Tax Planning in a Time of Historic Uncertainty

Although billions were spent during the 2012 campaigns, the political landscape in Washington hasn’t changed much. Congress is still bitterly divided–gridlocked over key economic issues and tax reform. Of course, the need for compromise becomes increasingly urgent as we draw closer to the scheduled expiration of the Bush tax cuts and the massive Federal budget cuts mandated at year end. To deal with the tax side of the equation, Republicans have suggested continuing the current tax code for six months or a year; however, thus far, Democrats have been unwilling to grant an extension for the top two tax brackets. And as each day passes without agreement, Washington pushes the economy closer to tumbling over the “Fiscal Cliff.”

Of course, the frustrating lack of tax clarity, combined with the stress of watching as Washington attempts to compromise to avoid the Fiscal Cliff, makes 2012 tax planning a challenge. Accordingly, we are proceeding cautiously in ways that take advantage of today’s low rates, while affording you maximum long-term portfolio flexibility. In previous newsletters, I’ve addressed some of the strategies described below. Because of the short window to take advantage of lower tax rates and the significant changes that likely loom ahead, they are worth re-visiting.

  • Selling appreciated stock positions. Let’s face it. At some point soon, top wage earners can expect to shoulder a tax increase. So, why not pay capital gains at today’s historically low rates? Of course, selling a position now results in the loss of any future price appreciation. However, the larger your unrealized gain, the better your investment would have to perform to overcome higher future capital gains tax rates. Keep in mind, too, that the IRS’ wash sale rule, which prohibits an investor from claiming a capital loss for tax purposes if the investment in which the loss originated is repurchased within 30 days, does not apply when you sell an appreciated security. Therefore, you can choose to buy back the same security immediately, without waiting 30 days.
  • Re-evaluating the role of dividends. Prior to the Jobs Growth and Tax Relief Reconciliation Act of 2003 (JGTRRA), dividends were taxed at ordinary income rates. With the passage of JGTRRA, qualified dividends became eligible for the more favorable capital gains rate of 15%. But, you guessed it, that rate sunsets in 2013. Also, because the highest tax bracket is set to increase from 35% to 39.6%, and high wage earners will also shoulder a new 3.8% Medicare tax on investment income, the Federal dividend tax could shoot up to a high of 43.4%. Amazingly, investors who bought dividend-paying stocks to boost their income in a low-yield environment could have nearly half of their dividend income eaten up by taxes. Accordingly, there’s tremendous incentive for business owners of closely held C corporations to make available dividend distributions before the end of this year, rather than keeping the money inside the business to defer taxation.
  • Making tax-savvy charitable gifts. Donating appreciated securities to charities is always a tax-savvy strategy. That’s because securities are tax deductible at their fair market value on the date of your contribution, and gifting exempts you from paying capital gains taxes. This year, you might also consider gifting appreciated stock to adult children (over 18 and, therefore, not subject to the kiddie tax.) Until the Bush tax cuts sunset on December 31, if your adult children are married and filing jointly with taxable income up to $70,700 (or $35,350 for individuals), they will pay 0% on capital gains. Therefore, gains on any appreciated securities you gift are tax free.
  • Converting to Roth IRAs. If you’ve been thinking about converting a traditional IRA (taxed at ordinary income rates) to a Roth IRA (where, once held for five years, distributions are tax-free), 2012 may be the year to make the move, because you will pay lower taxes on the conversion. What’s more, the Roth’s re-characterization rules may make converting an easier choice if you think market volatility could negatively impact your tax liability.That is, if you convert a traditional IRA to a Roth IRA and your new account declines, the IRS gives you until October 15th of the year following your conversion to re-characterize your Roth account back to a traditional IRA, thereby avoiding taxes. Another way to hedge the market risk of a conversion is to convert your traditional IRA into several different Roth accounts (each invested in different asset classes), track how each account performs, and re-characterize any account that underperforms.
  • Reviewing estate plans. For 2012, the estate tax and lifetime gift tax exemption are $5,120,000 per person and $10,240,000 per couple, with a 35% top tax rate. Beginning in 2013, however, unless further legislation is enacted, the exemptions will revert to 2001 levels, dropping to $1 million per person ($2 million per couple) with an effective top tax rate of 55%. While making immediate outright gifts is probably the easiest way to get money out of your estate, other strategies include establishing a grantor retained annuity trust (GRAT), a qualified personal residence trust (QPRT), or an irrevocable trust. However,these gifts must be completed by December 31, 2012.

Notably, while increases to ordinary and capital gains rates have gotten excessive publicity, there are scores of other tax changes on the horizon. These range from reductions in the Child Tax Credit and Higher Education Tax Credit to lower student loan interest deductions and Coverdell Education Account contribution limits.I’ll address each of these changes with clients on an individualized basis.

Rest assured that however tax policy evolves in the next several months and over the long term, I will monitor events and policies as they unfold in Washington so we can evaluate your portfolio and make any necessary adjustments in a timely manner. As always, if you have specific questions, please call me.

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