Unless Congress reaches a favorable agreement by December 31st, taxes on wages and investments will go up, the exemption from the estate tax will shrink, and several tax breaks will disappear. This will make year-end tax planning, an already stressful time even in ordinary circumstances, even more stressful for most taxpayers. According to an analysis by the Tax Policy Center, if no compromise is reached, 90% of Americans will pay higher taxes in 2013, and the average household’s tax bill will increase by $3,500. With these realities not far out of sight, consider the following tactics that will trim your tax bill regardless of what Congress decides.
1. Convert a traditional IRA to a Roth. When the threat of higher taxes looms, converting to a Roth can make a lot of financial sense. Kiplinger says, “Withdrawals from traditional IRAs are taxed at your ordinary income tax rate, while all withdrawals from Roth IRAs are tax-free and penalty-free as long as you’re at least 59 ½ and the converted account has been open at least five years.” This can be a smart move to make before New Year’s Eve because you will pay taxes at current rates, which will likely be on the rise in the future. There is always a chance that tax reform will bring lower rates, and if that happens after you’ve converted, Kathy Stewart, director of fiduciary research for fi360, which trains financial advisors, says that you can change your mind. If you converted, you would have until October 15, 2013 to undo the conversion and turn your Roth back into a traditional IRA.
2. Max out your tax-deferred retirement savings plans. This year, you can contribute up to $17,000 to your 401(k) or other employer-based plan, unless you’re 50 or older, then you can contribute up to $22,500. You have until April 15th, 2013 to contribute up to $5,000 (or $6,000 for ages 50 and up) to an IRA, which may be tax deductible if you’re putting the money into a traditional IRA.
3. Make gifts before the year is over. Another exemption that is being threatened by the decision weighing in Congress is the lifetime gift tax exemption. This exemption as well as that for estate taxes will drop to $1 million from $5.12 million, barring action by Congress. In addition, the maximum estate tax will rise to 55% from 35%. These gifts must be irrevocable, otherwise the IRS doesn’t consider them to be gifts, so you can’t ask for the money back at any point. Talk to an estate planning attorney for help with setting up trusts or other vehicles that might allow you to take advantage of the current exemption in order to transfer your wealth to your children or grandchildren, tax free. In addition, even if you don’t have a million dollars to distribute in gifts, you can still take advantage of the $13,000 gift tax exclusion. Under this exclusion, individuals can give up to $13,000 to as many individuals as they wish, tax-free. This exclusion will still be available next year, but if you don’t take advantage of it by New Year’s Eve, the 2012 exclusion disappears.
4. Boost your income. Normally, when tax rates are expected to stay about the same or decline, deferring discretionary income such as year-end bonuses would be a popular tax strategy. However, since the opposite is likely to happen in 2013, high-income taxpayers may want to accelerate discretionary income in an effort to avoid another tax hike. Beginning in 2013, taxpayers will pay an additional 0.9% Medicare tax on wages over $200,000 (or $250,000 for married couples).
5. Postpone your required minimum distribution for as long as possible. There was a tax break that allowed individuals age 70 ½ to make a tax-free distribution of up to $100,000 from their IRAs directly to charity, but it expired at the end of 2011. However, this tax break has been extended several times, so if you are interested in taking advantage of it, you’ll have to wait to see what Congress decides. To be safe, though, you will have to give instructions to your IRA custodian as soon as possible because failing to take your RMD by year-end will result in a 50% penalty of the amount you were supposed to withdraw.
These strategies may not be advantageous for everyone. If you would like help to determine if any of these, or other tax strategies are right for your personal situation, please give us a call. Our goal is to help you understand your options and guide you in the best direction so don’t hesitate to ask.