For regular citizens, the fiscal cliff deal brings lots of changes to how our taxes will be calculated.
The goal of year-end tax planning usually is to shrink the current year's tax bill as much as possible. Sometimes, changes make the following year's tax bill bigger -- and this season, the possibility is even greater. A variety of tax-code provisions are scheduled to expire Dec. 31, ushering in higher tax rates for most Americans in 2013.
Among other things, those expirations would unleash:
Meanwhile, health care reform has created a tax increase of its own: the first-ever Medicare tax on investment income for high earners, which will add a 3.8% surcharge on top of their income taxes.
Even with the election over, it's still unclear what Washington will do about the impending changes in the tax code -- which are set to kick in Jan. 1, weeks before President Obama is sworn in for his second term and the new House and Senate are seated. Given this uncertainty, consider delaying any major tax-related moves until the 2013 tax picture becomes clearer, and consult a tax adviser to make sure you'll do more good than harm.
"While uncertainty and volatility have been an unavoidable aspect of financial planning over the last few years, I've never seen so many unanswered questions with respect to taxes," says Dan McNamara, president of USAA Investments. "There are certainly steps you can take to reduce your 2012 taxes, but it's just not clear how you'll feel about those moves in 2013 -- tread cautiously."
Keeping that in mind as we head into the final stretch of 2012, here are nine tips that could help you reduce your 2012 tax bill:
1. Stack up your deductions. Consider making deductible payments early. These may include mortgage bills, property taxes and charitable contributions. Pay extra attention to the timing of your medical expenses, since they'll be harder to deduct in January. This year, they're deductible to the extent they exceed 7.5% of your adjusted gross income. In 2013, that floor is scheduled to rise to 10% for those younger than 65. Keep in mind, though, that rising income tax rates could make your deductions more valuable in 2013.
2. Find savings in your portfolio. If you have losses on investments held outside your retirement accounts, now might be a good time to consider selling for tax purposes. First, losses offset gains you've achieved elsewhere in your portfolio. "If your losses are greater than your gains, they can offset up to $3,000 of ordinary income, with anything left over carried forward to future tax years," says McNamara. Second, if capital gains tax rates do rise Jan. 1, you may owe less on the sale if you do it now instead of in 2013.
3. Save more of your bonus. Many employers pay bonuses before the end of the year. Unfortunately, the Internal Revenue Service looks forward to bonus day just as much as you do -- especially since employers generally withhold income tax from these "supplemental wages" at a flat 25% rate. At least temporarily, consider increasing your contributions to your employer pretax retirement plan; that way, you'll protect more of your bonus from current income tax. Every additional dollar you invest on a pretax basis may help cut your 2012 federal tax bill.
4. Put self-employment flexibility to work. Being your own boss can give you control over your schedule and when you're paid. Holding off on a bonus until January can slim this year's tax bill, and invoicing customers a little later can push the resulting income onto next year's return. This approach will definitely lighten this year's tax burden, but could backfire if your tax rates increase next year. If you anticipate being in a higher marginal tax bracket in 2013, you should consider accelerating your income this year and deferring charitable contributions until next year.
5. Charitable contributions. The end of the year can be a boom time for charities. Donations are tax-deductible, but make sure you've got the right documents to back up those deductions. Contributions can be substantiated by a bank record, such as a canceled check or credit card statement. But, remember, cash contributions of $250 or more and noncash contributions of any amount require a written acknowledgement from the charity.
"Instead of donating cash, consider transferring investment shares to a qualified charity," suggests McNamara. When you transfer an investment that's appreciated in value, you sidestep capital gains taxes, and -- provided you owned it for at least a year -- you can deduct the fair market value on the date of your gift. See IRS Publication 526 for guidance about charitable contributions.
And remember, just as with other deductions, charitable contributions could be more valuable in 2013 if tax rates increase. But, if you anticipate being in a higher marginal tax bracket in 2013, you should consider accelerating your income this year and deferring charitable contributions until next year.
6. Take required minimum distributions. If you'll be 70½ or older on Dec. 31, you're generally required to take distributions from IRAs, 401(k)s and other retirement accounts. "If you don't, you'll owe a stiff penalty equal to 50% of the amount you should have withdrawn but didn't," says McNamara. If you reached 70½ this year, you can wait until April 1, 2013, to take your first distribution -- but then you'll have to take another one by Dec. 31 of next year.
7. Check your strategy for paying off the rest of fall tuition. Do you have a child in college? If you have a hefty balance in a 529 college savings plan or Coverdell Education Savings Account, you might think the smart thing to do is pay all tuition out of those tax-advantaged accounts. However, if you do, you may miss out on the American Opportunity Tax Credit, which is worth up to $2,500. This is because you can't use the credit against expenses paid with tax-free accounts. If you qualify, consider paying some qualified expenses out of your regular accounts to capture the credit and then using your education accounts for the remainder. Remember, this credit is set to expire at the end of 2012.
8. See if you're on pace for an underpayment penalty. The federal income tax is a pay-as-you-go system. If you pay too little during the year, you could face penalties when you file your return. One simple way to help avoid the penalty is to make sure your withholding and estimated tax payments for this tax year are equal to your tax liability for last tax year (or 90% of this year's tax). However, if your adjusted gross income on last year's return was more than $150,000, you'll generally need to pay at least 110% of last year's amount (or 90% of this year's tax) to get the same protection against the underpayment penalties.
If you're not sure where you stand, consult a tax adviser who also can help you get back on track by making an estimated tax payment or adjusting your withholding.
9. Consider a Roth conversion. Roth IRAs are attractive because, unlike most other types of retirement accounts, they hold the potential for tax-free withdrawals of earnings in retirement. Unfortunately, you only can contribute to them if your modified adjusted gross income is below certain levels: For 2012, that limit is $125,000 for individuals and $183,000 for married couples filing jointly. The good news is that there is another way to get money into a Roth IRA -- it's called a conversion. It's accomplished by moving money from a traditional IRA or employer-qualified retirement plan into a Roth.
Generally, you'll owe income tax on the amount you convert. 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. Remember, converting this year would increase your 2012 tax bill, but it may be a smart move for the long haul, and even more so if tax rates rise next year.
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