There is no question that December finds many of us fully immersed in the holiday season.  Whether it is searching for the perfect gift or finalizing travel plans, spending time with family and friends is our highest priority.  However, if we can spare a few minutes between shopping and family photos, there is still time to take advantage of many tax saving strategies.

The transition from 2011 to 2012 lacks the same drama and uncertainty we experienced during the end of 2010.  There is no significant tax legislation effective January 1, 2012.  However, there are a few notable provisions scheduled to expire at the end of 2011 unless Congress decides to take action.

Provisions Expiring at the end of 2011

  • The option to deduct state sales tax will not be available after 2011.  If you find yourself considering the purchase of a big-ticket item, you may want to accelerate the purchase into 2011 in order to assure an itemized deduction option for the sales tax.
  • 2011 may be the last year that taxpayers age 70 ½ or older are able to make charitable contributions of up to $100,000 directly from their IRAs and avoid including that amount of the required minimum distribution in taxable income.
  • Unlike the regular tax system, the alternative minimum tax (AMT) system is not regularly adjusted for inflation.  Congress must legislate any adjustments.  Typically, they have done this through a “patch” which increases the amount of income exempt from AMT.  The patch increased the AMT exemption to $74,450 for joint filers during 2011.  Currently, there is no patch in place to increase the exemption for 2012.  Therefore, if Congress does not act, the AMT exemption will return to $45,000 for joint filers.  This will result in approximately 25 million additional taxpayers becoming subject to AMT in 2012.

Year-end planning involves some educated guesswork because we have to consider two years at the same time.  Tax rates will remain relatively the same, at least for another year.  Therefore, if you believe your 2012 income will be similar to that in 2011, it may be beneficial to defer as much income as possible from this year to the next.  The complicating factor is the uncertainty over whether Congress will act before the top tax rates are scheduled to return to 39.6% after 2012.  As always, we will monitor this situation closely and provide you with regular updates.  Until then, we will focus on the current tax saving strategies available to you during the next few weeks.

Strategy:  Postponing Income & Accelerating Deductions

A key portion of year-end planning focuses on income timing decisions.  The last month of the year may be the time to consider postponing income and accelerating deductions.  If you believe your income and deductions will be comparable during 2012, this strategy may allow you to defer taxes to next year since tax rates are relatively stable from 2011 to 2012.

In order to delay income to the following year, you may be able to:

  • Defer year-end bonuses;
  • Defer the sale of capital gain property;
  • Defer the receipt of IRA distributions (other than RMDs) until January 1st.

To accelerate deductions into this year:

  • Consider maximizing the use of itemized miscellaneous expenses and/or medical expenses by bunching such expenses in the same year to the extent possible.  This will allow you to meet the required threshold percentages of adjusted gross income (AGI).
  • Consider making your January mortgage payment in December in order to deduct the interest paid in the current year.
  • Consider paying 2012 property taxes in 2011.
  • Consider making next year’s charitable contributions this year.  You may use a credit card to make contributions to ensure they can be deducted in the current year.  Securities with an unrealized gain which you have held more than one year can be one of the best charitable gifts.  You are able to deduct the current fair market value (FMV) and avoid the capital gains tax that you would have paid if you sold the security.  On the contrary, if you have an unrealized loss in the security, you will want to sell it first to recognize the loss and then contribute the proceeds to charity.

If you believe AMT could be an issue for you, it is important that you exercise caution before utilizing the above strategies.  Certain itemized deductions are not allowed when determining AMT, such as the deduction for property taxes.  Other deductions, such as medical expenses and miscellaneous expenses have higher threshold percentages of AGI for AMT purposes.

Strategy:  Roth Conversions

If you have not made a Roth conversion, doing so at year-end 2011 or even 2012 might be an opportunity worth serious consideration.  If tax rates are expected to increase after 2012, you will want to recognize the income from the conversion before the rates increase.  Please keep in mind that there are many factors to consider when determining if a Roth conversion is right for you.

Consider the following:

  • Your age;
  • Your retirement date;
  • Your present income tax bracket;
  • Your ability to access non-IRA funds to pay the conversion tax; and
  • Your ability to postpone distributions from your Roth IRA for at least 5 years.

If you converted an IRA to a Roth IRA during 2010 and took advantage of the income deferral to 2011 and 2012, please remember to factor this additional income into your year-end planning. 

Strategy:  Roth Conversion Recharacterization

If you made a Roth conversion during 2011 and that account balance has significantly declined in value, you may want to consider recharacterizing the conversion.  This will “reconvert” your Roth IRA back to a regular IRA and allow you to avoid paying income tax on the higher account value.  You will be able to convert back to a Roth IRA at a later date.

Strategy:  Advantages of Federal Income Tax Withholding

Year-end planning also involves ensuring that you have paid in sufficient income taxes during the year to avoid an underpayment penalty.  If you believe that you did not pay in enough with your quarterly estimated tax, you still have an opportunity to avoid having the IRS assess an underpayment penalty.  If your income consists of wages and other income, you have the option to request that your employer increase your federal income tax withholding.  Even though the additional withholding will not be submitted until this month, it will be treated as if it were withheld evenly throughout the year.

If you do not have wage income, you still have the ability to take advantage of federal income tax withholding.  You have the option to take an IRA distribution and withhold the amount you believe you have underpaid for the year.  You would then immediately “redeposit” the entire distribution amount (including withholding) back into your IRA account.  The distribution will not be included in your taxable income as long as it is redeposited within 60 days.  However, the amount withheld will be treated as if it were paid evenly throughout the year and you will avoid any underpayment penalty.  Even though you have 60 days to redeposit the funds, it is recommended that you do so before the end of the year.  You are only allowed to redeposit funds once in any 12 month period.  Therefore, if you would like the option to utilize this strategy next year, you will need to have the funds redeposited before December 31st.

Estate & Gift Tax 2012 Inflation Adjustments

The unified estate and gift tax exemption for 2012 will be $5,120,000.  This is an increase of $120,000 from the 2011 amount.  The estate tax exemption is scheduled to return to the $1,000,000 limit established under previous law after 2012.

The gift tax annual exclusion will remain at $13,000 for 2012.

Planning for Future Changes

Beginning in 2013, high income individuals may be subject to a new 3.8% Medicare contribution tax on unearned income under the Health Care Reform Bill.  The tax is equal to 3.8% of the lesser of:

  • Your net investment income (generally, net income from interest, dividends, annuities, royalties and capital gains, as well as income from a business that is considered a passive activity), or
  • The amount of your modified adjusted gross income that exceeds $250,000 for married filing joint or $200,000 for a single filer.

Fortunately, qualified retirement plan and IRA distributions are not considered investment income.  This new tax is also imposed on estates and trusts, although slightly different rules apply.

2013 Worse Case Scenario:

  • The highest ordinary tax rate returns to 39.6%;
  • Qualified dividends are once again taxed at ordinary rates; and
  • The Medicare contribution tax is not repealed.

If you meet the income thresholds mentioned above, you may have a tax rate as high as 43.4% (39.6% + 3.8%) on certain income.

There is no question that Congress has to tackle some very difficult issues next year.  Their track record for compromising and passing legislation has not been very encouraging.  Next year is an election year and we can be certain that the post-2012 expiration of the Bush-era tax cuts, the expiration of the favorable estate and gift tax rules, and the consequences of the Health Care Reform Bill will be the topic of every campaign.  However, the real question is will Congress pass legislation before the end of 2012 or will they leave us scrambling a year from now while we attempt to plan for 2013?  We will be closely monitoring our legislators during the new year and ensure you have the information necessary to make informed decisions.

Disclosures

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.