Better to Give

Amid all the tax uncertainty we’re facing I’ve noticed some specific suggestions of things you can do protect yourself that I thought I’d pass along.  One caveat is that this particular suggestions list is only good for people who are doing estate planning and have assets they can give now or later. 

The first set of suggestions involves planning for the worst and hoping for the best.  So the worst is that Congress doesn’t act on expiring tax provisions.  The top tax rate on capital gains jumps to 20 percent, and dividends will face a rate as high as 39.6 % up from 15% at maximum.  Next, you need to add the Medicare surtax that will kick in on investment income for high earning households.   If all this occurs in 2013, it would make sense to divest highly appreciated assets in 2012.   Waiting on Congress may mean making this decision while supposedly enjoying the week between Christmas and New Years.  The issue will be that you don’t want to be figuring out what assets are on the list and trying to do the transactions while everyone you will need to actually make this happen is on vacation.  (I’m sure your accountant will help you out regardless, but I can’t speak for your broker or attorney.)

So the suggestion is to build a plan of what would be divested, as well as when and how in doing your 2012 tax planning scenarios.  In the worst case you then are just sending an e-mail saying you are ready for the nuclear option.  While it’s not great – it’s better than the alternatives.

The other item to consider in all this is giving gifts below the gift tax threshold.  You can give up to $13,000 a year to anyone you want without hitting the gift tax. This benefit is not due to expire, and can be helpful in terms of the areas of estate taxes that are in flux.    In addition, the little gifts don’t count towards your per individual lifetime gift tax exemption.  (That stands at $5.12 million now and it’s due to drop to $1 million per person next year unless Congress takes action.)  The only caveats are that it really has to be a gift in that you have to part company with the assets.  In addition, if it’s hard to value, it should be appraised or there can be questions when settling the estate.  One other reason to consider gifts even if you don’t have a really large estate is that every state except Connecticut doesn’t tax gifts.  If that money stays in your estate, many states collect inheritance taxes at much lower thresholds than the Feds.

Peering Over the Cliff

The too-close-to-call presidential election may be interesting from some perspectives, but it makes tax planning for 2012 particularly difficult.  The impending “fiscal cliff” includes all kinds of tax changes, including the expiration of the latest version of the “Bush tax cuts”.  In addition 60 tax provisions expired at the end of 2011 and 41 more are due to expire this year.  Most of these can be reinstated retroactively (and have been in the past) but right now we don’t know.  Among the big provisions in play are;  Alternative minimum tax thresholds , the ability to deduct state and local sales taxes in lieu of income taxes and the deductibility of mortgage insurance.

So besides investing in Kleenex stock, what is a tax planner to do?  I’m falling back on the old, “prepare for the worst and hope for the best” approach.  One important thing to note is even if there is unusually pro active action by Congress related to tax legislation – it’s unlikely that taxes will stay this low.   For most the 1990s and a little into the 2000s long term capital gains were taxed at 28% and dividends at 39.6%.  Currently the maximum rate for both is 15%.  In addition, as mentioned in an earlier post, higher-income tax payers are due to start paying an additional 3.8% on net investment income and 0.9% for Medicare taxes starting in 2013. 

If you agree that tax rates are likely headed up, the next question is when to take action on this.  Like market timing questions for investors, there’s no bullet-proof answer.  There are things you can do though to be poised for moving either way.  This year, instead of increasing your IRA contribution (fully deductible) you may want to convert to a Roth IRA.  It would mean paying the taxes on the conversion amount this year.  Should tax rates go up, that will look like a good move.  If however, tax rates aren’t changing for the foreseeable future at the end of 2012, you can undo any damage by “recharacterizing” the conversion by October 15^th of 2013.  (That means you convert it back to an IRA.) 

Another thought to consider this year is moving to a high deductible health insurance plan and contributing to a Health Savings Account (HSA) .  That HSA money will stay tax free as long as it’s used for medical expenses.  The likelihood of medical care costs is so high, there’s no need to think about a do over on this strategy.