2012 Year-End Tax Planning for Individuals

Author: Eric J. Wexler

This article provides a summary of several significant tax law changes scheduled to take effect on January 1, 2013, and provides a few planning ideas that individual taxpayers may want to consider in light of the coming changes. Bear in mind that Congressional action relating to 2013 tax laws prior to the end of 2012 is extremely likely. It is therefore wise to consult your attorney or accountant prior to taking any action based upon these scheduled changes.

New Medicare Taxes for Higher-Income Individuals

0.9 Percent Medicare Tax

Effective January 1, 2013, the Patient Protection and Affordable Care Act (PPACA) imposes an additional 0.9 percent Medicare tax on wages and self-employment income in excess of $200,000 for single individuals and $250,000 for married taxpayers.

3.8 Percent Medicare Contribution Tax Generally

The 2010 health care reform act also includes a provision subjecting higher income individuals to a 3.8 percent Medicare tax on net investment income if modified adjusted gross income (MAGI) exceeds $200,000 for individual filers or $250,000 for married/joint filers. Capital gains are also subject to this new tax. Taxpayers who are thinking about selling or otherwise disposing of appreciated assets may want to do so in 2012, before the tax takes effect.

3.8 Percent Medicare Contribution Tax on the Sale of One’s Primary Residence

Some clients have expressed concern that this new tax will be burdensome when they sell their house, given that current house prices are typically in the hundreds of thousands of dollars. Rest assured that the exclusion of $500,000 ($250,000 for individuals or married filing separately) of gain on the sale of a primary residence remains in effect.

For example, if a couple purchased their house for $100,000 and sold it for $700,000, the tax (3.8 percent) would apply to the gain above $500,000, which in this case equals $100,000.  Therefore, the tax would equal $3,800.  This would of course be in addition to the regular capital gains tax.  Remember, 3.8 percent Medicare contribution tax only kicks in if the taxpayers’ MAGI is greater than $250,000.   

Expiring Tax Cuts

Income Tax Rates

The “Bush-era” tax cuts, which resulted in reduced individual income tax rates, are scheduled to expire after December 31, 2012. Absent Congressional action, the current 10, 15, 25, 28, 33, and 35 percent rate structure will be replaced by the higher “Clinton-era” rates of 15, 28, 31, 36, and 39.6 percent. Unless legislation is passed, the increased tax rates will immediately be reflected by income tax withholding on payrolls beginning on January 1, 2013. Given the increasing rates, taxpayers may want to recognize income in 2012 and defer deductions until 2013. On the other hand, if the lower rate structure will be extended, it is generally advisable to take deductions now and defer income until 2013.

Capital Gains/Dividends

Without intervention by Congress, the tax rates on qualified capital gains and dividends are also scheduled to increase significantly beginning January 1, 2013. The current capital gains and dividends rate is 15 percent (0 percent for taxpayers in the 10 and 15 percent tax brackets). As noted above, absent Congressional action, these rates will increase to 20 percent (10 percent for taxpayers in the 15 percent bracket). Given the increasing rates, taxpayers may want to consider realizing some of their long-term capital gains prior to year-end.

Personal Exemption and Itemized Deduction Phase-outs

Personal Exemption Phaseout

Return of the personal exemption phaseout will reduce a higher-income taxpayer’s personal exemptions by 2 percent for each $2,500 in adjusted gross income (AGI) in excess of the phaseout threshold, adjusted for inflation.

Itemized Deduction Phaseout

If Congress does not act, the so-called “Pease limitation” on itemized deductions will return effective January 1, 2013. This limitation reduces itemized deductions by the lesser of 1) 3 percent of a taxpayer’s AGI above the threshold, or 2) 80 percent of the itemized deductions otherwise allowable for the tax year, exclusive of medical expenses, investment interest, casualty losses, and certain gambling losses. Taxpayers will want to keep this in mind when deciding whether to make certain year-end charitable donations.

Flexible Spending Arrangements

Employer-sponsored flexible spending arrangements (FSAs) allow employees to direct part of their pay into a special account to pay qualified health or dependent care expenses. Money that goes into the account avoids income and Social Security taxes. Employees decide at the beginning of the year how much to contribute to the plan and forfeit any unused portion at the end of the year. Beginning in 2013, under the Patient Protection and Affordable Care Act (PPACA), a dollar cap of $2,500 applies to contributions to a health FSA. The $2,500 limitation is scheduled to be adjusted for inflation after 2013. Individuals with unused health FSA dollars may want to spend them before the end of the year to avoid the “use it or lose it” rule. Before doing so, check to see if your employer has adopted the grace period established by the IRS, which allows employees to spend 2012 set-aside money as late as March 15, 2013.

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