2012-2013 Tax Planning

Dramatic tax increases scheduled to go into effect in 2013 make 2012 tax planning imperative. The following taxes may be impacted:

  • Not only are the Bush Administration tax cuts set to expire, but a new 3.8 percent Medicare surtax on investment income and a possible reinstated reduction of itemized deductions could raise the effective tax rate on ordinary income to as high as 44.6 percent for some taxpayers.
  • Similarly, the tax rate on long-term capital gains could increase from 15 percent to as high as 23.8 percent. The rate on qualified dividends could increase from 15 percent to as high as an effective rate of 44.6 percent.
  • Finally, if Congress doesn’t take action, the federal estate tax rate will increase from 35 percent to 55 percent and the exclusion amount will drop from $5,120,000 to $1,000,000.

This letter will suggest some ways to avoid or minimize the adverse effects of these changes. Planning for these potential and actual tax changes is a major undertaking and many clients are beginning the process now rather than waiting for the fall elections. Planning now may reduce the tax burden in the years to come, and the timing and composition of earnings becomes critical. In addition, the additional time will allow you to become comfortable with the potential gifting and the overall estate planning process.


Gain Harvesting

For many taxpayers it will make sense to harvest capital gains in 2012 to take advantage of the current lower rates. You would sell appreciated capital assets and immediately reinvest in the same or similar assets. You would then hold the new assets until you would otherwise have sold them, so there would be no change in your investment strategy.

Deciding whether to use the strategy is not as simple as it might appear on the surface, however, because the lower tax rates must generally be weighed against a loss of tax deferral. By harvesting the gains in 2012 you would be paying a lower tax rate, but recognizing the gains earlier. The benefits of gain harvesting will be most effective when the difference in tax rates is greater and there is shorter time before the second sale.

In some cases, the correct decision will be clear without doing any analysis. If you are currently in the 0% long-term capital gains bracket, 2012 gain harvesting would almost always be favorable because it would give you a basis step up free from federal tax, but still subject to Virginia tax. Gain harvesting would also be more favorable if you planned to sell the stock in 2013 or 2014 anyway. The time value of the tax deferral would be small compared with the future tax savings.

At the other extreme, if you are currently in the 15% long-term capital gain bracket and plan to hold an asset until your death and pass it on to heirs with a stepped-up basis, there is no reason to recognize the gain now. You would be incurring tax now without any offsetting future benefit.

If you do not fall into one of these categories, you will have to do a quantitative analysis to determine whether 2012 gain harvesting would work for you. The decision could be thought of as buying a future tax savings by recognizing gain in 2012. By analyzing the decision in this way, you could measure a return on the 2012 investment over time. If this return on investment exceeded your opportunity cost of capital, gain harvesting would make sense. We have software that enables us to do this analysis for you. Please contact us to find out which of your assets should be harvested in 2012.


Planning for the 3.8 Percent Medicare Surtax

For tax years beginning January 1, 2013, the tax law imposes a 3.8 percent surtax on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount. MAGI is generally the amount you report on the last line of page 1 of Form 1040.

The applicable threshold amounts are as follows:

Married taxpayers filing jointly                            $250,000

Married taxpayers filing separately                     $125,000

All other individual taxpayers                               $200,000

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts.

A simple example will illustrate how the tax is calculated.

Example - Al and Barb, married taxpayers filing jointly, have $300,000 of salary income and $100,000 of NII. The amount subject to the surtax is the lesser of (1) NII ($100,000) or (2) the excess of their MAGI ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000). Because NII is the smaller amount, it is the base on which the tax is calculated. Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (.038 x $100,000).

Fortunately, there are a number of effective strategies that can be used to reduce MAGI and/or NII and reduce the amount on which the surtax is paid. These include

  1. Roth IRA conversions (to remove the required minimum distributions from future income and minimize exposure to potential higher income tax rates),
  2. tax exempt bonds,
  3. tax-deferred annuities,
  4. life insurance, 
  5. rental real estate,
  6. timing estate and trust distributions,
  7. charitable remainder trusts, 
  8. maximizing above-the-line deductions, 
  9. rebalancing your investment portfolio by increasing allocations to growth rather than income assets, and 
  10. contributing appreciated securities to a charity and reinvest the cash saved.

We would be happy to explain how these strategies might save you large amounts of surtax.


Accelerating Ordinary Income into 2012

A final opportunity that should be noted is accelerating ordinary income into 2012. Potential strategies to accomplish this goal would be to

  1. realize capital gains in 2012, 
  2. elect out of installment sales in 2012, 
  3. negotiate an acceleration of prior installment sales to realize the gain in 2012, 
  4. accelerate non-qualified stock option exercises, 
  5. defer capital losses into 2013, and 
  6. sell bonds with accrued interest in 2012 or sell and repurchase bonds trading at a premium.

Perhaps the best way to do this would be to convert a traditional IRA to a Roth IRA in 2012, if a conversion otherwise made sense.


Estate Tax Provisions

The estate tax exemption is currently $5,120,000 per person and will revert to $1,000,000 on January 1st, 2013 unless Congress acts. The President is suggesting a $3,500,000 exemption. The potential reduction in the estate tax exemption is resulting in many clients making large gifts, in trust, for their family. In some instances the trusts are for the spouse, children and grandchildren and in others just for children and younger generations.


We are prepared to assist you in modeling scenarios to determine which strategies are right for you. Please don’t hesitate to call us at 757-625-4700 to schedule an appointment to begin discussing your options.