The unknown future of the Bush tax cuts, estate taxes and the new health care surtax make it wise to plan ahead.
Senate Finance Committee Chairman Sen. Max Baucus, D-Mont., left, shook hands with Rep. Fred Upton, R-Mich., after bipartisan House and Senate conferees signed a compromise agreement on the short-term payroll tax cut extension in February.
The Mayans tell us the world will end on Dec. 21 of this year. If for some reason, that doesn't happen, we all may be headed for a different form of Armageddon about a week later if a chain of events in Washington, D.C., is triggered on Jan. 1, 2013.
It's being called the "Fiscal Cliff" and it refers to the pending end to the so-called Bush tax cuts, combined with legislation that drastically cuts federal spending and Medicare payments to doctors, hacking approximately $500 billion out of the U.S. economy.
In addition to the palpable possibility that such draconian legislative measures could fling us back into recession, taxpayers should be paying very close attention to their tax situation this year. This is the year to think about some serious tax planning -- the sort that is significant, both on a federal and state level, but also at times counter to traditional planning advice.
If Congress doesn't act to in some way mitigate the expiration of the Bush tax cuts, income tax rates will increase across all brackets; capital gains rates will increase to 20 percent from 15 percent, and dividends will be taxed as ordinary income rather than more favorable capital gains rates. Plus -- barring an alternate view by the U.S. Supreme Court -- 2013 marks the first year of the new health care "surtax," adding a new tax of 3.8 percent for many taxpayers.
As a result of these changes, the maximum federal tax bracket could jump to 43.4 percent from 35 percent. When combined with Minnesota's top rate, a high-income taxpayer could see a combined federal and state income tax rate in excess of 50 percent.
Both political parties are rallying support to make some changes. But until the November elections are decided, legislative action appears unlikely. The recent trend in politics is to set temporary tax policies, lasting just a few years. Your planning horizon likely extends well beyond the near term. This is especially true if you have money to preserve for future generations.
So what to do?
Accelerate income. If you can draw income, such as bonuses or incentive pay, into 2012 that would otherwise be paid in 2013, do so, and pay the taxes on it. Consider, for example, converting some or all of a traditional IRA to a Roth IRA. This triggers income tax in the current year, but creates retirement funds that grow income tax free from then on. This could make sense for someone expected to remain in a higher tax bracket in the future. The key is to determine an optimal amount to convert today.
Re-evaluate. Consider looking at your current investment holdings and assess the impact of these tax changes. For instance, in a rising tax rate environment, municipal bonds may become more valuable if their taxable counterparts are subject to increased tax rates. If you are looking to save for college, you might take a second look at establishing a 529 college savings plan, which can provide income tax-free growth if used for qualifying education expenses.
Similar to income taxes, the future of estate and gift taxes is in flux. The current estate and gift-tax exemption is $5,120,000. But that is set to revert to $1,000,000 on Jan. 1. This concern has been recognized by political candidates, but again any changes are unlikely to happen until after the November elections.
Other considerations include:
• Don't focus solely on the federal laws. Of concern is the "decoupling" of the federal and state estate exemption amounts. The Minnesota estate tax exemption is currently $1,000,000 per person, significantly less than the federal exemption. Without proper planning, a significant amount of Minnesota estate taxes can be paid even if there's no federal estate tax. It's critically important to have flexible estate documents that recognize these differences. If your estate documents have not been reviewed by your attorney recently, it may be worthwhile to take a look.
• Consider gifts. The current annual gift exclusion is $13,000 per person, which many individuals employ for regular family gifting. If a larger gift is part of your plan, consider making those transfers in 2012 before the current exemption amount expires. A completed gift today removes future appreciation from your estate. Consider making larger gifts through an irrevocable trust which can provide protection to those assets and control in how the assets are ultimately distributed.
• Review asset ownership and titling. Even the best-drafted estate plan can be derailed by improperly titled assets and out-of-date beneficiary designations. IRAs, annuities and life insurance are examples of contracts that flow according to their beneficiary designations, not the carefully drafted language in your wills. Be sure to get your attorney's recommendation on ownership and beneficiaries and make changes where needed.
And, of course, make sure you talk to someone who does this sort of thing for a living -- your attorney or tax adviser, or both.