Now that the election is over, tax law changes are coming. It's important to prepare now for next year so you aren't surprised by what you owe (or the size of your refund) after end of 2013. Here's a look at what to watch:
Increases in the capital gains tax rate. The capital gains tax rate is increasing from 15 percent to 20 percent, and for lower-income households, it's going from zero percent to 10 percent. In a normal year, tax strategists talk about capital loss harvesting. However, with a pending rise in the tax rate, Michael Kitces, partner at the Pinnacle Advisory Group, a Columbia, Maryland, private wealth management firm, recommends investigating selling investments held in taxable accounts that have experienced sizeable gains. Because there is no wash rule for capital gains, you could immediately repurchase the same investment and readjust your basis, locking in the capital gain this year while tax rates are still lower. Higher income earners should pay special attention.
According to Kitces: "For higher income individuals, the capital gains rate rises not just to 20%, but to 23.8%, thanks to the new Medicare tax on unearned income, which just increases the imperative for harvesting capital gains. Alternatively, this also means that even if you think Congress will intervene to prevent the fiscal cliff, capital gains harvesting is still relevant for higher income clients to avoid the Medicare surtax next year. It's also generally still relevant for a lot of lower income individuals as well, as even if the rates are extended, it's hard to do harm by harvesting gains at 0% (especially if you're in a state with no state income tax liability either)."
Increases in the dividend rate. Qualified dividends will be taxed at the individual's income tax rate rather than at the previous 15 percent dividend tax rate. You can expect many companies to issue special dividends in 2012 rather than 2013 to allow their shareholders (oftentimes employees of the companies themselves) to benefit from what is usually a lower tax rate than they will face in the future. If you're a lower-income household, it might be worth investigating putting dividend-paying funds into your taxable accounts since you might wind up with a lower tax rate than before if your marginal tax rate is already below 15 percent.
If you're in a higher income household, you may want to look at moving your long-term, dividend-paying and interest-generating investments into retirement accounts and replacing them in your taxable accounts with growth-oriented investments.
Higher personal income tax rates. The highest personal income tax rate increases from 35 percent to 39.6 percent, and, additionally, there is a 3.8 percent Medicare surtax on unearned income above $250,000 for married filing jointly households and $200,000 for single filers. Depending on how the extension of the Bush tax cuts plays out, if you have to choose between contributing to an IRA in 2012 or in 2013 (ideally you contribute in both years, but sometimes it just doesn't work out that way), you may want to consider one of these strategies:
--If your income tax rate will rise and you qualify for a Roth IRA: Contribute in 2012, since Roth IRA contributions are made with after-tax money.
--If your income tax rate will rise and you do not qualify for a Roth IRA and can deduct IRA contributions: Contribute in 2013, since these contributions can reduce your adjusted gross income (AGI), and you're reducing the amount of tax you have to pay in a higher tax year.
The good thing about deciding what to do with your IRA is that you don't have to make the decision this year. You can fund your 2012 IRAs up until the April tax filing deadline in 2013, meaning you have some time to see how the "fiscal cliff" negotiations play out and what the new Congress does before making your decisions.
As always, there are many other considerations to take into account when planning your investing strategies to account for changing tax laws, so it may be wise to seek the advice of a financial planner or CPA before making these moves.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.