Many investors and taxpayers are tackling a daunting task: trying to plot a post-election personal finance strategy as Washington debates the future of Bush-era tax cuts. If they make decisions now, they fear they might guess wrong. But if they wait for the politics to settle, they could get hit with big tax bills they might have avoided.
“It makes things very difficult,” said Gary Hayes, head of the New England tax group at CBIZ Tofias in Boston.
Taxpayers who would ordinarily be in the midst of their year-end planning find themselves in a quandary instead. The Bush tax cuts, which lowered rates and included other tax breaks, will expire Dec. 31. President Obama and congressional leaders are negotiating whether to extend some or all of the tax cuts; if they deadlock, everyone’s taxes will go up in 2013.
The most likely increases include long-term capital gains taxes, income tax rates on the wealthiest Americans, and top rates on gift and estate taxes. Those are the areas where taxpayers — particularly couples with taxable income of more than $250,000 or individuals with more than $200,000 — are looking for planning advantages. Some may find them.
Take capital gains. The president wants the wealthiest Americans to pay a top rate of 20 percent on gains from selling stock and other investments, up from the current 15 percent. Yet if the Bush tax cuts are not extended, middle-income taxpayers would see the rate they pay on capital gains rise to 20 percent as well. Some people in lower tax brackets, who are currently exempt from capital gains taxes, would face a 10 percent rate.
The likelihood of such increases means investors may want to sell appreciated stock this year. But Robert Lepson, vice president of financial planning at Braver Wealth Management in Needham, said investors should only sell if it makes sense for nontax reasons, such as rebalancing a portfolio, diversifying holdings, or raising cash.
“Ultimately with investment decisions,” he said, “you don’t want to let the tax tail wag the dog.”
The fate of qualified dividends — which are currently taxed at a top rate of 15 percent — also has investors nervous. Without congressional action, the rates would rise to between 28 and 31 percent for middle-income tax payers.
Obama wants to impose even higher rates on dividends earned by wealthy individuals and families, increasing the top rate to as high as 39.6 percent for couples with $250,000 of taxable income and individuals making $200,000.
That increased tax bite could make dividend-producing stocks less attractive, which in turn could depress prices.
“The markets may already be in the process of adjusting,” said Hayes at CBIZ Tofias. He suggests that some investors may want to review their exposure to stocks paying dividends.
At the same time, municipal bonds may gain some luster since their interest is exempt from both federal income taxes and the new 3.8 percent Medicare tax. Under the federal health care overhaul, wealthy families and individuals will, for the first time, have to pay Medicare taxes on investment income that exceeds threshold amounts, starting in 2013.
Faced with the likelihood of higher rates, those at the top income levels find themselves in an unusual year-end planning position.
“Usually you want to accelerate deductions and defer income to the subsequent tax year,” said Braver’s Lepson. “In this case, you may want to do the opposite.”
That might include such strategies as taking a bonus in 2012 rather than after the New Year or paying property taxes or state estimated income taxes after Jan. 1. State and local taxes are deductible on federal returns, and such a strategy would lower taxable income next year when rates could be higher.
Trying to time deductions, however, comes with a caveat: Congress is considering capping deductions on the wealthiest taxpayers, potentially limiting the advantage of such tax planning.
Looking ahead to next year, taxpayers facing rate increases may want to take full advantage of contributions to retirement accounts, health savings accounts, and other vehicles that allow them to shelter pre-tax dollars and potentially stay in a lower tax bracket.
Financial specialists also agree that it’s a great time for the super wealthy to make gifts to children and other family members. That’s because the current estate and gift tax exemption of $5.12 million per person expires on Dec. 31. It’s likely to be replaced with a new exemption of $3.5 million — or perhaps just $1 million — with estate tax rates possibly jumping to as high as 55 percent from the current 35 percent.
“No one sees it getting any better than it is today,” said Hayes.
One low-risk strategy for many taxpayers is to convert at least part of a traditional IRA to a tax-free Roth IRA. Granted, a conversion will trigger income tax at current rates on every dollar taken out of that traditional IRA. That could create a very large tax bill. But once the money is in a Roth, there are no future income taxes no matter how high rates go, said Thomas McFarland, a fee-only financial adviser with the Darrow Co., Concord.
Why low risk? Should the conversion prove a mistake, taxpayers have until Oct. 15, 2013, to undo a 2012 conversion through a process call “recharacterization.”
As a rule of thumb, McFarland said, taxpayers can assume that the outcome in Washington won’t lead to more favorable rates, but he recommended that they limit their guesses to about what political leaders might or might not do.
“You know what the rules are right now, but you don’t know what the rules will be in a couple of months,” he said. And if you do decide to take advantage of the current rules, don’t dally. “There is not a lot of time left this year.”