Tax Planning Near the Fiscal Cliff

10/18/2012 10:27 am EST

Focus: TAXES

Robert Carlson

Editor, Retirement Watch

There are a lot of tax implications that are hanging in the balance as we close out this year, so it's time to make a plan, writes Bob Carlson of Retirement Watch.

We’re hurtling toward the fiscal cliff. Tax increases across the board are scheduled to take effect on January 1, 2013. In addition, a number of tax breaks expired at the end of 2011 and still haven’t been extended. Congress, at least at the moment, doesn’t seem inclined to do anything.

Some tax advisors recommend taking action now, assuming that the tax increases go into effect as scheduled. Others say not to worry…assume the tax breaks will be extended and maybe expanded, as happened at the end of 2010.

Don’t follow either path. This isn’t 2010 or any other past year. Different key players were in place then, and other circumstances were different. Many variables are at work here, and you shouldn’t assume a past series of events will be replicated.

Instead, you need to do some scenario planning, create alternative action plans, and implement the correct plan when we know which way events will break.

The consensus is that the most likely scenario is that Congress has a lame–duck session after the election and extends all the tax breaks through the first few months of 2013. Then, the new Congress will meet in 2013 to develop a longer–term solution. What that solution is likely to be will depend on the results of November’s elections for Congress and the White House.

But there are other plausible scenarios. Split election results could create gridlock after the election and into 2013. Congress might be unable to agree on anything, and that would cause the tax hikes to occur. Or the election could be a decisive victory for the Democrats, which would lead to several possible scenarios.

However, the most likely I think would be a partial extension of the tax breaks (except those deemed to favor the wealthy), followed by some comprehensive tax increases in 2013, such as those contained in the President’s last budget proposal. If Republicans win decisively, there likely would be full extension of all the tax cuts (except probably the payroll tax cut) for a full year.

A wildcard, however, is that a decisive victory by either party would cause the lame–duck members of the other party to prevent any action until the new Congress convenes in 2013. Then, the tax increases automatically would take effect on January 1, 2013, but we wouldn’t know what would happen as the year develops. The tax increases might be retroactively revoked later in 2013.

You might see other scenarios. You need to develop alternate plans for the scenarios. I think you generally need at least two plans drafted and ready to implement. One plan assumes taxes are likely to increase in 2013 and perhaps beyond. The other plan assumes no substantial tax increases and perhaps some tax cuts or tax reform.

When it appears taxes are likely to increase in 2013, be prepared to accelerate income into 2012 and defer deductible expenses. Remember that the 3.8% Medicare surtax on investment income kicks in next year for high income earners, so that’s already a reason to consider these steps.

One way to accelerate income is to take capital gains. With the long–term capital gains tax rate scheduled to increase in 2013, taking gains on assets you were likely to sell in the next few years anyway could save you money.

Those who still are working need to review issues such as payment of year–end bonuses, exercise of stock options, and elections to defer compensation. Business owners might want to accelerate billings and collections to bunch income in 2012. Those who sold property in installment sales in the past might look for ways to arrange acceleration of those payments.

For a longer–term strategy, traditional IRA owners might want to convert to Roth IRAs.

If you’re expecting tax increases in 2013, you generally want to move deductible expenses from 2012 into 2013. Most taxpayers can do this simply by delaying payment until January. You should defer both business expenses and itemized deductions to the extent you can. You also can avoid taking capital losses in 2012 and take them in 2013 instead.

Caveat: There’s a catch to this part of the strategy. Higher–income taxpayers might want to accelerate itemized expenses into 2012, if after the election it seems likely that proposals such as a cap on itemized expense deductions might be enacted.

You can accelerate charitable contributions by paying a lump sum of several years worth of contributions to a donor–advised fund or a charitable trust or foundation. Some miscellaneous expenses and other itemized deductions might be moved into 2012 by prepaying them. You should meet with a tax advisor to determine which can be accelerated and which can’t.

That’s one plan. You also need a plan that’s largely the opposite and much simpler. When the election results indicate future tax rates will be lower or the same as now, you can implement regular year–end tax planning. In general, that means deferring income and accelerating deductions.

As always in tax planning, calculate the effects of moves on both the regular income tax and the alternative minimum tax. Taking to excess what normally are smart moves can trigger the AMT and leave you with no tax benefit or even a tax penalty from the actions.

A portfolio review also should be taken when the election results seem likely or are known. As you know, if Congress doesn’t take action, the long–term capital gains rate will increase from 15% to 20%, and the tax rate on dividends will increase from 15% to your ordinary income tax rate. These changes could substantially change your after–tax rate of return.

You don’t want taxes to dictate your investment choices, but taxes are a factor to consider. The high dividend rates on some stocks might not appear so high after ordinary income tax rates are applied to them.

Many other people are watching these factors. That’s why I want you to have plans in place now.

You can’t wait to develop a plan. You need to develop alternative plans now and be ready to implement when the future taxes are clear. Otherwise, you’ll have trouble implementing your plan or seeking advice from a professional at the same time everyone else is.

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