This year, uncertainty over the future of federal tax policy has made tax planning a challenge. Last week’s election eliminated three big unknowns: who will occupy the Oval Office, which party will control the Senate and which party will control the House. But a great deal of uncertainty remains over what sort of tax legislation lawmakers will pass — and when.
The players are still the same in Washington
After the dust settled on Nov. 6, President Obama was reelected, the Democrats held onto a comfortable (but not filibuster-proof) edge in the Senate and the Republicans maintained their solid majority in the House. On the one hand, this continuation of the current balance of power in Washington may portend additional legislative gridlock. On the other hand, it may make lawmakers more willing to reach a tax and debt-relief deal before the end of the year rather than wait until after inauguration day next January.
Although the parties remain deeply divided, there’s intense pressure on lawmakers to make some compromises to address the looming “fiscal cliff” — a combination of higher taxes and forced spending cuts that will kick in next year if Congress does nothing. Yet there are no guarantees that Congress will pass tax legislation this year. And even if it does, there won’t be much time for year end tax planning. So it’s a good idea to be prepared for various scenarios so you can quickly implement planning strategies once legislation is passed — or it becomes clear that tax law changes won’t be passed this year.
What are the possibilities?
If Congress fails to act, the following tax law changes will take effect in 2013:
• The Bush-era tax cuts will expire, resulting in a top individual income tax rate of 39.6% and rate increases across the tax brackets.
• The top rate that applies to most types of long-term capital gains will increase from 15% to 20%.
• Qualified dividends will once again be taxed at ordinary income rates rather than long-term capital gains rates.
• Higher-income taxpayers will be subject to increased Medicare taxes, including a new 3.8% tax on capital gains, dividends and other investment income.
• Marriage penalty relief will expire, increasing taxes for many married couples.
• The current gift and estate tax regime — which includes a $5.12 million exemption and a 35% tax rate — will revert to its pre-2001 tax law levels of $1 million and 55% (top rate), respectively.
• The itemized deduction and personal exemption phaseouts for higher-income taxpayers will be reinstated.
• The reduced 4.2% rate on the employee share of Social Security taxes will revert to its previous rate of 6.2%.
In addition, if the alternative minimum tax (AMT) “patch” that expired at the end of 2011 isn’t restored, millions of taxpayers could be exposed to AMT in 2012 and beyond. Many other valuable tax breaks will expire at the end of 2012, including the $1,000 refundable child tax credit, increased dependent care and adoption credits, and certain enhanced education incentives.
President Obama’s tax proposal would extend the 2012 marginal tax rates for all but higher-income taxpayers — those with income over $200,000 for single filers, $225,000 for heads of households, $250,000 for married couples filing jointly and $125,000 for married couples filing separately. It would also limit itemized deductions to a 28% benefit for higher-income taxpayers.
The president would also extend the 2012 capital gains rates and favorable treatment of qualified dividends for taxpayers in the lower and middle tax brackets. For higher-income taxpayers, however, he would allow the capital gains and qualified dividends rates to go up as scheduled. And he proposes setting the gift and estate tax exemptions at $3.5 million, with a 45% top tax rate.
One significant outcome of the election: Gov. Romney’s proposals to reduce income tax rates across the board, repeal the estate tax and repeal the Patient Protection and Affordable Care Act likely are off the table. But the Republicans remain strongly opposed to any tax increases.
As lawmakers attempt to negotiate a deal that would address various tax and spending issues, there are several possible areas for compromise. Some Democrats have suggested that they may be willing to consider a higher income threshold — $1 million, for example — for restoring 2012 rates. Another possibility is to extend all of the 2012 rates temporarily to provide more time to negotiate. Because the increased Medicare taxes are part of the health care act, it appears they’ll remain intact, at least for the time being.
What are your planning options?
Most year end tax planning strategies involve estimating your marginal tax rate this year and next year and timing income and deductions to minimize your tax burden, or at least defer taxes. For example, if your marginal rate will go up next year, you’ll likely be better off accelerating income into 2012 (when it will be taxed at a lower rate) and deferring deductible expenses to 2013 (when the deductions will be more valuable). But if your rate will stay the same or go down, taking the opposite approach may be better.
For most taxpayers, it appears that marginal rates will either stay the same or go up next year, which complicates year end tax planning because the first scenario suggests deferring income and the second one suggests accelerating income. For higher-income taxpayers, however, the Medicare tax increase and the new 3.8% Medicare tax on investment income may make it advantageous to accelerate income into 2012 even if marginal rates do stay the same.
Starting next year, taxpayers with earned income over $200,000 (singles and heads of households), $250,000 (married filing jointly) or $125,000 (married couples filing separately) must pay an extra 0.9% (from 1.45% to 2.35%) in Medicare taxes on the excess earnings. If you’ll be subject to this tax, accelerating earned income into 2012 could be beneficial because you won’t have to pay the extra tax on that income. Accelerating earned income also could help you avoid triggering the 3.8% Medicare tax next year. The 3.8% tax will apply to net investment income (including interest, dividends, annuities, rents, royalties and certain capital gains) to the extent modified adjusted gross income (MAGI) — which includes earned income — exceeds the same threshold amounts that apply to the additional 0.9% tax.
You also may be able to avoid, or at least reduce, the 3.8% tax next year by accelerating capital gains or, to the extent possible, qualified dividends into 2012. This will allow you to avoid the 3.8% tax on those gains and dividends, so it may be beneficial even if your capital gains and marginal tax rates stay the same next year. And if you’re taxed at ordinary income rates on qualified dividends next year, accelerating qualified dividends into 2012 could make the difference between a 15% rate and up to a 43.4% rate (for taxpayers in the highest bracket).
As you consider your options, don’t overlook the potential impact of the AMT. Timing income and deductions to reduce your regular tax liability can sometimes increase your AMT liability, and this risk may be greater if the AMT patch isn’t restored. Fortunately, many believe that Congress will pass AMT relief before the year is out.
Finally, give some thought to your estate plan. Because there’s a chance that the exemption amount will shrink and the tax rate will increase next year, making large gifts this year to take advantage of the $5.12 million exemption may be a good strategy.
In the coming weeks, monitor lawmakers’ progress toward a tax and spending deal. To be prepared for any situation, meet with your tax advisor to review your year-to-date income, deductions, gains and losses and project what these amounts may be in 2013. You can then use this information as the 2013 tax landscape becomes clearer to quickly decide what steps to take by year end to achieve your goals.