If President Barack Obama and the U.S. Congress do not act before the end of the year, the Bush-era tax cuts will expire along with the December 2010 estate, gift and generation-skipping transfer taxes.
• The 10 percent income-tax bracket will be eliminated and the rates in the current 25 percent and higher brackets will increase.
• The marginal income-tax rate for top earners will increase from 35 to 39.6 percent in addition to the Medicare surtax (discussed below).
• The long-term capital gains tax rate will increase from 15 to 20 percent.
• Dividends will be taxed as ordinary income instead of at 15 percent. For top earners, this means that dividends will be taxed at 39.6 percent plus the Medicare surtax.
• Lower income bracket taxpayers (now in the 10 and 15 percent brackets) will no longer be exempt from paying tax on capital gains and dividends.
• The estate-tax exemption will drop from $5.12 million to $1 million. Assets exceeding the exempt amount, currently taxed at 35 percent, will be taxed at graduated rates starting at 35 percent and increasing to 55 percent. More assets will be taxed at higher rates.
• The same changes will affect the gift-tax exemption.
• The generation-skipping transfer tax exemption will decrease from $5.12 million to $1 million, adjusted for inflation, and the rate will increase from 35 to 55 percent.
• A 0.9 percent Medicare surtax will be levied on a taxpayer’s wages greater than $200,000 if single, $250,000 for joint filers. Withholding begins when earnings exceed $200,000, regardless of marital status. This additional tax applies to net earnings from self-employment.
• A 3.8 percent Medicare surtax will be imposed on net investment income for singles with modified adjusted gross income (MAGI) higher than $200,000 ($250,000 for joint filers). This tax applies to the lower of total net investment income for the year or MAGI over the applicable threshold.
• Itemized medical expenses will be deductible only to the extent they exceed 10 percent of adjusted gross income. Taxpayers 65 and older can continue to use the 7.5 percent AGI floor through 2016. The 10 percent floor continues to apply for alternative minimum tax purposes.
On the good side, there will also be the usual cost-of-living increases to the tax brackets and to exemptions, exclusions and deductions. However, the itemized deduction phase-out will apply again unless the Bush-era tax cuts are extended. Some notable improvements include higher IRA and Roth contribution limits ($5,500) and a higher annual gift-tax exclusion ($14,000).
Strategies for 2012
• Consider selling assets in 2012 if you will need the proceeds during the next several years. A $100,000 long-term gain this year would generate $15,000 in taxes, but the same gain next year would generate approximately $25,000 in taxes as a consequence of the scaled-back itemized deductions, the 3.8 percent surtax and the higher capital-gains rate.
• In taxable accounts, sell now and then buy back stocks and mutual funds over more than one year to increase the amount of capital gains this year then decrease them for future years as rates rise. Remember that the wash-sale rule does not apply to gains.
• Consider selling investment real estate this year (although if you haven’t done so by now, it’s probably too late).
• Sell vested company restricted stock held more than one year.
• Pull interest income into 2012 and push interest expense into 2013 where possible, especially if you are in a top tax bracket.
• Consider converting some portion of your IRAs into Roth IRAs.
• If you own a business, purchase machinery and equipment before the end of the year (the Section 179 deduction is set to decline in 2013 to $25,000, and the 50 percent bonus depreciation to end).
• If you own a C corporation, determine whether to pay more dividends this year if no deal is struck in Washington that will extend their current favorable treatment. In addition, watch for excess accumulations and authorize charitable contributions before year-end. (C corporations can deduct them if paid within the first 2 1/2 months of 2013.)
There are a number of estate-planning strategies to follow, but they are too complex and varied to be communicated here.
The bottom line: You should already be communicating with your tax consultant or financial planner given the magnitude of the tax changes. The changes may or may not constitute a “fiscal cliff,” but they are certainly worth preparing for.
Los Altos resident Artie Green is a Certified Financial Planner with Cognizant Wealth Advisors. For more information, call 209-4062.