When it comes to tax planning for 2012, only one word can describe the environment we face: uncertain. Many of the “Bush era” tax cuts are set to expire come year-end which, may directly impact your income tax planning as well as your estate planning. In the face of such uncertainty, it may be tempting to not take any action, but as is true in sports (or driving in Miami for that matter) sometimes the best offense is a good defense. So, what strategies should you be considering now?
Background
Before we begin to discuss strategies, a bit of a primer on the tax law might be in order. At the end of 2010, Congress passed The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (TRUIRJCA or “TRA 2010” for short), which created the tax law that is good until the end of this year. In short, it extended the more favorable “Bush era” tax rates for individuals and it also put into place a temporary estate tax regime through 2012. If Congress fails to adopt a more permanent tax structure before year-end, the income tax rates and the estate and gift tax would revert to pre-2001 law. This would spell an across-the-board tax hike for all taxpayers come 2013. Additionally, the 2010 health care reform legislation, which increases the Medicare Hospital Insurance tax for high-income taxpayers, is scheduled to take effect in 2013 as does the 3.8% Medicare tax imposed on unearned income.
Let’s dissect the tax issues into two: income tax and estate tax planning.
Income Taxes
Looking ahead to 2013, absent Congressional action, here’s what we can expect. The rates for ordinary income will change as follows:
Current / 2013 Rates
35.0% –> 39.6%
33.0% –> 36.0%
28.0% –> 31.0%
25.0% –> 28.0%
15.0% –> 15.0%
10.0% –> 15.0%
So, the combined marginal income tax rate and the Medicare contribution tax will be 43.4% high income taxpayers.
With respect to rates for investment income, long term capital gains will go up to 20% from the current 15% rate and qualified dividends will go from 15% back to 39.6%. A capital gains rate of 18% applies for assets purchased after December 31, 2000 and held longer than five years. As a refresher, capital gains are deferred until the asset is sold. Short term gains are taxed at ordinary rates and long term gains are taxed at lower tax rates. Of course gifts to charity or a charitable trust do not trigger a capital gain to the donor.
It goes without saying that any decision to sell assets should be based on economic fundamentals as well as investment goals. However, tax planning should also be considered as part of a comprehensive financial plan. Some strategies that individuals may consider for this year:
- Realize capital gains prior to 2013.
- Re-balance portfolio by shifting from investments that produce ordinary income to investments that produce capital gain.
- Save for retirement through tax deferred or tax free accounts.
- Swap out high cost, tax insensitive mutual funds for lower cost, lower turnover (more tax sensitive) index funds.
- Analyze when to take deductions in order to increase their value.
Estate Taxes
A taxable estate is determined by taking the aggregate value of all includible assets reduced by all allowable exclusions and deductions. For 2012, the current law provides a generous $5,120,000 per person federal estate tax exemption and taxes estates over that amount at a top rate of 35%. This compares with a $1 million per person federal estate tax exemption and a 55% effective top tax rate scheduled to go into effect on January 1, 2013.
The 2010 Act reunified the estate and gift tax exclusion amounts at $5 million for transfers made after 12/31/10. Individuals can significantly reduce their estates by simply making direct gifts to their descendents or other heirs. In fact, by making a gift during life, an individual can not only remove the value of the asset from their estate but also any future appreciation or income of the gifted property. We cannot stress enough the potential tax savings that this can have for wealthy families. Failing to utilize the full $5 million exclusion amount before it lapses in 2013 will result in the unused amount being subject to estate or gift taxes at higher rates in the future.
Another reminder is that the portability feature that was enacted in TRA goes away after 2012. During 2012, if one spouse dies without using up his or her federal estate tax exemption (that’s the $5 million), the unused portion may be transferred to the surviving spouse if elected by the executor of the estate of the first-to-die spouse.
Some planning ideas to consider for 2012:
- Consider making larger lifetime gifts this year.
- Establish a credit shelter trust, which is a trust used to help assure that both spouses in a couple use their federal estate and gift tax credits.
- Shift wealth down generational lines by taking advantage of annual gifting (max $13,000 per year per person).
- Forgive a family loan if loan repayment is not feasible (this would be a good time to use this as a “gift” when forgiving the loan).
- Fund future education expenses for heirs through gifts into 529 plan. By accelerating use of the annual gift tax exclusion, a grandparent — as well as anyone, for that matter — could elect to use five years’ worth of annual exclusions by making a single contribution of as much as $65,000 per beneficiary in 2012 (or a couple could contribute $130,000 in 2012), as long as no other contributions are made for that beneficiary for five years.* If the account owner dies, the 529 plan balance is not considered part of his or her estate for tax purposes.
- Donate appreciated securities, rather than cash, to charity to receive a charitable deduction equal to the fair market value of securities while also avoiding paying capital gains on the stock’s appreciation.
It’s hard to say at this point who will win the election in November, but it’s worth noting that the Obama Administration’s proposal would make permanent the gift, estate and generation-skipping transfer (GST) tax rates, exclusions and exemptions as they applied during 2009 ($3.5 million exemption for estate and GST taxes, $1 million exemption for gift taxes, a top tax rate of 45% and the “portability” of unused gifts/estate taxes between spouses would be permanent).
In closing, notwithstanding the uncertain nature of our current tax structure, it’s imperative that a plan be in place with respect to your taxes and your finances. Individuals will want to work closely with their estate, tax and financial advisers before year-end to discuss their plan and potentially update it to reflect any changes to the law.
Disclaimer: the information contained in this article is for educational purposes only and should not be construed as individual investment, tax or legal advice.