This is shaping up to be an interesting, and possibly historic, year for tax planning. Scheduled increases in tax rates for 2013 and beyond, the imposition of a new 3.8% surtax on high-income investors, and the upcoming national elections all could have an impact on your tax bill for years to come. But don’t wait until the election votes have been tabulated to develop your key strategies for 2012. By then, it may be too late to take any meaningful action. Here are eight tax-smart ideas you can put into play right away.
1. Distribute dividends of C corporations. If you’re the owner of a C corporation, it probably will make sense to have dividends paid out to you in 2012. This year, “qualified dividends”—including those paid by most domestic companies—are taxed at a maximum tax rate of only 15%. Unless Congress enacts new legislation, however, beginning in 2013 all dividends will be taxed at ordinary income rates of as high as 39.6%. That could more than double your tax liability for that income.
2. Sell appreciated property. If you own securities or other capital assets that have grown in value, consider selling the property before 2013. The reason is that long-term capital gains—for assets you’ve held for more than a year—will also be taxed at a maximum rate of 15% in 2012. Absent new legislation, however, the maximum tax rate for long-term capital gains will jump to 20% in 2013. Thus, it could be beneficial to start harvesting gains in anticipation of that change.
3. Accelerate installment sales of property. Similarly, if you’re contemplating a future sale of real estate on an installment basis, you might move up the sale to 2012, so that a portion of the gain on the sale will be realized in 2012. If it suits your purposes, you can arrange to recognize a larger portion of a gain from a sale—or even the remaining gain from a prior sale—this year. But keep in mind that if you take this approach you will forfeit any benefit you would have gotten from tax deferral.
4. Sell bonds with accrued interest. If you sell a bond before maturity, part of the sales price represents interest accrued to the date of sale. You must report that part of the sales price as interest income in the year of the sale. But since ordinary income tax rates are scheduled to rise in 2013—the current top rate of 35% will increase to 39.6% in 2013—you can actually save money by selling in 2012, especially if you’re in a high tax bracket.
5. Liquidate underperforming nonqualified annuities. A nonqualified annuity is an annuity that isn’t part of a tax-deferred account such as a 401(k) plan, traditional or Roth IRA, or another tax-advantaged retirement plan. Any gain from the sale of a nonqualified annuity is taxed at ordinary income rates. So if you’re ready to unload a nonqualified annuity that hasn’t met expectations, this is the year to do it, based on the pending tax changes for 2013.
6. Exercise nonqualified stock options. You don’t have to pay any tax when your company grants you nonqualified stock options. However, once you exercise the options, you’re taxed on the “compensation element”—the difference between the exercise price and the market value in that year. Therefore, if you’re holding options on stock that has increased in value, you could decide to exercise the options in 2012 due to the current tax rate structure.
7. Convert a traditional IRA to a Roth. While payouts from traditional IRAs are generally taxed at high ordinary income rates, qualified distributions from a Roth that has been established for at least five years are completely tax-free. The problem is that you have to pay tax at ordinary income rates on the amount you convert. With tax rates rising next year, it could pay to bite the bullet on a 2012 conversion. (If the price of the assets subsequently plummets, leaving you to pay unnecessary tax on their vanished value, you can still “recharacterize” the Roth as a traditional IRA next year and avoid the conversion tax.)
8. Buy permanent life insurance. Although this isn’t strictly an income tax strategy, permanent life insurance—including variations of whole life and universal life insurance—is one of the last great tax shelters. Should you die unexpectedly, your heirs will be entitled to the proceeds without any income tax strings attached. And if you’ve made the proper provisions, the proceeds will also be removed from your taxable estate.