As you may be aware, significant changes to the tax code are scheduled to take place in 2013. A lot of people are asking what they can do to plan ahead and avoid paying more taxes than necessary.

The following taxes are slated to experience changes:

  • The Bush Administration tax cuts are set to expire.
  • A new 3.8% surtax on investment income is scheduled to take effect.
  • A reinstated claw-back of itemized deductions is possible.
  • The tax rate on long-term capital gains could increase from 15 percent to 20 percent and the rate on qualified dividends from 15 percent to an effective 44.6 percent.
  • The federal estate tax rate will increase from 35 percent to 55 percent and the exclusion amount will drop from $5,120,000 to $1,000,000.

There are several ways you can minimize the impact of these changes or even avoid them altogether.

1) Harvest Capital Gains.

One strategy is to harvest capital gains in 2012 to take advantage of the current lower rates. This strategy would involve selling appreciated capital assets and immediately reinvesting in the same assets (or similar ones). Your original investment plan would play out from there.

You’ll want to weigh the benefit of the lower tax rate against the loss of a tax deferral, however. When you harvest the gains in 2012 you pay a lower tax rate, but you’ll also be recognizing the gains earlier. Basically, you would be buying a future tax savings by recognizing gain in 2012.

2. Plan for the 3.8% Medicare Surtax.

For tax years beginning January 1, 2013, A 3.8% tax will be places on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount.

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts. MAGI is generally the amount you report on the last line of page 1, Form 1040.

The threshold amounts are as following:

Married taxpayers filing jointly               $250,000
Married taxpayers filing separately        $125,000
All other individual taxpayers                 $200,000

There are several strategies you can use to reduce MAGI and or NII and reduce the base on which the surtax is paid. These include (1) Roth IRA conversions, (2) tax exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) rental real estate, (6) oil and gas investments, (7) timing estate and trust distributions, (8) charitable remainder trusts, (9) installment sales and maximizing above-the-line deductions.

3. Accelerate Ordinary Income into 2012.

One simple strategy is to accelerate ordinary income into 2012. If you have a traditional IRA, you could convert it to a Roth IRA in 2012. If you have bonds, you could sell them with accrued interest in 2012 or sell and repurchase bonds trading at a premium. You also might consider exercising non-qualified stock options in 2012.

4. Take into Account the Estate Tax Provisions.

Unless Congress acts, the estate tax exemption, currently $5,120,000 per person, will revert to $1,000,000 on January 1st, 2013. The President is suggesting a $3,500,000 exemption, but Congress has yet to take action. If this tax change will affect you, you may want to consider giving large gifts, in trust, for your family. On a $5,000,000 gift the savings would be $1,800,000 ($4,000,000*45%).

If you’d like to talk about different scenarios and how they would affect your tax situation, feel free to get in touch to schedule an appointment and I’d be happy to talk with you about your options.