The end of any year calls for a certain amount of routine tax planning—defer income, accelerate expenses, make a charitable donation. But this isn’t just any year; this is Taxmageddon. With the looming fiscal cliff and President Obama’s pledge to raise taxes on the wealthy, you may need to do things differently.
Already, hundreds of large corporations have acted preemptively. Wal-Mart moved its fourth-quarter dividend from Jan. 2 to Dec. 27—accelerating, not deferring, $1.34 billion of income to shareholders. Why? Currently, the top rate on dividend income is 15%. If no action is taken on the fiscal cliff, that rate will soar to 39.6%, and wealthy investors will be socked with an additional 3.8% to pay for the new federal health care law.
Teen apparel chains Hot Topic and Buckle also said they would move regular dividends into December. Others including gaming company Wynn Resorts and hospital firm HCA have declared special dividends in order to distribute cash to shareholders before tax rates rise. Special dividends this quarter are being announced at four times the ordinary pace.
The higher tax rate on dividends applies to all taxpayers, not just those with household income above $250,000. So dividend-dependent retirees should take special note. Dividends would become taxable as ordinary income at whatever bracket you fall under. Only those with income above the $250,000 threshold would pay the surcharge to fund the new health care law.
Also set to rise is the capital gains tax rate, which is 15% currently and would jump to 20% for all taxpayers that invest through a taxable account. The 3.8% surcharge for wealthy households applies here too. So it may make sense to accelerate this type of income. Many small business owners are racing to close the sale of their business this year, for just this reason. You might look at your stock holdings and consider taking gains before next year.
With fiscal cliff negotiations just heating up, much about next year’s tax schedule is up in the air. Most of the likely tax changes will hit only the wealthy. Yet there is no saying how this will sort out. Here are five steps to consider before year-end:
- Accelerate income It’s all but certain that you’ll pay more tax next year on dividend income and capital gains. But you may pay more on ordinary income too, a clear risk for wealthy households. Consider asking that any expected bonus be paid this year and if you are taking distributions from an IRA consider pulling out next year’s money before year-end.
- Convert a traditional IRA to a Roth If you believe tax rates will be higher next year, the cost of converting will be lower if you act now. You can always change your mind and reverse the conversion next year if you find that your tax rate has not gone up.
- Make gifts now The estate tax and lifetime gift tax exemption is set to drop to $1 million from just over $5 million and the maximum tax on amounts over the exemption is set to increase to 55% from 35%. A deal likely will reach some middle ground. But estates will be harder to shield going forward.
- Plan to live on less next year Marginal income tax rates are going up for top earners. Others will feel the bite of higher payroll taxes as the two-year break in Social Security payments runs its course and workers’ portion jumps back to 6.2% of pay from the current 4.2%.
- Pay next year’s school tuition now The American Opportunity Tax Credit, worth up to $2,500, is set to disappear and there is no evidence Congress will save it.