Tax and Financial Planning in 2012: Betting on the House?

Editor: Theodore J. Sarenski, CPA/PFS, CFP, AEP

Since many tax planning articles focus on providing year-end tax advice and planning techniques that may be effective only under certain assumptions about control of Congress and the presidency, some of the time-tested strategies that may benefit taxpayers regardless of the outcome of the election have fallen through the cracks.

Tax professionals offering tips based on possible legislation are essentially gambling and “betting on the House” (and the Senate and the presidency). However, it may behoove tax and financial professionals to avoid the urge to bet on the House and to simply focus on some traditional tips that have withstood the test of time. By doing so, professionals can increase the odds of providing beneficial and effective tax financial planning advice during these uncertain times.

This column reminds advisers of those tips that may be beneficial regardless of what plan is in place in 2013—keeping in mind that effective tax planning advice should ultimately be tailored to each client’s current financial situation, tax bracket, and other key personal factors.

The Current Status

Congress extended the majority of the so-called Bush tax cuts to Dec. 31, 2012, through the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312. But at this writing, no one could predict with any certainty whether those cuts will be extended into 2013 and beyond. Therefore, many advisers have been preparing their clients for a potential return to the “pre-Bush tax cut era” under which:

• Qualified dividends could be taxed at ordinary income rates;
• Ordinary rates could be substantially higher (with the highest bracket increasing from 35% to 39.6%);
• Capital gain rates could increase; and
• The current gift and estate tax provisions may expire, resulting in higher gift and estate tax rates and a reduction in the lifetime exclusion from $5.12 million to $1 million.

This potential reality has created a major planning conundrum for tax professionals, who are not only wondering whether the cuts will be extended, but are also attempting to combine with them the effects of certain provisions of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, (the Act) that are scheduled to be implemented in 2013.

The provision of the Act garnering the most attention among tax professionals is its 3.8% net investment income tax for high-income taxpayers. This tax is imposed for tax years beginning after Dec. 31, 2012, on net investment income, which includes capital gains, rents, dividends, annuities, royalties, and gross income from any other investments not derived in, and the disposition of property held in, the course of a trade or business that is not a passive activity or trading in financial instruments or commodities. It also includes gain on the disposition of a personal residence in excess of the current Sec. 121 exclusions.

The Act also imposes an additional 0.9% Medicare tax on individuals earning wages of more than $200,000 ($250,000 for married joint filers). Beginning Jan. 1, 2013, employers will be required to withhold the tax. Although employers are not required to match the additional Medicare tax, they are required to begin the additional withholding during the pay period when wages exceed $200,000 for the year.

With all of these uncertainties, it is no wonder that tax planning tips have been all over the spectrum. Professionals expecting 2013 to bring higher income tax and capital gain rates, as well as a lower lifetime gift exemption, have been advising their clients to accelerate income, sell long-term investments, defer deductible expenses, and accelerate gifts. Other professionals, expecting few or none of the aforementioned changes, have been discouraging clients from these strategies—recognizing that income tax rates could even be reduced and that accelerating gifts may result in unexpected consequences (such as the potential “clawback” described below).

Therefore, a tax or financial plan based on any one of the many possibilities for 2013 and beyond is essentially a decision to “bet on the House.” Clients should be advised that some planning strategies will be beneficial regardless of whose tax plan is in place in 2013. These clients should also be advised that 2012 may be the best time to be less creative and to stick to some of the traditional tips (“sure bets”) that continue to withstand the test of time. Clients should also be advised that even with the uncertainties, some “worthwhile gambles” may be better than failing to act.

The following tips may help tax professionals provide clients some sure bets and worthwhile gambles.

Sure Bets

Accelerating health care expenses: This planning tip, which has been around for ages, may be more important this year. Taxpayers projected to exceed the 7.5% of adjusted gross income (AGI) medical deduction threshold should consider making any additional necessary expenses during 2012 to take full advantage of the current threshold.

Beginning in 2013, the medical expense deduction threshold is 10% of the taxpayer’s AGI unless the taxpayer or spouse is 65 or older at the end of the tax year, for whom it remains 7.5% for tax years ending through Dec. 31, 2016. As a result, some taxpayers may not be able to take advantage of the deduction. Advisers should therefore examine their clients’ situation and determine whether medical procedures or major expenses scheduled for 2013 should be taken before the end of 2012.

Managing losses: While it is always important to manage losses, advisers should emphasize this strategy more this year. Before advising clients to recognize losses on worthless stock or other investments in 2012, carefully examine whether doing so will be beneficial. For example, if the sale will not create additional carryover losses or will only marginally reduce offsetting capital gains for the current year, the taxpayer may not get any benefit from recognizing the loss in 2012. It may therefore be wise to advise the client to wait until 2013, due to uncertainty surrounding the tax rates.

Investing in tax-exempt securities: Advisers should examine their clients’ portfolios and determine whether now is a good time to invest in tax-exempt securities. Of course, the drawback associated with this practice is that the return on these investments may not be as lucrative as other investments. However, when one considers that capital gain tax rates may increase, this relative disadvantage may disappear, as the higher rates may diminish returns on riskier investments. Further, regardless of the rates, the client will have safe investments that can be converted into other, possibly more lucrative, assets in the future. In addition, tax-exempt interest is not included in modified AGI in calculating the net investment income tax.

Redeeming savings bonds: Consider advising high-income taxpayers to redeem savings bonds before the end of 2012. Savings bonds traditionally offer very low return rates, and a decision to cash in the bonds before the end of 2012 will likely not have any adverse effects on your client. Conversely, a taxpayer waiting to redeem the bonds until 2013 may incur the 3.8% net investment income tax, further reducing any gain earned on the bonds.

Becoming active: This year is a good time to examine a client’s portfolio and determine whether real estate activities should be combined to change passive activities into nonpassive activities. Rents received by high-income taxpayers will be subject to the 3.8% net investment income tax unless the rent is derived in the ordinary course of a trade or business. Therefore, if you determine that a client is not benefiting from the passive nature of real estate investments, implement a plan to qualify the client as a real estate professional in 2013 (i.e., making sure the taxpayer meets the participation rules of Sec. 469(c)(7)(B)).

Focusing on retirement: It is always a good time to consider a variety of retirement savings vehicles. Now may be a better time than ever for small business owners to consider retirement plans other than 401(k) plans that allow higher contributions. Also, individuals should consider maximizing contributions or making catch-up contributions.

Worthwhile Gambles

Declaring year-end dividends: Many professionals are advising clients with the ability to declare (or deem) year-end dividends to do so. It is possible that as of Jan. 1, 2013, qualified dividends will be subject to ordinary income tax rates. This can result in an astonishing tax increase—from 15% to 43.4% (39.6% plus the 3.8% net investment income tax). Even though many experts believe that Congress will act to avoid such a steep increase, considering the potential effects if Congress fails to act, this gamble may definitely be worthwhile.

Harvesting gains: Many professionals are advising high-income taxpayers to sell lucrative investments and reinvest the proceeds to avoid potentially higher capital gain rates. The problem is that if the rates do not change, taxpayers may regret having forgone the opportunity to defer the tax on these investments and perhaps having lost money on reinvestment expenses. However, for taxpayers in the highest tax brackets, this technique may be worthwhile, considering that the tax on long-term gains may never be this low again.

Transferring assets: For clients still planning to make gifts in 2012, consider advising them to transfer certain capital assets to individuals in lower tax brackets. This may allow the recipient to take advantage of a zero capital gain rate while allowing the client to take advantage of the current gift and estate tax regime.

However, be aware of variables such as the “kiddie tax” and the possibility of a future “clawback” of the gift tax exemption. Currently, no provisions allow a taxpayer’s estate to claim the highest exemption available during the taxpayer’s lifetime. Accordingly, if a taxpayer uses the $5.12 million exemption on gifts this year and then dies in 2013 or after when the exemption may be lower—perhaps only $1 million—the taxpayer’s estate may still be subject to tax on $4.12 million. As a result, professionals advising their clients to transfer assets should carefully calculate the future tax impact associated with a future reduction in the exemption amount.

Observation: Practitioners are divided on whether the clawback in the form of additional estate tax will occur for deaths after 2012 as described above if the estate tax provisions in the Economic Growth and Tax Relief Reconciliation Act, P.L. 107-16, are allowed to sunset. For more, see Hills, “Clawback of the Gift Tax,” 42 The Tax Adviser 572 (September 2011).

Conclusion

While the uncertainties of future tax laws can make for some exciting, creative, and innovative tax and financial planning strategies, advisers should resist the urge to “bet on the House” with their clients’ tax dollars. This is not to say that advisers should completely forgo any tax planning in 2012. Regardless of the uncertainties, the old saying remains true that “failing to plan is a plan to fail.”

Therefore, advisers should take this time to review and implement some of those traditional tax planning tips that have worked well in the past—the sure bets. Some advisers should even determine if riskier plans are worthwhile gambles that may benefit their clients. However, all advisers should be careful and understand that in this time of uncertainty, the odds of providing beneficial and effective tax planning advice drastically decrease if they create a tax and financial plan that focuses on just one of the many possible 2013 tax structures.