-¨By Daniel Fuller
March 21, 2013
Until the first of the year, taxpayers were operating in a cloud of uncertainty, making planning extremely difficult. Would the Bush tax cuts be allowed to lapse? Would the estate tax exemption really go back to $1 million? With the presidential election last November, the political climate that ensued and the fiscal cliff towards which the country was heading, we all knew it would be nearly impossible for legislation to be passed before the end of 2012. On the first day of the new year, however, Congress reached a deal avoiding the fiscal cliff and providing some short-term certainty for taxpayers with the passage of the American Taxpayer Relief Act (“ATRA”).
As April 15 approaches, taxpayers are now looking at how to ensure they maximize the lowest tax rates in history. To do this, it is helpful to examine the differences between 2012 and 2103, illustrated below:
The major underlying principle to consider is that realizing income in 2012 at lower rates is better than realizing the same income at higher rates under ATRA. The sale of a business is one situation in which a transaction that occurred in 2012 could be significantly more valuable than one in January 2013. If the business was sold on a installment note, the taxpayer should consider electing out of the installment sale treatment for tax, which would make all of the gain taxable in 2012, thus creating a permanent benefit. For example, a business that sold for a $20 million gain would be subject to capital gains tax of $3 million at the 2012 15 percent rate, but $4 million at the 20 percent rate, and there could be an additional $760,000 of taxes if the sale is subject to the 3.8 percent Medicare tax in effect for 2013. However, the decision to elect out of installment treatment may also need to consider the taxpayer’s cash flow considerations and whether cash is available to pay the tax.
Another method for leveraging the 2012 lower tax rates is to make a Roth Individual Retirement Account (“IRA”) contribution and/or convert your traditional IRAs to Roth IRAs. This allows you to pay the income tax in 2012, and avoid taxation when you withdraw funds in the future. If you cannot contribute to a Roth IRA for 2012 because your income exceeds the contribution limits, consider the “backdoor Roth IRA” technique. To make a backdoor contribution, first make a regular contribution to a Traditional IRA with your IRA custodian. You do not specify to the custodian whether the IRA is deductible or not- it is just treated as a Traditional IRA. As soon as the contribution posts, convert to a Roth IRA.
Taxpayers looking to reduce their income tax have until April 15th to contribute to a Traditional IRA or a Health Savings Account and still get a deduction in 2012. Likewise self-employed individuals could look to contribute to other retirement plans such as a Keogh or Simplified Employee Pension (“SEP”) plan that may provide larger contribution amounts then 401(k) and Traditional IRAs.
For those of you with education expenses, make sure that you take advantage of the education tax credits or deductions. The American Opportunity Credit provides for a tax credit up to $2,500 of the cost of qualified education tuition and related expenses, and up to $1,000 of the credit could come back as a refund. If you are not eligible for the more advantageous education credits, you can still reduce taxable income by up to $4,000 for tuition and other qualified education expenses. Additionally, any student loan interest paid could reduce your income subject to tax by up to $2,500 if you are under the income limitations.
If you have expenses incurred related to your job, these may also be deductible. Teachers, in particular, are entitled to take a deduction up to $250 for classroom supplies that are paid out of their own pocket, regardless of whether they itemize. For taxpayers that receive a W-2, expenses incurred related to your job would be an itemized deduction subject to a 2 percent of Adjusted Gross Income floor. If you receive a K-1 with self-employment income, these expenses can directly offset the income that is reported to you on the K-1. The key in all cases is to maintain adequate records of expenditures.
As you receive your 2012 tax documents, you may notice some of the following changes:
Your W-2 may contain information in Box 12 reporting the cost of your workplace’s group health insurance coverage. This will have a designated code DD which means this is not taxable.
You may receive a Form 1099-K for the first time – don’t ignore it. The new form records payments received by credit card or through third-party networks such as PayPal. This is the Service’s way to ensure taxpayers are reporting all income received, since they did not have access to credit card or online payment details in the past.
Your 1099 for stock transactions will start to show basis. Ensure that the amount matches your records. The default basis reported will be on a first-in first-out basis unless you specifically identify which securities were sold. For 2012, you will want to identify your lowest basis stock to sell to maximize the low capital gains tax rate and avoid the potential additional Medicare tax.
The arrival of 2013 brought new tax laws and rates, but individuals still have time to maximize their 2012 tax savings through gain recognition, IRA contributions and taking advantage of available education credits and business deductions. With the higher tax rates under ATRA, tax planning will now be even more important. So start now.
Daniel Fuller is a tax partner in the Grand Rapids office of BDO USA LLP, with over 16 years of experience in federal and individual tax advisory services. He currently serves as the Technical Director for BDO’s Fixed Asset Advisory Group. He can be reached at [email protected].
(To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any links to outside sources) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein. Material discussed in this article is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances.)