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.