Prepare for tax changes
Consider these seven tax planning strategies that may help in multiple scenarios.
If Congress doesn't take action before the end of the year, a slew of tax breaks will expire in 2013-and a few new taxes will take effect. Rather than try to predict how the debate will turn out, your time probably would be better spent focusing on sound tax planning that can serve you well in multiple scenarios, says Jim Buza, vice president of guidance and advice for Fidelity.
Here are seven strategies that could help you do just that.
1. Convert retirement savings to a Roth (IRA).
There are no income limits for converting to a Roth IRA, so this is an option for taxpayers with eligible qualified retirement savings. Converting to a Roth IRA can be a good strategy if you expect your tax rate to be higher in future years. Qualified distributions from a Roth-including the earnings portion-are tax free.1
The downside to converting is that you have to pay tax on the amount of pretax contributions and earnings you convert. But, again, if you make the conversion in 2012, you'll owe tax at your current rate, not potentially higher future rates.
But what if tax rates don't go up? Not to worry. The law allows you to undo a Roth IRA conversion up until Oct. 15 of the year following the conversion year. So if you convert this year (2012) and Congress decides to retain the current tax rates-or even lower them-you can hit the "back" button until October 15, 2013 (Read Viewpoints: How to reverse a Roth IRA conversion).
2. Maximize tax-advantaged savings.
What if the tax cuts expire?
Contributing as much as you can to an IRA, 401(k), Simplified Employee Pension (SEP), or some similar retirement savings plan typically makes sense for most people in any tax environment. But this year, if you're choosing between contributing to a Roth IRA (assuming you're eligible) and a traditional IRA,2 you might want to see whether a Roth IRA is a good match based on the benefits covered in No. 1, above.
You might also consider a health savings account (HSA). Contributions to an HSA and the earnings in the account are tax free as long as the money is used for qualified medical expenses. (Read Viewpoints: Help grow your nest egg with an HSA).
Another tax-saving option if you have children or grandchildren who plan to attend college is a 529 plan, which allows tax-free earnings withdrawals if the money is used for qualified higher education expenses. Here's the bottom line: Whatever Congress decides regarding tax rates, the current debate and uncertainty underscores the need to get serious about maximizing your tax-deferred savings next year and beyond.
3. Accelerate income into this year.
If you have the option of pulling income into this year from, say, a bonus or by exercising a stock option, you might want to see if it makes sense for you. Be careful when exercising stock options, however, because it is inherently complex and may have a range of potential tax implications, including exposure to the alternative minimum tax (AMT).
If you've reached retirement age and you've been considering taking an elective distribution (as opposed to a required minimum distribution) from a qualified retirement plan, doing so in 2012 could be a wise move if you think your tax rate will be higher next year. Make sure the distribution fits into your long-term plan, however.
4. Carefully evaluate your charitable contributions strategy.
Get the details on looming tax hikes.
Several factors could influence your thinking on charitable contributions this year. On the one hand, you might want to push your contributions into next year, when income tax rates might be higher and the deductions would be more valuable. On the other hand, if the limitation on certain itemized deductions (Pease provision) is reinstated next year and your modified adjusted gross income (MAGI) exceeds the thresholds, you could find that your deduction is reduced.
5. Time your stock sales wisely.
With a possible increase looming in the capital gains tax rate, you might want to consider selling appreciated stocks this year. Similarly, if you typically use a capital loss harvesting strategy, you could consider pushing those losses into next year. Donation of appreciated securities can also be a tax smart charitable contribution strategy.
6. Reevaluate your investment mix.
Preparing for potentially higher taxes on dividends could include investing a larger portion of your income-producing accounts in tax-exempt municipal bonds instead of dividend-producing stocks, or locating dividend-producing stocks in tax-advantaged retirement accounts. Again, you'll want to pay close attention to this strategy's potential impact on your AMT exposure. (Read Viewpoints: Reduce the tax hit on investments.)
7. Prepare estate planning documents.
Of all the tax uncertainties, the estate tax rules could have the greatest financial impact on high-net-worth taxpayers who are unprepared. If you have significant net worth that you want to protect and pass along to future generations, you should seek professional assistance in developing an estate plan. A wealth-transfer plan takes advantage of the many tools involving wills, trusts, and life insurance that could potentially significantly reduce the tax exposure for you, your spouse, and your heirs.
Even if you think Congress is likely to extend the current $5.12 million per person exemption levels for transferring wealth, you should be prepared for the lowest exemption level and start drafting estate plan documents now, so they're ready to go if it does revert to $1 million.
"In all of these areas, you really have to be careful to tightly align your tax strategy with your overall financial plan," says Buza. "You have to balance your desire to minimize taxes with a retirement savings strategy or retirement income plan that suits your needs and preferences."