Tax time waits just around the corner and, this year, due to the market’s acute volatility and the impending December 2012 expiration of the Bush tax cuts which were extended last year by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, we’ll spend time harvesting portfolio losses and planning for an expected increase in future tax rates.
As the law stands today, on January 1, 2013, the top income tax rate will increase from 36% to 39.6%, qualified dividends will become subject to ordinary income tax rates, and the maximum tax on long-term capital gains will jump from 15% to 20%, with the addition of the 3.8% Medicare surtax. Yet, while plenty is uncertain about the future of the American tax code, today’s market provides opportunities to reduce your 2011 tax bill and position your portfolio for higher future taxes. For example, you might consider these ten big ideas:
- Manage your tax losses. While many investors give up on tax loss harvesting, or selling losing positions, in years when they have not registered significant portfolio gains, the exercise is always worthwhile. First, these harvested losses offset your annual portfolio gains. Additionally, up to $3,000 of remaining net capital losses can be deducted from your ordinary income on your tax return for the year and net losses above that $3,000 can be carried over to future years until they’ve all been used up by future portfolio gains. These stockpiled losses, referred to as capital loss carryovers, could be extremely helpful over the next several years as the market rebounds and tax rates potentially increase. That is, losses you book today and carry over can be used to offset future portfolio gains.
- Consider accelerating gains. Because it’s likely the capital gains tax rate will increase to 20 percent or more by the end of 2012, you may want to take gains at the maximum rate of 15 percent now. This is especially true if you have a low basis position and have specific expenses, such as college tuition, coming up in the next year or two. If the expense is more than a few years down the road, however, it may be less advantageous to sell now.
- Employ your children in your unincorporated business. Is your high school student having a tough time finding a job in this tough economy? If you have an unincorporated business, hiring your kids can fill their pockets with spending money and reduce your tax bill at the same time. Your children will not pay taxes on their first $5,800 of compensation, and you get a $5,800 deduction. If your children are under the age of 18, you don’t have to pay any Social Security, and if they’re under age 21, you pay no federal unemployment.
- Preserve wealth by taking advantage of increased gift exclusions. For 2011 and 2012, the gift exclusion has been increased to $5 million, and the estate and gift tax rates are set at 35 percent. The benefits of gifting assets you won’t need are two-fold. Your gifts get the future appreciation out of your estate and you get to enjoy helping family members now. How might this work? Let’s say a couple is worth $20 million. Each spouse gives a total of $5 million divided among their children or grandchildren this year. Over the course of the next 20 years, the couple’s remaining $10 million might grow to be worth $30 million by the time of their deaths. Although that $30 million will be subject to estate tax because they used up their lifetime exemptions under the unified gift and estate tax law, without the gifts, their initial $20 million estate might have grown to $60 million, leaving $50 million subject to the estate tax. (Note, however, that unless Congress acts, the gift exclusion will drop back to $1 million and the estate tax rate will increase to 55 percent on January 1, 2013.)
- Maximize the tax efficiency of your charitable gifts. Thanks to a provision extended through 2011 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, this year alone, IRA owners and beneficiaries who are age 70 ½ or older can make a Qualified Charitable Distribution (QCD), a tax-free distribution of otherwise taxable dollars from their individual retirement plan (IRA), to a qualified charitable organization. These QCDs are limited to $100,000 per year, per IRA owner or beneficiary, and these distributions also satisfy your required minimum distribution (RMD) up to $100,000.
- Donate appreciated stock. Gifting appreciated stock instead of cash to your favorite charity has long been a solid tax strategy, but the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 has left the window open for another charitable planning opportunity. Because the Act extended the 0 percent capital gains rate on long-term investments for taxpayers in the 10 and 15 percent tax brackets, you might consider gifting appreciated stock to your adult children in these low tax brackets. If your child is married filing jointly this year, he can have taxable income up to $68,000, or $34,000 for individuals, and not have to pay capital gains tax.
- Consider itemized deductions that are now 100 percent deductible. Prior to 2010, once your income hit approximately $100,000, you lost 2 percent of your itemized deductions. For example, if you had $40,000 in itemized deductions, you lost $800. Now you are allowed to retain 100 percent of these deductions,regardless of your income.
- Exclude your home-sale gain. If you have a gain from the sale of your primary residence, you may be able to exclude up to $250,000 of that gain from your income. In fact, in most cases, the exclusion goes up to $500,000 on a joint return. Generally, you may exclude the gain if you have owned and used your home as your primary residence for two years out of the five years before your sale date. You may not take the exclusion if you excluded the gain from the sale of another home during the two-year period before the sale of your home.
- Correct previous tax errors. It’s rare to be granted a mulligan by the IRS, but if you forgot to deduct a valid business expense, you usually can claim it by filing an amended return within three years. Additionally, there’s a seven-year window for amending your return to claim a deduction for worthless securities or bad debts.
- Clean out your closets. Talk about a win/win.If you clean out your closets and donate your old clothes and unused household goods to charity, you’ll enjoy a de-cluttered home, feel good about helping others and benefit from a tax deduction. Just be sure to get a receipt. To determine the value of your donations, visit the Salvation Army’s website and type “valuation guide” into the search box.
Over the last few years, we’ve certainly had to deal with plenty of uncertainty in the tax arena, but effective tax management always requires employing a multi-year lens. As always, your investment decisions should never be based solely on tax rates. You should consult your financial advisor or tax profession with any tax questions.