As the year draws to a close, there's still time to reduce your 2012 tax bill and plan ahead for 2013. The following are a few potential tax-saving opportunities. While none of us can predict the outcome of the fiscal cliff drama unfolding in Washington -- except to say that it will be torturous and prolonged and entirely satisfactory to no one -- these strategies offer a way to take some control of your financial future. More detailed information is available in Bloomberg BNA’s Federal Tax Essentials: Individuals.
Accelerate or Defer Income
Typically taxpayers seek to defer income to the following year. And for taxpayers who expect to see lower earnings in 2013 than in 2012 (such as a taxpayer planning to retire), that’s a good strategy. Given the scheduled expiration of the Bush tax cuts and the resulting 2013 tax rate increases, however, many taxpayers may benefit from accelerating income to 2012. If you're self-employed and report income and expenses on a cash basis, issue bills and attempt collection before the end of 2012.
Consider Converting a Traditional IRA to a Roth IRA
Generally, distributions from a Roth IRA are tax-free. Funds in other types of IRAs (including SEPs and SIMPLE IRAs), 401(a) qualified retirement plans, 403(b) tax-sheltered annuities or 457 government plans may be rolled over into a Roth IRA. Such a rollover is treated as a taxable event. The advantage of a conversion in 2012 is that the amount subject to tax would be taxed at a presumably lower rate than the scheduled 2013 rates, and would ensure that future distributions are tax-free.
If you already made a conversion this year, you have the option of undoing it.
In the past, higher-income taxpayers were precluded from making the conversion. Now taxpayers can make Roth IRA conversions regardless of their adjusted gross income (AGI). Also, if you already made a conversion this year, you have the option of undoing it -- and then doing it over again. This is useful if the investments in your IRA have gone down in value, so that if you were to do the conversion now your taxes on the amount would be lower.
Maximize Individual Deductions
There is no overall limit on itemized deductions for 2012. For 2013, the overall limit on itemized deductions is scheduled to be reinstated, which makes deductions more valuable in 2012. Too many itemized deductions in 2012 could trigger the alternative minimum tax, though.
Consider accelerating medical expenses into 2012, especially if your adjusted gross income will be lower this year.
Medical expenses, including amounts paid as health insurance premiums, are deductible in 2012 only to the extent that they exceed 7.5 percent of adjusted gross income. In 2013, medical expenses will be deductible only to the extent they exceed 10 percent of AGI, except for taxpayers age 65 and older. Therefore, it would be wise to consider accelerating medical expenses into 2012.
Remember: If you are self-employed, you are allowed to claim 100 percent of the amount paid during the taxable year for health insurance for yourself, your spouse and your dependents, regardless of that 7.5 percent floor.
Maximize Business Deductions
If you're in business and purchase equipment, you may want to make a Section 179 election. That allows you to expense (i.e., currently deduct) otherwise depreciable business property as long as the property cost does not exceed the yearly cost limitations. Generally, for 2012, you can expense up to $139,000 of equipment costs if the asset is "placed in service" during 2012. In 2013, the $139,000 amount is scheduled to decrease to $25,000. Although there's a chance the 2013 amount will go up if Congress acts, it would be wise to place more assets in service in 2012 if you have yet to hit the $139,000 figure.
For the most part, bonus depreciation is scheduled to expire in 2013.
Also, for assets placed in service in 2012, taxpayers can expense 50 percent of business equipment purchases under a provision giving taxpayers bonus depreciation, mitigating the need for the Section 179 election. Bonus depreciation is additional depreciation allowed in the first year the property is placed in service. Property that exceeds the overall cost limitations that apply to a Section 179 election may still qualify for 50 percent bonus depreciation. And no election is required on the taxpayer’s return in order to take advantage of this additional first-year depreciation deduction. For the most part, bonus depreciation is scheduled to expire in 2013.
Maximize Education-Related Tax Benefits
College tuition, books and certain fees paid on behalf of the taxpayer, his or her spouse or a dependent may qualify for a refundable education credit. The maximum credit for 2012 is $2,500. It's phased out at modified adjusted gross income (for most taxpayers, modified adjusted gross income is the same as adjusted gross income) of between $160,000 and $180,000 for joint filers, and between $80,000 and $90,000 for other taxpayers. However, 40 percent of the credit is refundable, which means you can receive up to $1,000 even if you owe no taxes.
This is an important year to maximize post-secondary savings in a Coverdell Education Savings Account (ESA).
One way to take advantage of the credit for 2012 is to prepay 2013 spring tuition. After 2012, unless extended by Congress, this credit reverts to a lower dollar amount, fewer expenses qualify and it is no longer refundable.
This is an important year to maximize post-secondary savings in a Coverdell Education Savings Account (ESA). For 2012, the aggregate annual contribution limit to a Coverdell ESA is $2,000 per designated beneficiary of the account. In 2013, the amount is scheduled to decrease to $500. The $2,000 limit is phased out for individual contributors with modified AGI between $95,000 and $110,000 and joint filers with modified AGI between $190,000 and $220,000. For 2013, the AGI limits are scheduled to be reduced to $150,000 and $160,000 for joint filers, although the AGI limits for other filers remain the same. So if you file a joint return and your income is approaching the phaseout amount, 2012 is a better year to contribute than 2013.
Plan for Increased Investment Income Taxes
Congress has yet to extend the reduced 15 percent (zero if an individual is in the 10 percent or 15 percent marginal tax bracket) capital gains rates beyond 2012. If not extended, the maximum capital gains rate in 2013 will be 20 percent (10 percent for taxpayers in the 15 percent bracket).
In addition, beginning in 2013, a 3.8 percent tax is levied on certain investment income. This is an Affordable Care Act tax, in effect whether or not the Bush tax cuts are extended. Generally, the tax applies to taxpayers with modified AGI of more than $250,000 for joint returns and more than $200,000 for individuals.
In 2013 dividends could be taxed at ordinary income rates, which could reach 39.6 percent.
Investment income includes interest, dividends, annuities, royalties and rents (other than from a trade or business) and gains attributable to property dispositions (other than property attributable to an active trade or business). Investment income does not include distributions from a qualified retirement plan or amounts subject to self-employment tax. This tax on investment income will raise the maximum net capital gains rate as high as 23.8 percent in 2013. Because distributions from qualified retirement plans aren't subject to the tax, taxpayers may want to invest in retirement accounts, if possible, rather than taxable accounts.
Qualifying dividends received in 2012 are taxed at a maximum rate of 15 percent. Qualifying dividends include dividends received from domestic and certain foreign corporations. If Congress doesn't extend the reduced dividend rates, in 2013 dividends will be taxed at ordinary income rates, which could reach 39.6 percent (43.4 percent with the additional 3.8 percent tax).
Finalize Mortgage Loan Modification of an Underwater Home
If you currently owe more than your home is worth and are attempting to complete a short sale or receive any other mortgage relief from your lender, you absolutely should get this done in 2012. In 2012, qualified mortgage debt relief from your lender is not considered income. However, if Congress fails to extend this tax benefit, any debt discharged on or after January 1, 2013, will be considered income and taxes will be owed on the amount forgiven.
(Karen Fickes is Managing Editor, Federal Tax, at Bloomberg BNA.)
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