Tough tax return choice for 2012: Pay more now to save later?
It's a brainer this year. The steep increase in tax rates for 2013 might make you less eager to take all the deductions you can in 2012. There are two important increases in tax rates this year. The "Fiscal Cliff" legislation increases the top effective "regular" income tax rate for individuals to 40.78%. Many business owners will also have to pay an additional 3.8% "Net Investment Income" tax in addition under Obamacare. That combined rate of more than 44% compares to a 35% top individual rate for 2012. That means deductions will be worth a lot more in 2013.
That leaves businesses with some perplexing choices on their 2012 tax returns. For example, the Fiscal Cliff bill increased the "Section 179" deduction maximium to $500,000 in 2012 and 2013. That means taxpayers can deduct up to $500,000 in expenditures that would otherwise have to be capitalized and depreciated over a period of years. The natural reaction is to deduct as much as you can as fast as you can. The new higher rates could make that costly.
For example, assume a taxpayer places a $500,000 computer system into service into 2012. If a top-braket taxpayer takes a Section 179 deduction in 2012, the tax benefit of the deduction is about $175,000, ignoring state taxes. If the taxpayer instead depreciates the system over its usual five year life, it will get a $100,000 deduction in 2012 and the remaining $400,000 over 2013-17, for a total tax benefit of about $211,000.
That means the taxpyer can reduce taxes from 2013-17 about $31,000 by not taking the biggest possible deduction this year. Is it worth paying less now to pay more later? That depends. If you are short of cash now, you might take the big deduction anyway -- you don't care about future taxes if you can't stay in business until then, and that big deduction might be the difference between staying alive and not.
But the implied cost of funds for getting smaller tax benefit now for a bigger one later works out to over 11%. That's pretty expensive money.
Bottom line? Every taxpayer is different. You should discuss with your tax advisor whether it's worth paying extra 2012 taxes to save taxes in future years. The Section 179 deduction is just one instance where you might have to make that choice.