2013 Tax Outlook: Facing the “Fiscal Cliff”

December 27, 2012

2013 Tax Outlook: Facing the “Fiscal Cliff”

The 2012 election left us with the same President, same Democratic-controlled Senate, and same Republican-controlled House of Representatives. But 2013 brings several new challenges. That’s because several important tax provisions are scheduled to expire at the end of the year, in what some observers are calling “Taxmageddon” – and others are calling a “fiscal cliff”:

• First, the Bush tax cuts are scheduled to expire. If Washington can’t find political agreement to extend them, top rates on ordinary income will return to their previous level, rising from 35% to 39.6%, top rates on capital gains will rise from 15% to 20%, and top rates on qualified dividends will rise from 15% to 39.6%.

• Next, the current 2% payroll tax “holiday” will end. This will mean as much as $1,000 in additional tax on workers earning $50,000 per year.

• Third, the Alternative Minimum Tax “patch” will expire, subjecting millions more Americans to the AMT.

• Finally, the Medicare tax provisions of the Affordable Care Act, or “Obamacare,” take effect. This will mean an additional 0.9% tax on earned income above $250,000 and a 3.8% tax on investment invome for taxpayers earning more than $200,000 ($250,000 for joint filers).

Right now, taxpayers across the country are waiting for Washington to act. And you can be sure we’ll be watching closely to see how it all affects your taxes!

This letter summarizes some of the future tax hikes we can expect and offers suggestions for avoiding them where possible. We look forward to discussing these threats and helping craft the appropriate response! Call us at 8052643305.

Tax Brackets Uncertain!
If Congress can’t agree to extend the Bush tax cuts, rates will rise automatically in 2013. Traditional tax planning wisdom suggests that if rates are set to rise you should consider timing your income and deductions where possible, for maximum tax advantage.

If you expect to earn less in 2013, consider delaying some of this year’s income (to subject it to tax next year, when you’ll be in a lower bracket). And pay deductible expenses this year, as much as you can.

Or, if you expect to earn more in 2013, consider accelerating income from commissions, bonuses, and qualified plan withdrawals into this year (to subject it to tax now, before you move up into a higher bracket next year). You might also delay paying deductible expenses until next year, to the extent possible.

The problem now is that we can’t be sure which way rates are headed. As previously mentioned, President Obama has proposed raising rates back to Clinton-era levels on income above $200,000 ($250,000 for joint filers). Republicans generally favor keeping current rates for all taxpayers. We’ll just have to wait and see whose plan prevails.

Itemized Deductions Going Down?
Over the longer term, President Obama has proposed limiting the value of itemized deductions to just 28%, even for taxpayers in higher brackets. Republican candidate Mitt Romney proposed limiting itemized deductions from all sources to a certain fixed number, such as $25,000 or $40,000, and this idea is also gaining favor. Either of these would amount to a “stealth” tax increase and cut the value of deductions for medical expenses, state and local taxes, mortgage interest, and even charitable gifts.

Tax Strategies for Healthcare Costs
Paying for medical care becomes harder every year. The recent healthcare reform act improves coverage and extends it to more Americans, but actually makes it harder to deduct unreimbursed expenses. (Under current law, you can deduct medical expenses exceeding 7.5% of your Adjusted Gross Income. Under the new law, starting in 2013, that floor rises to 10%.) It also limits contributions to employer-sponsored flexible spending plans to $2,500/year.

If you’re free to select your own coverage, consider choosing a “high-deductible health plan” and opening a Health Savings Account. These arrangements bring down premium costs and use pre-tax dollars for out-of-pocket costs, bypassing the floor on AGI. If you’re self-employed, consider establishing a Medical Expense Reimbursement Plan, or MERP. These plans let you pay family medical expenses with pre-tax business dollars. They may even help you avoid self-employment tax.

Audits Are on the Rise
IRS audit odds are increasing, basically doubling since the year 2000. But while your chance of getting audited is relatively small, certain income levels and certain items of income or deductions can really escalate the chance of audit. This being said, don’t take low audit rates as an invitation to cheat! But don’t let fear of an audit stop you from taking every deduction you’re entitled to.

New Tax on Interest Income
The healthcare reform act imposes a new “Unearned Income Medicare Contribution” of 3.8%, beginning on January 1, 2013, on interest income, for taxpayers reporting more than $200,000 ($250,000 for joint filers). This tax may make municipal bonds and money market funds more attractive relative to fully taxable vehicles. However, the recession has jeopardized state and local tax revenues, so there may be credit quality issues to consider. You might also consider deferred annuities and permanent life insurance for fixed-income portions of your portfolio.

New Tax on Dividend Income
Tax on “qualified corporate dividends” is currently capped at 15%, even for taxpayers in the highest brackets. However, beginning in 2013, the healthcare reform act imposes a new “unearned income Medicare contribution” of 3.8% on dividend income for individuals earning over $200,000 ($250,000 for joint filers). Consider favoring stocks that pay little or no dividend in taxable accounts and holding stocks paying higher dividends in tax-deferred accounts.

New Tax on Real Estate Income
The healthcare reform act imposes an “unearned income Medicare contribution” of 3.8%, effective starting in 2013, on income from real estate investments and taxable gains from the sale of your primary residence, for individuals making over $200,000 ($250,000 for joint filers). There are several strategies you can use to minimize taxable real estate income, including favoring tax-deductible “repairs” over depreciable “improvements” and cost segregation strategies to maximize depreciation deductions.

Higher Tax on Capital Gains
Tax on long-term capital gains (from property you hold more than 12 months) is currently capped at 15%, even if your regular tax rate is higher. President Obama has proposed letting that rate return to a Clinton-era 20%, for those earning over $200,000 ($250,000 for joint filers). We’ll just have to wait for Washington to act on the “fiscal cliff” to see where 2013 rates fall.

The recent healthcare reform act also imposes a new “unearned income medicare contribution”, beginning in 2013, of 3.8% on capital gains for individuals earning over $200,000 and families earning over $250,000. If you have appreciated assets such as securities, real estate, or a business you’d like to sell, consider doing so before new rates become effective. Check with us first, to discuss if you can use tax-free exchanges, installment sales, charitable trusts, or similar strategies to minimize or even eliminate tax on those sales.

Uncertainty on Estate Tax
The estate tax actually “died” for 2010. Washington brought it back to life, with a 35% tax applying on estates over $5.12 million per person. However, the new system applies only for 2011-2012. If Washington doesn’t act to extend it, the tax reverts to 55% on estates over $1.0 million, beginning January 1, 2013. This means that smart, flexible estate planning will still be part of most affluent families’ plans.

Next Steps
We’re sure you appreciate this brief outline of upcoming tax threats. While smart intelligence is crucial, intelligence alone is useless without the right action. If the threats we’ve discussed so far have you worried about your financial future, you owe it to yourself to take a more comprehensive look at your taxes and finances, so that we can determine exactly which concepts and strategies will work from here.

Sincerely,

Bob

Robert W. Craig, E.A. Tax and Business Services
1444 Aarhus Drive, Solvang CA 93463
Tel: (805) 264-3305

Any tax advice contained in the body of this presentation was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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