Photo: Flickr / rittyrats
A good mantra, for investing and the rest of your life, is “Focus on what you can control.”Although most people are inclined to put taxes into the “out of my control” bucket, that doesn’t have to be the case. (For proof, look no further than the army of tax advisors and attorneys geared toward helping the well-heeled shave their tax bills.)
Key to cutting your tax bill is staying current on tax-law changes. Although there aren’t substantial changes to the tax code for the 2012 tax year versus 2011, here’s a summary of recent and impending tax-law changes.
I’ve also provided some ideas on how you can act to either take advantage of these changes or minimize their effect on your bottom line. Some of these changes have an impact only on those in very high tax brackets, while others affect individuals of all income levels.
Social Security Payroll Tax Holiday
Congress extended The Social Security payroll tax holiday through the end of February 2012, though many pundits believe the holiday will eventually be extended through year-end. Under the holiday, the Social Security withholding rate has dropped from 6.2% to 4.2%. As in the past, individuals won’t pay Social Security tax on any earnings over a certain level–currently $110,100. (One related provision that has gotten less play is that when Congress extended the payroll tax, it included an additional provision that levies an additional tax on high-income earners–specifically, a 2% tax on any income earned in the first two months of the year that’s in excess of $18,350 and not greater than $110,100.)
Given that taxpayers are effectively receiving a pay hike, one idea is to divert that money to your own retirement fund, either your company retirement plan or an IRA. Bump up your 401(k) plan contribution to at least match the amount you’re gaining during the tax holiday, and keep your contribution elevated if the holiday is extended for the full year.
Alternative Minimum Tax
The alternative minimum tax is a parallel tax system that disallows many of the credits and deductions that taxpayers are entitled to under the conventional tax system. In the past, Congress has passed “patches” to help limit the number of new taxpayers who are subject to the tax, though it hasn’t yet passed a patch for the 2012 tax year.
If you’ve fallen into the AMT zone in the past, a new patch may not keep you out of it. However, by taking steps to control your AMT-subject income and managing your deductions, you may be able to reduce your AMT tax hit. This article discusses some of the key strategies you can employ, including carefully managing the exercise of stock options (a well-versed tax advisor should be able to help with this) and watching out for private-activity municipal bond funds, which aren’t taxable under the conventional tax system but are for the purposes of AMT.
Through 2012, the tax on qualified dividends remains at zero for taxpayers in the 10% and 15% tax brackets, and is 15% for all other taxpayers. However, the tax on dividends is set to increase to investors’ ordinary income tax rates in 2013, barring Congressional action. Thus, investors who hold dividend payers in their taxable accounts may want to formulate an exit strategy for relocating income-producing stocks to their tax-sheltered accounts, while staying mindful of capital gains taxes if dividend payers have appreciated in their taxable accounts. (Don’t act pre-emptively, though, as Congress could change its mind.)
Long-Term Capital Gains Tax
Through 2012, taxpayers in the 10% and 15% brackets will not owe capital gains tax on the sale of assets they’ve owned for more than one year. Long-term capital gains tax rates remain at 15% for all other taxpayers. Short-term capital gains are taxed as ordinary income. In 2013, long-term capital gains tax rates will jump up from 15% to 20% for most investors; those in the 15% tax bracket will pay a 10% tax on long-term capital gains. Thus, if you were planning on reducing your position in a security anyway, you may be better off doing so in 2012 versus waiting until 2013.
The top estate tax rate is 35% for 2011 and 2012, and it only affects those who have amassed estates of more than $5 million. Those who inherit assets will also once again receive a step-up in the cost basis of those assets, meaning that the inherited assets are valued at their fair market value as of the decedent’s death. However, the federal estate tax is set to jump to 55% for estates of more than $1 million in 2013, barring Congressional action.
Given the uncertainty, you may be assuming that a visit to your estate-planning attorney isn’t necessary. Even if you don’t anticipate that you’ll ever amass $5 million in assets, there’s more to creating an estate plan than sidestepping taxes. A properly crafted estate plan will detail how you’d like your assets distributed after you’re gone and will also specify agents to act on your behalf if you should become disabled.
The annual gift-tax exclusion stays the same as it was in 2011: $13,000. That means you can gift $13,000 apiece to an unlimited number of people this year without having to worry about a gift tax or even fill out the gift-tax paperwork.
Say, for example, you and your spouse would like to help your daughter and her husband buy a new house. You could each gift $13,000 to both your daughter and son-in-law, for a total of $52,000.
Savers in 529 college-savings plans can actually gift $65,000 in a single year without triggering a gift tax, assuming they make no further contributions to the same individual’s college plan in the subsequent four years. In that case, the IRS assumes that your contribution is spread over five years ($13,000 x 5 = $65,000). Married couples can actually contribute $130,000 to one child’s college-savings plan in 2011–assuming they make no further gifts from 2012 through 2015–without getting into gift-tax terrain.
Also, if you’re gifting to pay educational or medical expenses, you can circumvent the gift-tax system altogether by making payments directly to the educational or medical institution.
401(k) Contribution Limits
The maximum 401(k) contribution has jumped slightly in 2012: It’s $17,000 for those under age 50 and $22,500 for savers over 50. (Contribution limits for 403(b) and 457 plan participants are the same.)
Note that the 401(k) limits apply to both Roth and traditional 401(k) contributions. However, because you’re contributing aftertax dollars to the Roth 401(k), your effective contribution rate is much higher than it is for the traditional 401(k). This is one of several reasons I think the Roth 401(k) can be a very attractive option for higher-income savers looking to max out their tax-advantaged options.
IRA Contribution Limits
IRA contribution limits are unchanged from 2011: $5,000 if you’re under 50 and $6,000 for individuals over 50. These amounts apply whether you’re contributing to a Roth IRA, a traditional deductible IRA, or a traditional nondeductible IRA.
Individuals filing singly and making less than $125,000 who are covered by a company retirement plan will be able to make at least a partial Roth IRA contribution in 2012. (The amount you can contribute is phased out, or reduced, for single filers who make between $110,000 and $125,000 a year.) Married couples filing jointly can make at least a partial contribution if they are covered by a company plan and earn less than $183,000 per year in 2010. (Contributions begin to phase out for joint filers earning between $173,000 and $183,000.) Individuals of any age can make a Roth IRA contribution, as long as they have eligible compensation, such as wages, salaries, tips, and commissions.
It’s worth noting, however, that the current Roth IRA income limits are little more than a formality, provided you don’t mind some extra paperwork and don’t have a lot of other traditional IRA assets. This article discusses the so-called “backdoor IRA” manoeuvre, as well as some pluses and potential pitfalls of this strategy.
Individuals earning less than $68,000 in 2012 who are covered by a company retirement plan can make at least a partially deductible contribution to a traditional IRA. (Contributions phase out, or are reduced, for individuals who make between $58,000 and $68,000.) Married couples filing jointly can make at least a partially deductible IRA contribution if they earn less than $112,000. (Contributions begin to phase out for couples who make between $92,000 and $112,000.)
However, despite the deductibility of traditional IRA contributions for some individuals, I think the Roth is the better bet for most people. That’s because you’ll enjoy tax-free withdrawals from a Roth IRA, whereas you’ll owe ordinary income taxes on the traditional deductible IRA withdrawals. Also, the fact that Roth IRAs don’t require mandatory withdrawals is an added benefit for individuals who don’t need the money in retirement; that allows Roth investors to stretch out the tax-saving effects for a longer period of time than is possible for a traditional IRA.
In addition, you can still contribute to a Roth at any age, as long as you have eligible compensation, but traditional IRA contributions aren’t permitted after age 70 1/2. Finally, should you need the money before retirement, a Roth enables you to put your mitts on your contributions at any time without taxes or penalty. Tapping your retirement accounts early isn’t a great idea, but this is by far the best option if you’re in a bind.
As has been the case since 2010, people at all income levels may convert their IRAs from traditional to Roth. This article details the ins and outs of IRA conversions.