This article was last updated on December 27
Being the finance wonk that I am, I rather enjoy reading some of the tax advice that the big accounting firms put out for their clients. While their target audience (based on their $250 to $500 hourly fee) is clearly higher net worth individuals, you can glean some pretty useful advice from their reports. Take Deloitte’s, Essential Tax and Wealth Planning Guide, which provides the following factors to consider in light of the looming fiscal cliff, tax uncertainty and potential changes in 2013. I like the way the authors of the report suggest thinking about tax planning in terms of categories of income, such as investment income, ordinary income, retirement savings, and deductions. This approach provides a clearer foundation on which to focus your planning options.
Investment income: Any decision to sell capital assets should be based on economic fundamentals, together with your investment goals; however, you also should consider the tax aspects and transaction costs associated with disposing of capital assets. If you believe capital gains tax rates will increase, there are then a number of factors and planning issues to consider before year-end in addition to the Medicare related taxes on unearned income discussed below.
The top individual income tax rate in 2013 does not include the rate increases included in the Health Care Reform Act. Rather, an additional 0.9-percent Medicare Hospital Insurance (HI) tax will apply to earnings of self-employed individuals or wages of an employee received in excess of $200,000 ($250,000 if filing jointly) on that return. Self-employed individuals will not be permitted to deduct any portion of the additional tax. If a self-employed individual also has wage income, then the threshold above which the additional tax is imposed will be reduced by the amount of wages taken into account in determining the taxpayer’s liability.
An additional 3.8 percent Medicare tax also will be imposed on unearned income (income not earned from a trade or business or subject to the passive activity rules), such as interest, dividends, capital gains, annuities, royalties, and rents. Because the tax applies to “gross income” from these sources, income that is excluded from gross income, such as tax-exempt interest, will not be taxed. The tax is applied against the lesser of the taxpayer’s net investment income or modified adjusted gross income (AGI) in excess of the threshold amounts. These thresholds are set at $200,000 for singles and $250,000 for joint filers. Some types of income are exempt from the tax, including income from the disposition of certain active partnerships and S corporations, distributions from qualified plans, and any item taken into account in determining self-employment income.
Ordinary income: The economic analysis of whether to accelerate compensation (salary, commissions etc) – where possible – may be easier than the analysis involved in evaluating capital gains, as in many cases you will incur little in the way of transaction costs by accelerating compensation, and all of the compensation is taxable. Additionally, once you realize the compensation, you can invest the after-tax earnings in alternatives that may generate capital gains or other tax-favored income.
Retirement savings: Sound retirement planning involves a range of economic and tax considerations. Most important, though, it involves consistent discipline to save. Taxpayers sometimes wonder whether they should skip making retirement plan contributions when it appears that tax rates will rise. Keep in mind that you cannot make up missed retirement plan contributions in later years, and you will lose the potential for tax-favored earnings on that amount. Regardless of your view on the future direction of tax rates, you should consider contributing the maximum amount to your retirement plans annually.
Deductions: With respect to deductions, the key planning issue is determining in which year the deduction will generate the greatest tax benefit. Understanding this allows you to determine the most appropriate timing for deductions. If your tax rate rises, deductions are likely to be more beneficial; conversely, if your tax rate declines, they likely will become less beneficial. You will need to model this analysis carefully, as the impact of the AMT, phaseouts and limitations on deductions, as well as the character of the income your deductions will offset, all will have significant bearing on the result.
When Congress does address tax reform in 2013, there are three broad possible outcomes: an extension of current rates; tax reform accompanied by lower rates and elimination of various tax preferences; or tax reform accompanied by tax increases that help reduce deficits. Another important set of considerations will be the decisions made with respect to the alternative minimum tax (AMT) and the rate differential between regular tax rates and AMT tax rates.
Given the degree of uncertainty as we approach 2013, it is important that you closely monitor the continuing tax debate in Washington.I will continue to provide updates on 2013 tax rate changes and encourage you to subscribe (free) via RSS, Email, Facebook or Twitter to get the latest news.