8 Tax Changes That Could Affect You

By year's end, Americans usually have a good idea of what the tax rules will look like in the new year and can plan accordingly. That's not the case this time around. With a huge chunk of the tax code set to expire Jan. 1, the 2013 tax forecast is, well, foggy.

"The problem is, if you wait to see what Washington does before you give this any real thought, it might be too late to take any meaningful action," says Dan McNamara, president of USAA Investments.

Instead, you have to know the current tax landscape and what could be coming in 2013 -- and you have to understand what each could mean to you. That way, when Congress ultimately takes action -- or doesn't -- you'll be ready to act.

We do know the laws could change, and the changes could be big. And while the elections are over and President Obama is headed for a second term, America's near-term tax fate is in the hands of the current officeholders -- not the ones who will be sworn in late January. If President Obama and the House and Senate don't collaborate to extend expiring tax rate provisions by Dec. 31, Americans face a $500 billion tax increase in 2013, according to the Tax Foundation.

While President Obama and Congress wheel and deal, you can prepare for the outcome by knowing about eight key tax-code provisions that could change and the steps you may take to possibly lessen their impact on your finances.

1. Income Tax Brackets

Tax rates could increase for all Americans, with the lowest bracket rising from 10% to 15% and the highest from 35% to 39.6%. As a result of this change alone, a single individual with $30,000 of taxable income (the amount left after subtracting adjustments, deductions and exemptions) would have to pay $421 more in taxes in 2013.

What You Could Do

• If it looks as if your income tax bracket will increase in 2013, consider accelerating income into 2012, if possible. This is easier for business owners and the self-employed, who often can control the timing of their invoices and income, but it's something we should all have on our radar screens.
• On the other side of the coin, higher tax brackets in 2013 mean you may get a bigger bang for your deductions. If possible, consider delaying taking deductions until then. Also consider tax-exempt investments. Municipal bond funds, which focus on debt issued by state and local governments, can generate income that's not taxed by the federal government. Those in the 25% and higher tax brackets may benefit from shifting more of their bond investments into tax-exempt bond funds.
• If you planned to eventually convert your traditional IRAs to Roth IRAs and you have nonretirement assets available to pay the tax bill, consider converting in 2012. Roth IRAs may provide more retirement-income flexibility and potential tax-free growth opportunities, and may allow you to reduce taxes in retirement.
• Consider contributing as much as possible to employer retirement accounts. Regardless of the tax environment, it's generally wise to take full advantage of employer-sponsored retirement plans (particularly if your employer matches some or all of your contribution). Consider a single person making $50,000. If she increases her 401(k) contribution rate from 8% to 12%, she could reduce her adjusted gross income by $2,000, slice $560 off her tax bill and strengthen her retirement outlook in one move.

2. Taxes on Investments

Today, capital gains and dividends are taxed at a maximum rate of 15%. Without intervention by Congress, the top rate on capital gains will rise to 20%, while dividends will be taxed at the same rate as ordinary income. Also, due to a provision of the Affordable Care Act that takes effect Jan. 1, taxpayers with income exceeding $200,000 ($250,000 for married couples filing jointly) would pay even higher effective rates, with a new 3.8% Medicare tax on certain net investment income stacked on top of the higher income tax.

What You Could Do

• If capital gains tax rates are indeed heading up next year, it could be an opportune time to harvest long-term gains at the relatively modest 15% rate. If it's possible, practical and in line with your overall financial plan, recognize capital gains in 2012. It also may make sense to delay recognizing capital losses until 2013, since they could be used to offset higher capital gains tax rates or ordinary income tax rates if rates increase. Consult with your tax advisor to discuss what's best for you.
• Take a look at your portfolio. Review your investments to make sure your allocation still matches your goals and risk tolerance. When your tax fate grows clearer, you may be in a better position to make tax-savvy adjustments.

3. Education Savings

The annual contribution limit for Coverdell Education Savings Accounts would fall from $2,000 to $500, and qualified withdrawals no longer would be permitted for kindergarten through 12th-grade expenses.

What You Could Do

If the limit is going to drop and you have the cash in 2012, consider maximizing your contributions to Coverdell accounts, if they are part of your plans. While there may not be a need to close your Coverdell account just because of the lower contribution limit, consider contributing (and/or transferring existing Coverdell assets) to a 529 college savings plan account, which has much higher contribution limits. (Avoid making a contribution to the Coverdell if you make a contribution to a 529 college savings plan account for the same beneficiary in the same year. This is because this type of contribution to the Coverdell will be subject to a 6% excise tax.)

4. Estate Taxes

Barring intervention, a lower $1 million estate tax exemption (down from more than $5 million for 2012) will expose many more families to the tax, and the maximum rate will soar from 35% to 55%.

What You Could Do

• Revisit your legacy plan. Figure out if your estate would be snared by estate tax, keeping in mind that life insurance proceeds are typically included in tallying the size of your estate.
• Talk with your estate-planning attorney. Basic planning strategies could sharply reduce your family's estate tax burden if exemptions decline and rates increase.

5. Payroll Taxes

Individuals' share of their Social Security taxes would jump from the temporary 4.2% to 6.2%; the FICA portion of the self-employment tax rate would rise from 10.4% to 12.4%.

What You Could Do

While there's nothing you can do to change these rates, you can plan how to adjust your expenses to account for this 2% decrease in your paycheck, such as eating out less, looking for opportunities to trim your cable or wireless bill and cutting out nice-to-haves, like gym memberships.

6. Child Tax Credit

This credit would fall from $1,000 to $500 per child for those eligible to claim it.

What You Could Do

Without this credit to ease your final tax bill, you may need to have more money withheld from your paycheck to avoid underpayment penalties, especially if you have a large family. Check your math with the IRS withholding calculator.

7. Married Couples Filing Joint Returns

The expiration of features meant to address the so-called "marriage penalty" would reduce standard deductions and push many couples into higher tax brackets. This change would no longer be double what it is today for single filers.

What You Could Do

While it may not block all the financial pain from this change, consider increasing pretax contributions to your retirement plans, which could go a long way in easing your current tax bill.

8. Popular Tax Breaks

Deductions for state and local sales taxes, higher education and teachers' classroom supplies would vanish.

What You Could Do

Considering a big purchase, such as a vehicle? If you've taken advantage of sales tax deductions in the past and this break goes away, making those purchases in 2012 might be better than waiting. The same is true for any higher-education expense and teachers' classroom expenses you might have made in 2013. This year might be a better time to incur those expenses.

The Bottom Line: What You Really Need to Know

There are two key takeaways from these possible changes:

• Nearly every individual with income could be affected. With tax rates poised to rise and a two-year discount on payroll taxes nearing its end, very few Americans would be untouched if no federal action is taken before Jan. 1.
• High-income Americans face the most dramatic tax increases and will benefit from a full review of their personal situations. With higher investment taxes and tax rates, a first-ever Medicare tax on investment income and reductions in exemptions and deductions, the most prosperous Americans could see some of their income taxed at marginal rates approaching 44%.

It's also important to realize that nobody knows how this situation will play out. As they grapple with these broad-reaching tax expirations, President Obama and Congress also confront:

• Another debt-ceiling showdown when the federal government reaches its $16.4 trillion limit on how much debt it's authorized to carry. That's expected to happen in late December.
• A budget conundrum, thanks to across-the-board 2013 spending cuts, known as "the fiscal cliff," which sprang from Congress' inability to agree on specific deficit-cutting measures after the last debt-ceiling showdown.

If recent tax face-offs are any indication, this controversy could come to an anticlimactic conclusion -- a temporary extension that preserves the current tax rules for a few months or a year or two. At the other extreme lies the possibility of sweeping tax reform that affects other tax provisions that aren't now in play.