferred accounts, you may find an opportunity in a Roth IRA conversion,” Palazzo says. Consult a financial adviser before making such a move, though, to be sure it makes sense for you.
7. See whether you’ll save on taxes by paying for some discretionary medical expenses this year. Currently, you can deduct medical costs if they exceed 7.5 percent of your adjusted gross income and you itemize. But a little-known provision in the Obamacare law will raise that threshold, beginning in 2013, to 10 percent of income for anyone under 65. (The 7.5 percent figure will remain for older Americans through 2016.)
(MORE: Flexible Spending Account Tips for 2013)
As Forbes noted, this change means that someone with $100,000 in income and $10,500 of medical expenses could claim a $3,000 deduction in 2012 but only $500 in 2013.
“If you have enough medical expenses in 2012 to be close or over the 7.5 percent threshold, it may be more beneficial to move expenses into 2012,” Hewitt says. You might buy prescription drugs or have a checkup in December, when you know you’ll still qualify for the write-off.
8. Make year-end gifts to your children or grandchildren. Under current law, you can give each beneficiary up to $13,000 in 2012 without incurring gift taxes; the federal estate tax exemption is $5.12 million (larger estates are taxed at 35 percent). A married couple could give away $104,000 to four kids or grandkids this year without setting off the gift tax. The gifts would also remove $104,000 from their taxable estate.
Next year, the estate tax exemption is scheduled to fall to $1 million and assets over that amount would be taxed at a 55 percent rate. President Barack Obama has proposed setting the estate tax exemption at $3.5 million and the estate tax rate at 45 percent. That’s more likely to happen than Congress extending the current estate tax rules, according to John O. McManus, an estate lawyer with McManus & Associates in New Providence, N.J.
But no one can say for sure what the outcome of the fiscal cliff negotiations will be. So estate planners recommend taking advantage of the estate and gift tax laws on the books this year. Making gifts to your kids or grandkids in December might not only save you taxes, it could help brighten their financial futures, too.