2012 Tax Planning: A Mid-Year Update

Tax circumstances can change with a single event. Life events, such as marriage or divorce, the birth or death of a family member, retirement, relocation or a job change will generally alter your tax position, often drastically.

Conventional wisdom is to avoid paying taxes for as long as possible by accelerating deductions and/or deferring income. But conventional wisdom may not apply in 2012.

Two ominous tax clouds loom on the horizon for 2013, adding a significant level of uncertainty and reducing the value of traditional planning techniques.

The most broadly applicable change is the imminent expiration of the so-called Bush-era tax cuts. The scheduled arrival of the new 0.9 percent tax on earned income and 3.8 percent tax on investment income, enacted to pay for the 2010 healthcare legislation, also should not be overlooked.

Note that, as this letter is being written, the U.S. Supreme Court is considering the constitutionality of the entire healthcare law, including the new taxes. Whether the Supreme Court will uphold the law, strike it down entirely or uphold selected parts of the law remains to be seen.

We recognize that 2012 tax planning requires you to consider a series of unknown future events, the Supreme Court’s position being only one of them. Educated guesses and reasonable assumptions go a long way, but keep in mind that no tax strategy is final until the time for changing course has passed.

Planning in Times of Tax Rate Change

Basic framework

Intentionally raising taxable income in the current year is contrary to the long-standing general guidelines to tax planning. Historically, tax planning has focused on accelerating deductions into the current year and deferring income into future years. But, with rates scheduled to increase, what has worked in years past may not produce the best tax outcome for the future.

The basic framework to help shape your overall income tax planning in 2012 follows:

This year and going forward, keep in mind that focus should always be on your marginal tax rate – the highest rate at which your last, or marginal, dollar of income will be taxed. Even though overall tax rates may rise in the future, if your income will be substantially lower in 2013 than in 2012, your marginal tax rate may decrease under the graduated tax bracket system.

It’s also important to keep in mind a couple of additional key income tax concepts while mapping out tax techniques for 2012:

Rising tax rates

Individual income tax rates are set to rise on Jan. 1 of next year to a top rate of 39.6 percent – a 13 percent increase over the customary rates in recent years. In addition, limitations on both itemized deductions and personal/dependency exemptions are scheduled to return for 2013, potentially raising the income tax rate another 3 to 4 percentage points for taxpayers subject to these limitations.

Further still, dividends are set to once again be taxed as ordinary income in 2013. The 15 percent rate enjoyed on qualified dividends for a number of years could potentially become a 39.6 percent rate. The top tax rate on long-term capital gains is also set to increase by roughly one third to 20 percent.

Unfortunately, the increasing rate news does not end here. Assuming the Supreme Court does not overturn the healthcare legislation, the tax impact of the legislation begins in 2013.

Taxpayers with modified adjusted gross income above $200,000 ($250,000 on a joint return) will be subject to two additional taxes:

For taxpayers above the threshold, the impact of these two new taxes will be broad-reaching. With the addition of the UIMC, the top rate for long-term capital gains will rise by more than 50 percent to 23.8 percent, while the top ordinary income rate will rise by more than 15 percent to 40.5 percent.

Planning now may reduce the tax burden in years to come, and the timing and composition of earnings become critical. Potentially, a bonus from your company during 2012 instead of 2013 or a 2013 capital transaction accelerated into 2012 could save significant tax dollars. With uncertainty in these rates – and all tax rates this year – midyear may not be the time to initiate the transaction, but it is an ideal time to lay the foundation.

Although the new healthcare taxes apply to most types of earned (HI tax) and unearned (UIMC tax) income, the new taxes will not apply to retirement plan distributions, IRA payouts or tax-exempt income, such as interest from state and local government bonds.

Increases in tax rates are generally adverse for most taxpayers, but with increased rates comes increased value in your deductions, making this a great year to strategize with your tax adviser about the best timing for your deductions.

Here are some 2012 and 2013 planning points to consider if the new healthcare taxes go into effect Jan. 1, 2013:

Planning Your Estate and Gifts

Absent congressional action, the $5.12 million estate tax exemption and current top tax rate of 35 percent, in place for 2012, will revert to a $1 million exemption with a top tax rate of 55 percent beginning Jan. 1, 2013. Moreover, the estate tax exemption will no longer be portable between spouses.

With the lifetime gift exclusion also at $5.12 million for the rest of 2012, there exists what could be a once-in-a-lifetime opportunity to transfer significant assets to the younger generation without incurring any wealth transfer taxes. On Jan. 1, 2013, the lifetime gift tax exclusion is scheduled to revert to $1 million.

Along with the high gift tax exemption, the generation-skipping transfer tax exemption is also $5.12 million during 2012. So the door is open to bypass children and defer the impact of estate taxes for many years into the future.

It’s uncertain where the estate tax exemption and tax rates will end up in future years. And with the expiring provisions, it’s a good idea to review your plan to ensure it is up to date.

Legislation proposed in Congress limiting valuation discounts attributable to minority interests or lack of marketability also potentially affects wealth transfer. The tax cost of gifts could increase should the changes be enacted.

Since these rules have not yet gone into effect, planning potential remains. Before transferring interests in family businesses or family limited partnerships, consult with your tax adviser to discuss potential tax and valuation pitfalls.

The gift tax annual exclusion remains at $13,000 per donee, or recipient, for 2012. With gift-splitting, spouses can transfer up to $26,000 to each person before the lifetime gift tax exclusion comes into play.

Gifting techniques you may want to consider this year include:

Other Tax Planning Opportunities

Timing of payments

Reviewing your withholding and planned quarterly estimated tax payments now provides the flexibility to adjust payments to limit or prevent penalties and manage cash flow.

Underpaying your taxes over the course of the year will subject you to underpayment penalties, which can be reduced or eliminated by increasing your withholding or quarterly estimated tax payments. A quirk in the penalty rules treats withholding, even if it occurs late in the year, as if it had been taken evenly throughout the year, making it a powerful planning tool for individuals.

On the flip side, why remit payment too soon when you can invest those funds until April 15, 2013? As long as you will not be subject to an underpayment penalty, consider holding on to your cash as long as possible by cutting back on your withholding or lowering your remaining quarterly estimated tax payments.

Retirement funding 

You can reduce your current tax obligations and help save for your retirement in a tax-efficient manner by contributing to a tax-qualified retirement plan. Qualified plans provide tax deferral – or tax avoidance in the case of Roth accounts – on earnings until you receive distributions.

The earlier you make the contribution, the sooner your tax-deferred or tax-free earnings begin. If you already have a retirement plan in place, consider funding it as soon as possible to allow funds to start growing now.

To qualify for a tax deduction in 2012, your retirement plan generally must be in place before the end of the year. Exceptions are IRA and SEP (simplified employee pension) plans, which can be set up and funded through April 15, 2013.

Establishing a new retirement plan requires thoughtful decision-making. Small employers (generally those with 100 or fewer employees) that set up a qualified retirement plan may be eligible for a tax credit of up to $500 per year for three years. The credit is limited to 50 percent of the qualified startup costs.

The following contribution limits, along with the catch-up contribution limits for those 50 and older, apply for the 2012 tax year:

Individuals with earned income, including alimony, are generally eligible to contribute to traditional IRAs. Claiming a deduction for your contribution is another matter. It depends on your income and whether you or your spouse is covered by an employer-sponsored retirement plan.

If neither you nor your spouse is covered by an employer’s plan, you may deduct your contribution to your traditional IRA. If you or your spouse is an active participant in an employer-sponsored plan, the deduction for your IRA is phased out at the following adjusted gross income (AGI) levels:

Many taxpayers find the long-term benefits of contributing to a Roth IRA or a Roth 401(k) outweigh the short-term financial benefits of tax-deductible contributions. While Roth contributions are not tax-deductible, none of the income earned in the Roth account will have tax consequences unless there are early distributions, in which case penalties may apply. In addition, the Roth account is not subject to the required minimum distribution rules that apply when you reach age 70½.

Eligibility to contribute to a Roth IRA depends on the amount of your income level. Contributions are allowed if your modified adjusted gross income for 2012 is between $110,000 and $125,000 for singles and $173,000 and $183,000 for joint filers.

You can still roll your retirement savings from your traditional IRA or other qualified retirement plan into a Roth IRA. However, you must pay tax on the rollover amount. Unlike in past years, income limits no longer apply to Roth rollovers.

You might want to consider a Roth rollover in 2012 if you expect to be subject to the unearned income Medicare contribution tax in future years. Although distributions from a traditional IRA are not subject to the UIMC tax, taxable IRA distributions increase your modified adjusted gross income. If your MAGI exceeds the $200,000/$250,000 threshold, your investment income will be subject to the UIMC tax.

By rolling over your traditional IRA to a Roth IRA in 2012, you will recognize the additional income before the UIMC tax goes into effect. Once you have had a Roth IRA account in place for five years, future distributions from the Roth IRA will be nontaxable and will not increase your modified adjusted gross income.

If you own a business, you may be able to avail yourself of a defined benefit type of retirement plan. These plans often allow higher retirement contributions than other types of plans. The higher retirement benefit must be weighed against the additional cost of providing comparable retirement benefits for your employees.

Charitable contributions from IRAs

The tax rule allowing those over age 70½ to make charitable contributions from their IRA without the need to include the distribution in income expired at the end of 2011. Making these contributions directly was generally advantageous because it didn’t raise the contributor’s income for limits on itemized deductions and certain phaseouts.

Although Congress has a track record of reinstituting expired tax provisions and applying them retroactively, it is certainly not guaranteed. If you are confident that you want to make the donation regardless of the tax treatment, you can still transfer the contribution directly from your IRA to the qualified charity. If Congress decides to retroactively reinstate the donation rule, the transfer will be excluded from income just as under the pre-2012 rule.

If Congress does not reinstate the rule, any charitable donation made from your IRA will be treated in the same manner as a donation made from any other source. The distribution from the IRA will be recognized as income, and the contribution will be included on your return as an itemized deduction. While the deduction should offset the income, the benefit will not be as great as it would have been if the income had not been recognized in the first place.

Employee health plans

If you are not currently providing health coverage for your employees, a tax credit for small businesses may make the cost of purchasing this coverage more affordable. The maximum credit is 35 percent of the premiums paid by the employer.

To be eligible for the credit, the employer generally must contribute at least 50 percent of the total premium. The full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $25,000. Partial credits are available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $50,000.

New employees

Congress extended the Work Opportunity Tax Credit for employers that hire eligible unemployed veterans after Nov. 22, 2011, and before Jan. 1, 2013. The credit can be as high as $9,600 per veteran for for-profit employers or up to $6,240 for tax-exempt organizations.

The amount of the credit depends on a number of factors, including the length of the veteran’s unemployment before hire, hours a veteran works and the amount of first-year wages paid. Employers who hire veterans with service-related disabilities may be eligible for the maximum credit.

If you own a business and have children, consider putting them to work during summer vacation or after school. You will be able to deduct their wages as long as you make their pay commensurate with what you would pay a nonfamily employee for the same services. For 2012, they can earn as much as $5,950 and pay zero income tax. If they earn $10,950 and contribute $5,000 to a traditional IRA, they will also pay zero income tax.

Capital expensing

Generous expensing rules apply to most non-real estate assets acquired and placed in service during 2012. The expensing election limit under Section 179 is set at $139,000 if the total amount of qualified asset purchases does not exceed $560,000. The deduction is available for most business equipment, furniture and off-the-shelf computer software.

There are limits to the Section 179 deduction, including a requirement that the deduction not cause or increase a taxable loss. But the 50 percent bonus depreciation election, also available through the end of 2012, can cause or increase a taxable loss.

The key to qualifying for these enhanced deductions is that the asset must be placed in service by Dec. 31, 2012. Just ordering or paying for the asset is not enough. Considering the time it may take to identify the appropriate equipment, obtain competitive bids, order the product, have it assembled and shipped, and then get it installed and operational, now may the time to begin the acquisition process.

With tax rates on personal income scheduled to rise in 2013, those who operate businesses as S corporations, partnerships, LLCs and sole proprietorships will have to consider carefully whether to take advantage of the enhanced business deductions available for assets placed in service during 2012. Particularly for assets with shorter depreciable lives, forgoing the enhanced deductions for 2012 may result in more tax savings in 2013 and later years.

No one can predict the future, and predicting future actions of Congress is particularly hazardous. Congress can – and all too often does – change the tax law at a moment’s notice.

2012 tax planning is an ongoing process. Saving taxes is generally a good strategy, but making a bad business, investment or personal decision just to save some tax dollars is never a good strategy.

By James W. Barrett, CPA, PFS, MST

As seen in the June issue of Business West