With the election behind us and the close of 2012 approaching, a new reality is coming up the walk and knocking at the door — the 2011 Budget Control Act.
Set to go into effect Jan. 1, the law brings with it mandated cuts in spending — $1.2 trillion to be split between defense and nondefense spending — and higher taxes. This is the “fiscal cliff.” Unless Congress takes action, the economy is going to have a bitter pill to swallow as we head into 2013.
The list of tax cuts set to expire is long and will impact many people in many different ways. Here are some of the more notable changes:
• Payroll tax cuts will result in a 2 percent pay decrease for workers.
• The alternative minimum tax (AMT) patch, or exemption, will fall back to $45,000 for joint filers, which could lead to a tax increase for many unsuspecting families. The exemption for joint filers in 2011 was $74,450.
• The option for taxpayers to elect to claim general sales taxes instead of income taxes as an itemized deduction will expire.
• The phase-out of itemized deductions and exemptions for those with high “adjusted gross incomes” (AGI) will be reintroduced.
• The child tax credit will be cut in half, from $1,000 to $500.
• There will be a reduction in the dependent care credit and adoption credit.
• The 30 percent tax credit for consumer energy efficiency will turn off.
• The $250 teacher deduction for supplies will be erased.
• Marginal tax rates will increase, with the top two brackets moving from 33 and 35 percent to 36 and 39.6 percent, respectively.
• Capital gain rates will rise from 15 to 20 percent.
• Qualified dividends now taxed at 15 percent will be taxed as ordinary income, with a top rate of 39.6 percent.
On top of these changes, the 2010 health care reform legislation adds an additional 3.8 percent Medicare tax on the unearned income (interest, dividends, capital gains, rent, etc.) of high income taxpayers (income in excess of $200,000 for individuals/$250,000 for married couples).
These are significant changes that will ultimately touch all Americans in one form or another.
Will lawmakers keep on the current course despite the Congressional Budget Office report that suggests the decreased spending and increased taxes could push our economy into another recession?
If the bridge is out ahead, will the economic bus keep going? Maybe. Maybe not.
THE TAX PLANNING CONUNDRUM
There’s not a lot of time left, but Congress can still act. Here are a couple of possible scenarios:
1. Congress can eliminate some or all of the scheduled tax cuts set to expire and remove some of the target cuts in defense and nondefense spending.
2. Lawmakers could opt to work from the middle and address budget issues on a limited basis, mitigating the impact on the economy.
Since Congress opted to delay any changes regarding spending or the removal of tax cuts until after the election, an agreement has to be reached in a matter of weeks. And here lies the conundrum. If the economic bus keeps on its current course, the general rule of thumb for tax planning — delay income and accelerate expenses — gets thrown to the side of the road.
Instead, taxpayers need to take the following steps now to help ease the pain later:
• Accelerate income and long-term capital gains.
• Postpone losses and deductions.
• Convert nondeductible debt to deductible debt.
• Consider a Roth IRA conversion.
• Exercise employer stock options.
• Maximize retirement plan contributions.
• Take advantage of tax diversification and asset location strategies.
• Use tax-exempt municipal bonds for fixed income allocation in taxable accounts.
• Consider partial allocation to cash-value life insurance.
• If gifting, consider income-producing assets.
We can’t predict whether Congress will act to change these tax laws. So taxpayers need to buckle up and keep their eyes on the road ahead. And given that 2012 income tax rates are historically low and taxpayers are faced with potential rate increases, it’s important to compare your current tax situation with a projected tax scenario under the higher tax regime.
Doing so will allow you and your advisers to determine which strategies are best for your individual circumstances.
Remember, specific tax strategies need to be tailored to your unique situation and the tax impact should only be one factor in determining how you manage your finances.
However, proper planning for the projected tax changes can enhance your financial position. Your financial planner can help ensure that it does.
Sterling Kozlowski is the president of the New England district of KeyBank in Portland. He can be reached at 874-7298 or by email at email@example.com.