Taxpayers last year stood helplessly at the edge of a fiscal cliff waiting for Congress to act on the budget. This year, the earlier resolution of the debt stalemate gives individuals time to plan.
People will need it. They will have to deal with significant changes put into effect at the start of this year in the deal that averted that earlier run toward the fiscal cliff. Despite vows by both parties to simplify things, the four-million-word tax code got heftier, as it does each year. "You really need to do year-end planning," says Gary DuBoff, managing director of CBIZ MHM LLC. "You can't just stick your head in sand. There are so many changes in the law, you need to understand the potential tax implications."
In the weeks that remain in 2013, here are six steps you can take to manage the impact of this year's taxes due April 15:
1. Match gains and losses on your investments. This is always the biggest issue to handle by the end of the year, and this year, the stakes have been raised. The tax rate on long-term capital gains remains at 15 percent for all but the highest income bracket (20 percent now). If you plan to cash in on stock market gains, you might also want to come up with stocks that have lost money that you want to dump. You are allowed to deduct up to $3,000 in losses in a given year. But you can use tax losses to save more than that by taking gains and matching them with losses. So, for example, if you have a $50,000 gain, you can sell an equal amount in losing positions and avoid that large capital gain. It's the net amount that matters for tax purposes. Once you've recognized a loss, you can repurchase a stock if you think it still fits in your portfolio. The so-called wash rule lets you sell a stock to recognize a loss and repurchase it within 30 days. "Time is running out on that one for this year's taxes," DuBoff says.
2. Review dividends to make sure you get lower tax. Qualified dividends get treated the same way as capital gains. The rate remains 15 percent for most people, and increases to 20 percent on the top bracket. There is a holding period of 60 days to qualify for the lower rate on common stock, and 90 days for preferred stock. "This higher rate can really take a tax bite for higher-income people" says Christine Fahlund, senior financial planner for T. Rowe Price Investment Services. "Especially retired people who depend on investment income."
3. Manage your bracket. There are two big cutoffs in tax brackets that have the most impact. If you are close to either, you might have to look for ways to limit your income between now and the end of the year. One way is to hold off on taking a capital gain. If you are a contract or self-employed worker, you can hold off on billing for services.
"Figure out if you are at or near the threshold. And consider ways to defer and avoid recognizing income," Fahlund says. What are the biggest bracket concerns?
- Upper-income taxpayers will see the biggest change. For those with more than $400,000 in income ($450,000 for married couples), the tax rate rises to 39.6 percent from 35 percent. At the other end of the spectrum, nothing changes.
- The most important bracket is the one you hit at the $72,000 income level for married couples, or $36,000 for single filers. This is a significant level, especially for young people and those who are retired. It's the point at which your U.S. income tax rises 10 full percentage points – the biggest single incremental gain on the tax charts – going from 15 percent to 25 percent on income above that level. What's more, it's also the point where you begin paying taxes on dividends and long-term capital gains. Welcome to the middle class!
Since most deductions and credits need to be based on expenses incurred before the end of the year, now is the time to figure them out. (There are numerous smaller brackets where rates rise by between three and five percentage points. You can find them on IRS.gov.) Apart from putting off capital gains, you can contribute to a 529 college fund, donor-advised funds or qualified charities to keep income levels lower, Fahlund says. The college contributions can be revised in later tax years if the money is not used, she adds.
4. Maximize your IRA tax benefits. You have until the tax-filing deadline April 15 to contribute to an individual retirement account, but start planning before the year is up. The amount you can contribute to an IRA has increased $500 this year. It's now $5,500, or $6,500 if you are 50 or older. (The contributions are tax-deductible, for the most part, but the deductions can be limited if you have a workplace plan, depending on your income level.) As part of your year-end check, "make sure you are putting the maximum into workplace savings plans that have a company match," DuBoff says. That's free money.
5. Prepare for the so-called Medicare surtax. This is a new tax that will hit upper-income payers. It will tax net investment income, meaning dividends or capital gains, with an additional 3.8 percent on investment income for people who make over $200,000 if they are single, or $250,000 for married filers. If you are in this income bracket and plan to take capital gains, consider the impact of this new tax before you do. "Harvesting capital losses is a common year-end strategy, but it is more important this year to minimize the 3.8 percent Medicare payroll tax on investment income," says financial planner Jeffrey Christakos of Westfield Wealth Management.
6. Figure out that messy alternative minimum tax so you can finally forget about it. This provision "hits particularly hard those taxpayers who have not done any tax planning," says Nina Olson, the IRS's National Taxpayer Advocate, in her annual report calling for its repeal. Getting it wrong can trigger fines and unexpected taxes. Congress took some action to soften the provision at the start of the year, effectively keeping the provision from hitting middle-income taxpayers.
What is this much-misunderstood tax provision? The AMT is a separate tax you must calculate that figures your tax without adding in often-used deductions. It was instituted decades ago as a way to limit the overuse of deductions. Starting this year, it will have an inflation index so that middle-income earners will be less vulnerable. But you may still need to figure it out on your taxes this year.
(The back-of-the-hand calculation on who pays: Everyone gets an AMT exemption on income of $51,900 for individuals and $80,800 for married joint filers. Then, you apply a rate of 26 percent if your income is below $179,000 or 28 percent if you make more. If the calculation is more than the tax you figured on your old 1040, you must pay the difference.) The Tax Policy Center of the Urban Institute and Brookings Institution estimates that 4 million people will still pay AMT, but the American Taxpayer Relief Act of 2012 spared an estimated 23 million who would have paid under existing rules.
The AMT is complicated – a 55-line calculation on your tax form. If you figure out that piece of your tax puzzle this year, you might not have to worry about it again, maybe ever, thanks to the new inflation index fix. It's a good thing to ask a tax advisor.
Do-it-yourselfers will be happy that electronic returns can actually make filing taxes easier. The online calculators help get you through some of the rough spots. But e-returns are difficult for those who itemize deductions. Consider getting a professional to help if that's your plan. Remember, there have been 4,680 changes to the tax code since 2008, or one per day, according to the Taxpayer Advocate's Office. That's a lot for an amateur to keep up with.
The IRS now has an immense amount of personal data on you, and it is starting to cross-check your personal charge card records and brokerage transactions by computer. Keeping good records is more important than ever. It might be a good year to get a comprehensive review with a tax advisor to go over every item ahead of time.
Ever try to get an accountant's attention in April? Now is the time to get the best help so you are ready for the new tax year.