Year-end tax tips in midst of ‘fiscal cliff’

UPDATED with additional tips, Sunday – 12/30/2012

WASHINGTON – There is more to ringing in the New Year than champagne toasts and resolutions. Jan. 1 marks the official start of tax season.

The current situation with the “fiscal cliff” is not making tax planning very easy. In fact, it’s leaving many Americans uncertain of what to expect. Ellen Stark from Money Magazine offers tips on how to navigate and manage your taxes this year.

Tax breaks and deductions: Now that the stock market has bounced back from the financial crisis, you may be looking at big taxable gains in your portfolio. If you’re concerned about a sizable tax bill on your investment gains, especially if capital gains tax rates go up in 2013, you have a few options.

One is to donate stocks or mutual funds to a charity instead of giving cash. You’ll get to deduct the investment’s full market value on the date of the gift, and you’ll avoid paying any taxes on your gains. But act quickly. Shares must be officially transferred before the end of the year for you to take the deduction next April. You can also give stocks or funds to your children. In 2012, any gifts worth no more than $13,000 are entirely tax-free. Keep in mind, though, when your children sell your investment, they will owe taxes on your entire gain, plus any future profits.

Deadline for retirees: Retirees with IRAs and similar plans have an important December deadline to keep in mind, or pay a steep price. If you have a retirement plan like an IRA or 401K, once you reach age 70.5, you must take money out every year, whether you need it or not. You have to take your first distribution by April 1; after that, the deadline is Dec. 31.

If you fail to take out the minimum required by the IRS, you’ll owe a penalty of up-to-half of what you should have withdrawn. Since 2006, retirees have been able to donate up to $100,000 in IRA distributions directly to a charity. By doing so, you don’t get a deduction for the gift, but you also don’t owe income taxes for the withdraw. The question of whether to renew this popular rule is one of the many matters on Washington’s plate now.

Flexible spending account: An easy way to save on your taxes is to open a health care Flexible Spending Account (FSA) at your job. You fund an FSA with pre-tax dollars, and then spend that money on out-of-pocket health care costs, like co-pays and prescription drugs.

Trouble is, if you don’t spend the money in time, you lose it. About one-third of workers do just that, giving up $120 of their own money, on average. Still have funds left? Stock-up on staples like contact lenses or regular medications, or pick-up a spare pair of glasses. These accounts will be less-generous next year. In 2013, the maximum you can put in shrinks from $5,000 to $2,500.

Shelter your investment gains: If you haven’t fully-funded your 401K retirement plan, you only have until Dec. 31 to do so. Even if it’s too late to change your payroll deduction, your employer may allow you to make an extra lump sum contribution.

You have until April 15 to contribute to an IRA for 2012, but why not get the benefit of tax-deferred growth earlier? You can put in $5,000 or $6,000 if you are 50 or older. If you’re saving for college in a 529 plan, you may want to top-off that account. Thirty-four states offer some kind of deduction for 529 contributions. With a high-deductible health insurance plan, you’re eligible to shelter money in a Health Savings Account. You have until April 15 to fund it, but you must set it up by Dec. 31.

Investment loss: If some of your investment choices didn’t pan-out, you can find a silver lining in your loss, but you’ll need to cut the cord fast. At tax time, investment losses are a valuable thing to have. You can use capital losses to off-set any capital gains; that adds up to tax-free investment income. With what’s left, you can off-set up to $3,000 in ordinary income, and then stockpile losses for future years.

Of course, if capital gains tax rates go up in 2013, those losses will be even more valuable next year. So you might not want to take any more losses than you need to in 2012. If you think the stock or fund you sold is a smart investment, you can buy it back, but you must wait 30 days to do so.

Deductions: If you expect your taxes to go up, one common tax-saving tactic is to push as many deductions as you can into the following year. The higher your top tax rate is, the more valuable deductions are to you. But there’s been talk in Washington of capping the amount of itemized deductions you can take.

For high-earners, a limit on deductions that had been repealed is scheduled to return in 2013. In that case, you might be better off grabbing all the deductions you can in 2012. Most lenders let you make an extra mortgage payment, and you could pre-pay local property taxes or increase your charitable donations. Trouble is, it’s hard to plan amid so much uncertainty. In the end, you may want to grab all of the tax savings you can find now.

Converting a traditional IRA to a Roth IRA: If you’ve been thinking of converting your traditional IRA to a tax-free Roth IRA, this may be the time to do it. There are good reasons to swap-out a regular IRA for a Roth. Individual Retirement Account withdraws are fully taxable. With a Roth, you can take money out tax-free in retirement.

The catch is that you owe income tax on your old IRA balance when you make the switch. In general, converting is a good strategy if you expect your tax rate to be higher in the future. The speculation of rising taxes in 2013 means this may be the time to act. By converting before year-end, you can pay the conversion tax at your low 2012 rate. If tax rates don’t go up in 2013 and you’d rather not pay the tax bill, you can undo a Roth IRA conversion up until October 15.

Unearned income: As part of the health reform law that passed in 2010, high earners will pay an additional 3.8 percent tax on so-called “unearned income,” starting in 2013. That includes your investment gains, dividends and interest. But you’ll only pay this tax on income above $200,000 per year for single tax filers, $250,000 for married couples.

This new tax, often referred to the Medicare tax, is one of the reasons that you may be wondering if you should sell stocks before the year end. The answer is “maybe,” but be cautious. Tax considerations should never get ahead of your overall investing strategy.

Estate taxes: Unless Congress acts quickly, more of your estate could be hit by taxes starting next year. The estate and gift tax limits are among the many expiring tax breaks on the agenda in Washington. In 2012, you can leave just over $5 million to your heirs, free of federal taxes. The same limit applies to lifetime gifts. That cap is scheduled to drop to $1 million in 2013.

Even if Congress raises the estate cap, making small gifts in your lifetime is a smart move. It’s less likely your heirs will owe taxes down the road, and you can help out your kids when they may need it the most. This year, you can give as many people as you want up to $13,000 tax-free. In 2013, you’ll be able to give $14,000 per person.


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