Depending on what, if any, tax legislation Congress is able to enact in the next several weeks, we will likely experience a tax increase for 2013 and later years. That said, the following are some key strategies that should be considered.
Business Expense Strategies
If you are a cash-basis taxpayer and business owner operating as an S corporation, partnership or sole-proprietorship, you pay tax on the business’s net income on your individual federal income tax return. The business itself does not pay the tax. Therefore, an increase in tax rates is going to affect you. Now is the time to plan for these tax rate hikes. Specifically, pay close attention to when you incur deductible business expenses. You may postpone some of these expenses to a future year when tax rates may be higher. On the other hand, businesses with carry-forward losses may benefit more by accelerating income (to the extent possible based on tax law) into 2012 and deferring expenses to 2013 or later.
State and Local Tax Payment Strategies
Taxpayers often have some flexibility in determining when to make state and local tax payments. Such payments include income tax, real estate and personal property taxes. All of these items may be deductible for you depending on your tax situation. Review your situation to determine whether you have flexibility to delay these payments into next year. The delayed payment, and subsequent increase in tax deductions, may provide greater tax savings next year if tax rates increase.
Timing Charitable Contributions Strategies
As you consider additional 2012 charitable contributions, you should project forward to 2013. It might be advantageous to split your charitable giving budget between the two years. A charitable deduction (as long as it is not subject to limitation based on your income) could potentially be more valuable in 2013 than in 2012. After some analysis, you may find it more beneficial to lower your remaining 2012 charitable contributions and allocate more assets (cash or securities) to your 2013 charitable budget. If you choose to wait for 2013 to make charitable gifts, you should consider making them with appreciated long-term assets rather than cash. Given the potential for rising tax rates, this strategy deserves a second look. When the strategy is appropriate, the benefits are twofold:
When gifting appreciated stock to charity you avoid incurring capital gains taxes on the stock
A gift to a qualified charity provides a tax deduction, to the extent it is not limited based on your income.
Make sure to discuss this option to insure expenditures are fully deductible.
With respect to payments from your employer, consider whether you anticipate receiving a bonus or a lump sum payment due to retirement or a job transition, and talk with your employer about your flexibility in the timing of receiving the payment. Some employees are offered transition payment schedules that stretch over more than one year. This may not be ideal when tax rates are expected to increase as in 2013. A review of the payment amount, date(s) of receipt and your expected income tax bracket in 2012 and future years will be important in deciding or negotiating when to receive this income.
With respect to IRA or annuity distributions, taxable distributions from IRAs or annuities are a concern in a rising-tax-rate environment. If you are required to take minimum distributions from a retirement plan, IRA or inherited IRA, you’ll want to factor that into future-tax-year projections. Taking mandatory distributions boosts your taxable income and may require either an increase in your withholding or, perhaps, paying estimated taxes quarterly to avoid an underpayment penalty. If you’re considering taking an elective distribution in the next few years, taking that distribution in 2012 when income tax rates are lower may be beneficial. This strategy is particularly timely when it comes to potential distributions and recognition of taxable income attributable to a Roth IRA conversion.
IRA to a Roth IRA Conversion Strategies
Anyone, regardless of income, now can convert a traditional IRA to a Roth IRA. The benefits of converting are the potential for tax-free income in retirement and the ability to pass on assets that your heirs can withdraw tax-free after your death. However, you may incur income taxes in the year you make the conversion. Because rates are scheduled to increase on January 1, 2013, if you’re considering converting, you may be better off doing it this year rather than in 2013.
Accelerating Long-Term Capital Gains Strategies
January 1, 2013, may see the end of historically low long-term capital gains rates. How much these rates will increase depends on your ordinary income tax rate bracket. Various Congressional proposals have been made that included alternative schedules, with some affecting only higher-bracket taxpayers; however, at this point they remain just that — proposals. As it stands now, you may find it beneficial to sell appreciated securities or assets that you’ve held for the long term in 2012 to take advantage of this year’s lower capital gains tax rates. This strategy may be particularly appropriate in certain situations: You can take advantage of the current 0% long-term capital gains rate. If your net taxable income, including your long-term capital gains, is less than $70,700 (joint filers) or $35,350 (single filers) in 2012, you will be in the 10% or 15% ordinary income tax bracket, which means you may be able to realize some tax-free long-term capital gains. If your capital gains push you over your threshold, or you are in a higher tax bracket, then some or all of the gains will be taxed at the 15% long-term capital gains rate.
If you hold a concentrated equity position, meaning a substantial position in one stock that has appreciated over time, selling a portion of the shares and purchasing other investments with the proceeds can help you diversify and reduce the market risk in your portfolio. If you have other goals that involve recognizing the gain, then you should evaluate the various strategies to help manage the risk of a concentrated position and the tax liability that may occur upon selling the investment. However, given the limited window of opportunity for 2012’s historically low long-term capital gains tax rates, you may want to seriously consider selling a portion this year. Doing so can help you avoid the potential tax rate increase that is scheduled for long-term capital gains recognized in 2013 and thereafter.
If you own real estate or business assets, the upcoming tax rate changes should prompt you to consider how you are managing those assets. In some cases, the buyer and seller of such assets can structure the sale so that proceeds are paid over more than one tax year. Typically, this strategy helps the seller manage his or her tax liability. However, given that both ordinary income tax rates and long-term capital gains tax rates are scheduled to rise in 2013, you may want to attempt to complete a sale, and receive its proceeds, in 2012. If that is not possible, then perhaps electing out of an installment sale treatment and accelerating the income recognition all to 2012 may be an option.
Think ahead before selling if you decide to sell appreciated securities in 2012 to take advantage of the lower long-term capital gains rates, but be strategic in how you do it. For the portion of your portfolio you have designated for long-term goals, review and rebalance your allocation so that you are in a better investment management position going forward. Doing so will let you benefit from 2012’s lower long-term capital gains tax rates, and in future years you may need less rebalancing, which should help reduce the gains that you realize when the tax rates are higher.
Accelerating Capital Losses Strategies
Typically, investors consider selling investments near year-end to realize losses to offset capital gains or up to $3,000 in ordinary income. However, if you have modest unrealized losses in 2012, and do not anticipate generating sizable capital gains, you might consider waiting to realize those losses until 2013.
Offsetting long-term capital gains that are taxed at 20% (the 2013 rate) will provide more tax savings than using the losses to offset gains taxed at 15% (the 2012 rate). You’ll need to look closely to project any potential capital gains (and don’t forget about long-term capital gains distributions from mutual funds). For investors whose income (including long-term capital gains) is within the 10% or 15% income tax bracket, harvesting losses will not provide a tax benefit if it only reduces long-term capital gains. Losses in excess of gains will offer a nominal tax savings at best and may provide more value if left for future years.
If, on the other hand, you have substantial capital losses or capital loss carry-forwards, it can sometimes be difficult to use up all of those losses. In this case, it probably does not make sense to postpone offsetting capital gains or waiting to recognize gains.
Rebalancing Your Portfolio Strategies
In general, a qualified dividend is one paid by a U.S. corporation or an international corporation that trades on a U.S. stock exchange. You may also receive a qualified dividend if you hold shares in a mutual fund that invests in these types of corporations.
Currently, qualified dividends are taxed at a maximum 15% rate — like long-term capital gains; however, in 2013, they are scheduled to be taxed at ordinary income tax rates, which could be a maximum 39.6% rate (and quite possibly an additional 3.8% Obamacare surtax on high income taxpayers). Given this anticipated change, you may want to consider reallocating the portion your portfolio held in taxable accounts using the following strategies.
Consider adding growth-stock holdings. If you don’t need current income, you may want to consider the advantages of shifting some of your equity allocation to growth stocks. Or you might reposition a portion of your tax-deferred account allocation to dividend-paying stocks, where the dividends will be shielded from current taxation. With a dividend-paying stock, your total return is based on both growth and income, and the income portion may be taxed as ordinary income starting in 2013.
If you hold a growth stock for the long term, any appreciation in the stock’s price will not be taxed until you sell it. At that point, you would owe long-term capital gains taxes (as long as you held the stock more than one year), which will still be lower than ordinary income rates even after 2012. Because this strategy involves issues surrounding both your long-term asset allocation and taxation, careful analysis must be done to help determine the right strategy for your situation.
Reassess your tax-exempt bond holdings. If you need income, carefully weigh the pros and cons of tax-exempt bonds versus dividend-paying stocks. With rising tax rates, tax-exempt income may be more appealing. Dividend-paying stocks run the risk of having their dividend reduced or eliminated altogether. Also, tax-exempt bonds are usually less volatile than stocks.
However, tax-exempt investments have inherent risks. For example, bond investments may not be as well equipped to protect against inflation as stocks. In addition, keep in mind that some municipal bond interest may trigger the AMT tax. Also, bond prices will fluctuate and move inversely to interest rates. If interest rates increase, your bond investments’ principal value will fall. We recommend continual portfolio monitoring and the outlook for the economy and the markets, so any proactive changes can be made when necessary.
You’ll also want to evaluate the investment’s yield. At 2012 income tax rates, a tax-exempt bond with a 4% yield would be comparable to a taxable investment with a 5.3% yield for someone in the 25% federal income tax bracket. If income tax rates increase, this same taxpayer would need to find a taxable investment with a 5.6% yield to generate the same after-tax income as the 4% tax-exempt bond.
If you choose to alter your portfolio’s investment mix, remember that overall asset allocation remains appropriate for your investment goals, time horizon and risk tolerance.
Medicare Tax on Investment Income Strategies
Starting in 2013, married filing joint taxpayers with incomes over $250,000 and single taxpayers with incomes over $200,000 will be subject to a new (Obamacare) Medicare tax. If you’re in either group, an additional 3.8% tax will be applied to some or all of your investment income, including capital gains. This will be in addition to ordinary and capital gains taxes that you already pay!
Exercise Employer-Granted Stock Options
If your company has granted you stock options as part of your compensation package, you may have either (or both) nonqualified stock options (NSOs) or incentive stock options (ISOs). You will want to understand the choices you have and the tax consequences of exercising each type of stock option. NSOs give you the choice to exercise the options sometime between the vesting date and the expiration date. (See your stock option plan document or your employee benefits representative if you do not know these dates.) When you exercise an NSO, the difference between the stock’s fair market value and the exercise price will be taxable compensation that’s reported on your W-2. If you have vested options and the opportunity to exercise them in 2012 or 2013, you’ll need to determine in which year it might be more beneficial to exercise the options and recognize the income. You may want to project your taxable income for 2012 and a later year and then decide at which time it may be less taxing to exercise your options and realize the additional income. You’ll also want to consider the stock’s market outlook, its valuation and the options’ expiration date, in your decision-making process.
ISOs are somewhat more complex because your holding period determines whether the exercise proceeds are taxed as ordinary income (similar to NSOs) or long-term capital gains. To benefit from the potential long-term capital gains tax treatment (with its 15% top rate in 2012 and 20% top rate in 2013) versus ordinary income tax rates (which range up to 35% in 2012 and 39.6% in 2013), you must hold the stock you receive more than one year from the exercise date and more than two years from the grant date. Because of the holding period requirement, it’s obviously too late to lock in the 15% capital gains tax rate on options you have not yet exercised. However, if you exercised options in 2011 or earlier and still hold the shares, you’ll want to weigh the pros and cons of selling them and recognizing gains in 2012 versus later years.
You should also be aware that if you exercise and hold shares from your ISO exercise, the taxable spread (the difference between the stock price on the exercise date and your option cost) will be taxable income for AMT purposes in the year in which the exercise occurs.
If you exercise your ISOs and sell without meeting this holding period, you will recognize taxable W-2 compensation similar to NSOs. Due to the lower capital gains rates, you may find it more attractive to hold ISO shares instead of selling them soon after your exercise. Just be sure to consider any ATM tax potential.
If, instead, you decide to exercise ISOs and sell the stock, you may want to consider selling by year-end to take advantage of 2012’s lower ordinary income tax rates. As with NSOs, you’ll want to the market outlook for the stock, in your decision-making process.
Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning. Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.