Phil Castle, The Business Times
Investors and business owners still have some options to consider in planning for the prospects of higher tax rates and lower exemption levels next year.
But time is running out even as what’s been called a “fiscal cliff” looms and the likelihood Congress will address the issue beforehand diminishes.
That makes it important that investors and business owners meet with their financial and legal advisors before what could be a window of opportunity closes at the end of the year, according to an investment advisor and two accountants who recently offered a detailed analysis of the situation.
Roy Stachnik, an investment advisor who operates Integrated Benefits in Grand Junction, presented a workshop on the potential effects of the fiscal cliff in conjunction with Chris West and Dan Vogel, accountants at Dalby, Wendland & Co., a public accounting and business consulting firm based in Grand Junction.
Stachnik says Federal Reserve Chairman Ben Bernanke coined the term “fiscal cliff” to describe what could be the expiration of Bush-era tax cuts combined with mandatory government spending cuts triggered by the failure of budget deficit negotiations.
Given the extent of congressional action required not only on tax cuts and budgets, but also a farm bill and trade deal with Russia — not to mention the short time available after the upcoming election in which to take action — it’s becoming less likely anything will happen, Stachnik says.
That increases the probability tax cuts will expire and impose higher tax rates on income, capital gains and dividends as well as lower exemption levels for estate and gift taxes.
West says federal income tax rates will increase from 5 percent to 8 percent for the various tax brackets and the top rate will increase from 35 percent to 39.6 percent.
What’s currently no tax on long-term capital gains for those in the lowest two tax brackets will increase to 10 percent and 15 percent. What was a 15 percent tax rate on capital gains for all other brackets will increase to 20 percent, he said.
Qualified dividends, which were taxed at between 0 percent and 15 percent, will be taxed as ordinary income.
Vogel says changes in estate and gift taxes also could take affect in 2013, with estate and gift tax exemptions dropping from $5.12 million to $1 million.
What was a portability provision allowing the unused portion of a tax exemption to pass to the surviving spouse to be used following his or her death could expire, Vogel says.
Moreover, the top estate tax rate on estate assets or gifts above exemption levels could increase from 35 percent to 55 percent.
The presidential candidates have proposed different plans that could be applied retroactively, Vogel says. President Barack Obama has proposed a $3.5 million estate tax exemption and $1 million gift tax exemption with continued portability. Challenger Mitt Romney has proposed an unlimited exemption for estate taxes and a tax rate of 35 percent on gifts above an exemption of $1 million.
In addition to the higher income and estate tax rates that would be imposed following the expiration of tax cuts, a Medicare surtax of 3.8 percent kicks in starting in 2013 under the provisions of federal health care reform legislation.
West says the tax will be applied to certain investment income for taxpayers who exceed threshold levels of $125,000 for married taxpayers filing separately, $250,000 for married taxpayers filing jointly and $200 for all other individual taxpayers.
Although nothing is yet certain, some options remain available to individuals and business owners through the end of the year to avoid or minimize the potential effects of the fiscal cliff, Stachnik, West and Vogel say.
One possible option, West says, would be to harvest capital gains — to sell assets that have appreciated to take advantage of lower tax rates in 2012.
An asset purchased for $2,000 that’s now worth $10,000, for example, could be sold. Depending on the tax bracket of the owner, the resulting $8,000 gain either would not be taxed at all or could be taxed at 15 percent.
If an asset is going to be needed within the next five years, it could make sense to sell it now and avoid higher capital gains taxes later on, West says.
Another option could be the partial or full conversion of traditional individual retirement accounts (IRAs) into Roth IRAs. While taxes are deferred on money put into traditional IRAs, taxes are paid up front on money put into Roth IRAs. When money is withdrawn from traditional IRAs, taxes must be paid. The money, including gains, from Roth IRAs comes out tax-free.
Given the potential for higher income taxes in the future, it could make sense to pay lower tax rates now in converting a traditional IRA to a Roth IRA and then enjoy tax-free withdrawals.
Stachnik says it’s possible to establish multiple Roth IRAs using different assets to allow for more flexibility.
Still another option for those who can afford it is to make gifts in 2012, before potentially lower estate and gift tax exemptions are imposed, Vogel says. Such gifts may be made outright or in the form or trusts.
Business owners faced with lower deduction levels next year who need new equipment, vehicles or other major purchases should consider making those purchases this year, West says. “If you have a need, get it done this year.”
The most important thing to do in preparing for the looming fiscal cliff, Stachnik says, is to meet with financial and legal advisors to start the planning process now.
That process should include a review of all sources of income and take into consideration and short- and long-term goals, he says. It’s then possible to discuss options and implement an appropriate plan.
“There’ a lot of complexity to all of this,” Stachnik says. “It requires planning, but we’re running out of time.”