Year-End Tax Planning for 2011 Is Mainly About 2012 Changes

Year-end tax planning for U.S. taxpayers may be more about what’s happening next year.

While there aren’t major changes to federal tax law for 2011, there’s an “overhang of uncertainty” about what Congress will do next year to reduce the national debt and improve the economy, said Clint Stretch, managing principal of tax policy at Deloitte Tax LLP in Washington.

“There are a lot of unhappy people and a lot of unhappy businesses out there because they want to know what the rules are,” said Stretch.

Decisions by lawmakers in 2012 may affect everything from federal levies on income to estate-tax laws. One rule change investors can plan for next year is a new tax-reporting requirement for mutual funds and most ETFs.

Starting next year, financial-services firms will have to report to the Internal Revenue Service and customers information on the cost basis, which is usually the purchase price, of mutual funds and most ETFs bought and sold after Jan. 1, 2012. That means investors will have to decide before selling what reporting method they want to use such as average cost or first shares acquired. Firms already are required to report the cost basis of individual stocks bought after Jan. 1 of this year to the IRS.

The IRS has been phasing in the cost-basis reporting rules by investment type. The requirements began this year for equities bought and sold after Jan. 1. Photo Illustration: Rich Clement/bloomberg Close

The IRS has been phasing in the cost-basis reporting rules by investment type. The... Read More

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The IRS has been phasing in the cost-basis reporting rules by investment type. The requirements began this year for equities bought and sold after Jan. 1. Photo Illustration: Rich Clement/bloomberg

“Gone are the days when you can take all your statements in the tax season and go to your accountant and say, ‘OK, use all these forms and use them to determine the basis,’” said Maria Bruno, a senior analyst in the investment counseling and research group at Vanguard Group Inc. “Now you really have to think about it at the time of the transaction.”

Mutual Fund Holders

An estimated 44 percent of U.S. households, or about 52 million, owned mutual funds in 2011, and 3.5 million households held ETFs, according to an October research report by the Investment Company Institute, a Washington-based trade group for the mutual-fund industry. Shares of exchange-traded funds, known as ETFs, trade on stock exchanges and don’t have a fixed number of shares outstanding.

The IRS has been phasing in the cost-basis reporting rules for financial firms by investment type. The requirements began this year for equities bought and sold after Jan. 1. As a result, taxpayers will use a new Form 8949 for their 2011 returns to record capital gain and loss transactions, said Eric Smith, an IRS spokesman. The form lets investors provide information about securities covered by the law and those acquired prior to the rules, or non-covered shares, according to the IRS.

Improving Compliance

Next year the legislation extends to mutual funds, most ETFs and dividend reinvestment plans, which generally require investors to reinvest at least 10 percent of dividends paid. In 2013, it includes options (VIX) and fixed-income securities, such as bonds, according to the IRS. The changes don’t apply to assets in tax-deferred retirement accounts including 401(k)s and IRAs, the IRS said.

The changes are designed to improve tax compliance and reduce the record-keeping burden for investors by ensuring that they receive the information they need to easily report their gains and losses correctly, said Smith.

Investors may set a preferred method for their firm to use when determining cost basis and investment providers generally will use a default, said Bruno of Vanguard, the world’s largest mutual-fund company. While customers can change their decisions at the time of sale for a specific transaction, “there are no do-overs” after securities are sold, she said. Vanguard, based in Valley Forge, Pennsylvania, is encouraging customers to designate a preference before year-end. It can be done online or by mailing a form, Bruno said.

Loss Carryover

“If you’re doing some tax planning and trying to match gains and losses, you may end up using different cost basis methods for different sales,” said Lisa Featherngill, managing director of wealth planning for Wells Fargo (WFC) Family Wealth.

For example, taxpayers may have bought shares of stock at $23 this year, so they’re covered under the new rules, and additional shares of the same company at $20, said Featherngill, who’s based in Winston-Salem, North Carolina, and a certified public accountant. If the security’s current value is $18, the investor may tell the brokerage firm to sell the shares with the highest purchase price to generate the biggest loss, she said.

When capital losses exceed gains, the extra can be deducted on individuals’ tax returns and used to reduce other income, such as wages, up to an annual limit of $3,000, according to the IRS. If the total loss is more than the cap, the unused portion may be carried over to following years.

Distributing Gains

Some investors have dwindled away large capital losses that built up and were carried over in 2008 and 2009, which is why they should review whether to take some this year, said Bill Fleming, managing director in the private company services group at accounting and advisory firm PricewaterhouseCoopers LLP.

Many mutual funds distribute taxable capital gains at year- end, which individuals also should consider in their planning, said Clay Stevens, director of strategic planning at Aspiriant, a Los Angeles-based wealth management firm serving clients with at least $5 million in investable assets.

Investors who bought shares of a fund in the middle of the year may have lost money, especially as equity markets have been volatile, while a fund may have had a gain for the year overall, said Stevens. “It may be appropriate to sell a fund to avoid realizing the gain,” he said.

State Taxes

Taxpayers who do “harvest” losses should keep in mind that the IRS prevents them from reinvesting in the same or substantially identical investment for 30 days before and after the sale, said Timothy Steffen, director of financial planning for Robert W. Baird & Co. in Milwaukee. And individuals shouldn’t upset their long-term investment plan “just to get a tax break,” said Rande Spiegelman, vice president of financial planning at Charles Schwab Corp. (SCHW)’s Center for Financial Research.

There also may be tax changes at the state level that individuals should consider, said Elda Di Re, area leader of the personal financial services tax division of Ernst & Young in New York.

New York Governor Andrew Cuomo and legislative leaders reached an agreement on Dec. 6 to create new tax brackets that would cut taxes for married couples earning less than $300,000 and set a maximum levy of 8.82 percent for those joint filers earning more than $2 million. Under a so-called millionaire’s tax that is scheduled to expire on Dec. 31, those making more than $500,000 are taxed at 8.97 percent.

Saul Brenner, a tax partner at accounting and advisory firm Berdon LLP, said he had told clients in New York to postpone closing deals until January because of the expected lower rates.

Donations to Charities

There are other federal tax breaks set to expire at the end of 2011 that individuals may want to use while they still can, said Ted Sarenski, a certified public accountant and president of the fee-based financial planning firm Blue Ocean Strategic Capital in Syracuse, New York. That includes a rule related to charitable donations from IRAs, Sarenski said.

Owners of traditional IRAs, which generally have tax- deferred contributions, must take annual distributions starting at age 70 1/2 or over, according to the IRS. This year, savers are allowed to donate up to $100,000 from their IRA directly to a qualified charity without paying income tax on that money.

“That’s often a good way to get rid of the required minimum distribution without it hitting your income,” said Stevens of Aspiriant. The tax break doesn’t include gifts to so- called donor-advised funds or private foundations, and the payment must be a direct transfer from the IRA trustee to the qualified charity, according to the IRS.

Other Tax Breaks

Congress has in the past extended, or retroactively extended, miscellaneous tax breaks that are expiring such as deductions for teachers or the so-called patch on the alternative minimum tax, said Di Re of Ernst & Young. “They always seem to be able to pull that out of the bag at the last minute,” she said.

The alternative minimum tax requires taxpayers to compare their tax liability under the regular tax code with what they would owe under the AMT, which doesn’t allow taxpayers the full benefits of state and local tax deductions or personal exemptions. Because the AMT wasn’t indexed for inflation, over time it captures more Americans and Congress has spared some with a series of annual “patches.”

Payroll Tax

Lawmakers also are debating the extension of a payroll tax cut for workers that expires Dec. 31. Senate Democrats are heading toward a Dec. 9 vote on a plan to pay for it with a 1.9 percent surtax on annual income exceeding $1 million, which Republicans have declared unacceptable.

Advisers including Di Re of Ernst & Young and Fleming of PricewaterhouseCoopers said the biggest changes they’re planning for may come at the end of next year.

A provision letting individuals generally gift up to $5 million during their lifetime without paying tax is set to expire at the end of 2012 and revert to $1 million unless Congress acts. Those wanting to move money out of their estate should consider making a plan to use some or all of that gifting opportunity as they prepare this year’s return, said Di Re.

‘Double Whammy’

In 2013, higher earners also may see a “double whammy” from increased levies on income and investments, said Fleming.

The health-care bill passed by Congress in March 2010 included a 3.8 percent tax starting in 2013 on investment income such as realized capital gains, plus a 0.9 percentage point rise in the Medicare payroll tax on wages for those couples earning more than $250,000 and for individuals making at least $200,000.

President Barack Obama also has proposed letting tax cuts enacted during the presidency of George W. Bush expire at the end of 2012 for those same higher earners, meaning levies on their income increase to as much as 39.6 percent from 35 percent.

“We’re telling people, get ready to bunch your income in 2012 and postpone deductions in 2013,” Fleming said. “You can’t turn income on a dime. You have to plan months and months ahead of time.”

To contact the reporter on this story: Margaret Collins in New York at mcollins45@bloomberg.net.

To contact the editor responsible for this story: Rick Levinson at rlevinson2@bloomberg.net.

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