As 2012 winds down, the uncertainties about income and estate tax rates for 2013 persist. Unfortunately, it’s not entirely clear when we will have answers. Whether the 2001 and 2003 income tax cuts (i.e., the so-called Bush tax cuts) and/or the estate and gift tax rules enacted in 2010 will be allowed to expire is difficult to predict. Their fate will be in the hands of a lame duck Congress after the November election. If the Bush tax cuts are allowed to expire, the highest ordinary income tax rate will increase from 35% to 39.6%, the highest rate on long- term capital gains will increase from 15% to 20% and dividends will be taxed at ordinary income rates instead of 15%. A host of other tax breaks would also be eliminated.
There is speculation that the Bush tax cuts will be extended in full or at least in large part for at least one year so as to not disrupt an already fragile economy. However, given the political climate in Washington, there are no guarantees or safe bets when it comes to tax legislation.
We do know that, as a result of the Health Care Reform legislation, Medicare taxes will increase for “high” income individuals. Beginning in 2013, the employee’s share of Medicare tax imposed on earned income (i.e., wages) will increase from 1.45% to 2.35% on earned income above $250,000 for individual’s filing joint tax returns (above $200,000 for single filers). In addition, a new 3.8% Medicare tax will be imposed on the lesser of the individual’s investment income (i.e., capital gains, interest and dividends) of individuals or the excess of the adjusted gross income over $250,000 on a joint tax return ($200,000 for a single return). The new Medicare tax on investment income will not apply to distributions from retirement plans or distributions from S corporations.
In light of the potential increase in tax rates in 2013, consideration should be given to departing from traditional tax planning strategies for deferral of income and acceleration of deductions. If rates increase significantly, taxpayers may be dollars ahead if they are taxed on income in 2012 rather than 2013 even taking into account the time value of money. It is too early to take action now; but it is advisable to look ahead to possible tax saving moves that could be implemented when tax legislation takes shape at year end.
Notably, the possible increases in tax rates are likely to occur at the individual as opposed to corporate level. As a result, year-end tax strategies should involve individuals and individual owners of pass-through entities. Even if regular tax rates increase, one must still consider the impact of the alternative minimum tax to determine whether accelerating income or deferring deductions will produce a tax savings. Income deferral/acceleration opportunities include the timing of 401(k) deferrals, charitable contributions, conversions of traditional IRAs to Roth IRAs, sales of capital assets and whether or not to effectuate Section 1031 like-kind exchanges of real property.
It is an interesting time. Paying close attention to year-end tax legislation and reacting appropriately may produce significant tax savings.
*This post was written by attorney Bruce E. Babcock