As we reach the mid-year point, much attention will be paid to the reduced income tax rates, known as the “Bush Tax Cuts,” slated to expire at the end of this year. In addition, there are other new taxes and changes in tax deductions and credits that may affect your tax planning. These changes may have an impact to your investment making decisions.
After the end of this year, we are scheduled to go from six income tax brackets (10%, 15%, 25%, 28%, 33% and 35%) to five (15%, 28% 31%, 36%, and 39.6%). In addition, the tax rate on long term capital gains and qualified dividends will change. Currently, the maximum tax rate for long term capital gains and qualified dividends is 15%. For those individuals in the 10% or 15% marginal income tax brackets, a 0% rate generally applies. However, starting next year the maximum rate on long term capital gains will increase to 20% and 10% for those in the lowest income tax bracket of 15%. The rates are slightly lower (18% or 8%) for qualifying property held for more than 5 years. In 2013, qualifying dividends will no longer be taxed at long term capital gains rate and instead will be taxed at ordinary income tax rates.
Now that the Supreme Court has ruled on health care reform, the new Medicare surtax will take effect in a few months. Beginning in 2013, an additional .9% payroll tax will affect those with wages greater than $200,000 ($250,000 for those married filing a joint tax return). A new 3.8% surtax will be assessed on net investment income for taxpayers with modified adjusted gross income greater than $200,000 ($250,000 for married couples filing a joint tax return). For someone in the highest marginal income tax bracket, this means the tax on some of the investment income may be as high as 43.4%.
What else is going away?
The 2% reduction in the payroll tax that was extended early this year will expire on December 31, 2012. Currently, the Social Security portion of FICA is 4.2% and is scheduled to go back to 6.2%. Starting next year, for individuals with high adjusted gross income, some of their itemized deductions, personal exemptions, and dependency exemptions will be phased out. Tax credits such as the earned income credit, the child tax credit, and the Hope credit will revert back to lower amounts and limits. For example, the child tax credit is currently up to $1,000 per child and after this year will go back to $500.
The marriage penalty relief will also be discontinued. The relief provided married couples with double the standard deduction of an unmarried taxpayer and also made the lower tax brackets double the level at which they entered at compared to a single flier.
What to do about it?
Higher rates on the horizon may impact the investment strategy of a portfolio. You may want to consider selling investments that have appreciated in value to recognize long term capital gains before the end of 2012. Conversely, recognizing a capital loss on investments that have depreciated in value in 2013 could be more valuable. Another consideration would be to sell taxable bonds with accrued interest to be paid in 2013 by the end of 2012 which may save some taxes.
Another consideration is to review the investment portfolio of qualified plans and non-qualified plans. Based on the tax changes, investment assets may need to be reallocated. Other income related items that may be considered to accelerate the recognition of by the end of this year include; the exercise of stock options, receipt of bonuses, and annuity income.
Since itemized deductions may be phased out for high income taxpayers in addition to a proposal to limit itemized deductions at 28%, you may want to accelerate itemized deductions in 2012. A Donor Advised Fund allows for a charitable deduction in the year established while allowing the flexibility to fund future charitable gifts.
If you have been debating a Roth IRA conversion, you should give it a hard look this year. When a Traditional IRA is converted to a Roth IRA, the conversion is subject to income tax. The cost of a Roth IRA conversion will increase with rates scheduled to increase next year.
Will the current tax structure be extended again? Maybe. However, the odds are any action will not take place until after the presidential election. This means any plans put in place need to account for various “what if” scenarios. For example, should gains be realized at the end of the year or compensation income deferred? For further analysis of what may make sense for your circumstances, please contact your Coldstream Relationship Manager.
Vince Lee, CFP® CPA/PFS
Director of Wealth Planning