What the fiscal cliff looks like from the back side of the election
What we know
There will be a tax increase on "investment income" and wage and self-employment income starting next year. Investment income for taxpayers with adjusted gross income over $200,000 (single filers) or $250,000 (joint filers) face a new 3.8% Obamacare surcharge on their investment income. "Investment income" is broadly defined and includes taxable interest, dividends, capital gains, rental and royalty income, and "passive" income from K-1s.
Taxpayers with wage and self-employment income face a new .9% Medicare surtax for wages or self-employment income exceeding $200,000 (single filers) or $250,000 (joint filers). This is the first time a Medicare tax rate has depended on joint income. Because employers can't know what a spouse makes, this will require many taxpayers to pay additional Medicare tax when they file their 2013 returns. Employers will withhold the .9% tax on wages over $200,000.
What we don't know
We don't know what the tax rates will be for 2013. If Congress and the President fail to agree on a plan for next year, the tax rates effective in 2000 will return, with a 39.6% top rate for ordinary income. The top rate on capital gains would rise from 15% to 20%, and the top rate on dividends would rise from 15% to 39.6%. Of course the 3.8% tax on investment income would also apply. You can see a state-by-state map of the effects of going off this "fiscal cliff" here.
We don't even know what the Alternative Minimum Tax rules are for this year
Congress has not yet "patched" the AMT by increasing the annual exemption amount. If they fail to do so, some taxpayers may be surprised by an additional tax bill of more than $8,000 this coming April.
What to do?
You should consult your tax advisor before you do anything. Some steps advisors will be discussing in the coming weeks with their clients include:
- Reversing the usual tax planning by accelerating income and deferring deductions. If rates are going up, deductions will be worth more next year, while income taxed this year will be treated more kindly.
- Examine the timing of capital gain income. For taxpayers who are going to be selling a stock or other capital asset anyway, this year may well be the time to do so. While that's true for taxpayers in top brackets for obvious reasons, it's also possibly true for taxpayers in lower brackets; the zero rate for capital gains for lower bracket taxpayers will expire this year.
- Consider electing out of installment sales. The tax law lets taxpayers choose to be taxed on 2012 installment sales in 2012, even if the payments on the sales will be made in later years.
- Dividend distributions. C coporations and S corporations with old C corporation earnings will contemplate whether to distribute earnings to be taxed without the 3.8% Obamacare surtax. If cash is tight, they will consider making distributions in the form of notes to get the income out this year.
- Fixed asset elections. Taxpayers usually choose to write off fixed assets as fast as possible through "bonus depreciation" and "Section 179" expensing. If rates go up, that may be counterproductive.
- Family gifting. The current $5 million lifetime gifting and estate tax exclusion will decline, perhaps all the way to $1 million. Advisors will be looking at ways to move wealth to the next generation before year-end.
Above all, stay flexible, be ready to act fast, and stay in touch with your tax advisor. The politicians may or may not change the tax picture in the coming weeks, so flexibiltiy is important.