2012 Year-End Tax Planning for Individuals
October 18th, 2012

2012 began with great uncertainty over federal tax policy and now, with the end of the year approaching, that uncertainty appears to be far from any long-term resolution. As the year draws to a close, many taxpayers are asking how they can plan in light of the uncertainty surrounding the fate of the Bush-era tax cuts and other expiring tax incentives.

A host of reduced tax rates, credits, deductions, and other incentives (collectively called the “Bush-era” tax cuts) are scheduled to expire after December 31, 2012. To further complicate planning, over 50 tax extenders are up for renewal, either having expired at the end of 2011 or which are scheduled to expire after 2012. At the same time, the federal government will be under sequestration, which imposes across-the-board spending cuts after 2012. The combination of all these events has many referring to 2013 as “taxmaggedon.”

Expiring Incentives

Effective January 1, 2013, the individual income tax rates, without further congressional action, are scheduled to increase across-the-board, with the highest rate jumping from 35 percent to 39.6 percent. The current 10-percent rate will expire and marriage-penalty relief will sunset. Additionally, the current tax-favorable capital gains and dividends tax rates (15 percent for taxpayers in the 25-percent bracket rate and above, and 0 percent for all other taxpayers) are scheduled to expire. Higher-income taxpayers will also be subject to revived limitations on itemized deductions and their personal exemptions. The child tax credit, one of the most popular incentives in the Code, will be cut in half. Millions of taxpayers would be liable for the alternative minimum tax because of expiration of the AMT “patch.” (Note that the AMT patch also has not been extended for the 2012 tax year.) Countless other incentives for individuals may either disappear or be substantially reduced after 2012. While a divided Congress may indeed act to prevent some or all of these tax increases, a year-end planning strategy that protects against worst-case scenarios may be especially wise to consider this year.

Year-End Planning

Income tax withholding. Expiration of the reduced individual tax rates will have an immediate impact. Income tax withholding on payrolls will immediately reflect the increased rates. One strategy for taxpayers to avoid being surprised in 2013 is to adjust income tax withholding. Keep in mind that the current 2-percent payroll tax holiday is also scheduled to expire after 2012, so it is a good time to review if a taxpayer is having too much or too little federal income tax withheld from pay.

As mentioned, traditional year-end planning techniques should be considered along with some variations on those strategies. Instead of shifting income into a future year, taxpayers may want to recognize income in 2012, when lower tax rates are available, rather than shift income to 2013. Another valuable year-end strategy is to run the numbers for regular tax liability and AMT liability. Taxpayers may want to explore whether certain deductions should be more evenly divided between 2012 and 2013 and which deductions may qualify, or will not be as valuable, for AMT purposes.

Harvesting losses. Now is also a good time to consider loss-harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may be taxed at a higher rate). The first consideration is to identify whether an investment qualifies for either a short-term or long-term capital gains status, because short-term gains are first offset with short-term losses and long-term gains with long-term losses. Remember also that the wash-sale rule generally prohibits taxpayers from claiming a tax-deductible loss on a security if the taxpayer repurchases the same or a substantially identical asset within 30 days of the sale.

Education expenses. Taxpayers with higher educational expenses may want to consider the scheduled expiration of the American opportunity tax credit after 2012 in their plans. The AOTC (an enhanced version of the Hope education credit) reaches the sum of 100 percent of the first $2,000 of qualified expenses and 25 percent of the next $2,000 of qualified expenses, subject to income limits. If possible, pre-paying 2013 educational expenses before year-end 2012 could make the expenses eligible for the AOTC before it expires. The “regular” Hope credit, and another popular education tax incentive, the Lifetime Learning credit, are not scheduled to expire after 2012.

Job search expenses. Some expenses related to a job search may be tax deductible. There is one important limitation: The expenses must be spent on a job search in the taxpayer’s current occupation. A taxpayer may not deduct expenses incurred while looking for a job in a new occupation. Examples of job search expenses are unreimbursed employment and outplacement agency fees paid while looking for a job in the taxpayer’s present occupation. Travel expenses to look for a new job may be deductible. The amount of job search expenses that may be claimed is limited. A taxpayer can claim the amount of expenses only to the extent that they, together with other miscellaneous deductions, exceed 2 percent of the taxpayer’s adjusted gross income.

Gifts. Gift-giving as a year-end tax strategy should not be overlooked. The annual gift tax exclusion per recipient for which no gift tax is due is $13,000 for 2012. Married couples may make combined tax-free gifts of $26,000 to each recipient. Use of the lifetime gift tax exclusion amount ($5.12 million for 2012) should also be considered. Without congressional action, the lifetime exclusion amount drops to $1 million in 2013.

Charitable giving. For many individuals, charitable giving is also a part of their year-end tax strategy. Under current law, the so-called “Pease limitation” (named for the member of Congress who sponsored the law) is scheduled to be revived after 2012. The Pease limitation generally requires higher income individuals to reduce their tax deductions by certain amounts, including their charitable deductions. A special rule for contributing IRA assets to a charity by individuals age 70½ and older expired after 2011 but could be renewed for 2012.

New Medicare Taxes

In 2013, two new taxes kick-in. The Patient Protection and Affordable Care Act, P.L. 111-148, imposes an additional 0.9-percent Medicare tax on wages and self-employment income and a 3.8-percent Medicare contribution tax. The 3.8-percent Medicare contribution tax will apply after 2012 to single individuals with a modified adjusted gross income in excess of $200,000 and married taxpayers with an MAGI in excess of $250,000. MAGI, for purposes of the Medicare contribution tax, includes wages, salaries, tips, and other compensation, dividend and interest income, business and farm income, realized capital gains, income from a variety of other passive activities, and certain foreign earned income. For individuals liable for the tax, the amount of tax owed will be equal to 3.8 percent multiplied by the lesser of (1) net investment income; or (2) the amount by which their MAGI exceeds the $200,000/$250,000 thresholds. Taxpayers with MAGIs below the $200,000/$250,000 thresholds will not be subject to the 3.8-percent tax.

More Changes for 2013

Many employers with health flexible spending arrangements limit salary reduction contributions to between $2,500 and $5,000. Effective 2013, the Patient Protection Act requires health FSAs under a cafeteria plan to limit contributions through salary reductions to $2,500. After 2013, the $2,500 limitation is scheduled to be adjusted for inflation. Individuals with unused health FSA dollars should consider spending them before year end, or a 2½-month grace period if applicable, to avoid the “use-it-or-lose-it” rule. Keep in mind that health FSA dollars cannot be used for over-the-counter medications (except for insulin) after 2010.

Additionally, the threshold to claim an itemized deduction for unreimbursed medical expenses increases from 7.5percent of adjusted gross income to 10 percent of AGI after 2012. The Patient Protection Act provides a temporary exception for individuals (or their medical expenses cannot be timed for tax deduction purposes, batching expenses into 2012, when the threshold is 7.5 percent, may make it more likely that the expenses will exceed that threshold.

Looking Ahead

In July 2012, the House and Senate passed competing bills to extend many of the expiring incentives one more year. Both bills would extend the current income tax rates (10, 15, 25, 28, 33, and 35 percent) through 2013. The House bill would extend the current capital gains and dividends treatment, but the Senate bill would extend the tax-favorable rates only for individuals with incomes below $200,000 (families with incomes below $250,000). For income in excess of $200,000/$250,000, the tax rate on capital gains and dividends would be 20 percent. Both bills would extend the $1,000 child tax credit through 2013 and provide for an AMT patch for 2012 (the House bill also provides an AMT patch for 2013).

At this time, it is increasingly likely that the fate of all the expiring tax provisions will be decided by the lame-duck Congress after the November elections. Although the House and Senate bills passed in July differ, they have many points in common, the most important being that lawmakers could agree on a one-year extension of the Bush-era tax cuts. However, some observers anticipate no resolution until January 2013 or beyond.