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Fiscal Cliff Issues Complicate Year End Tax Moves

Normally around this time, you usually see a lot of financial publications write about year end tax moves. It’s a common topic and one that’s worth reviewing every year because our tax laws change and what you should be doing year to year might need some adjustment.

This year, it’s a lot trickier than it’s ever been because of the fiscal cliff [3].

The basic premise behind all year end tax moves is that you should accelerate expenses and delay income. You won’t owe taxes on income you collect on January 1st, 2013 until you do your taxes the following year. You can claim expenses you pay on or before December 31st, 2012 when you file your taxes next year. By claiming deductible expenses early, you reduce your taxable income. By delaying and deferring income, you reduce your taxable income.

The tricky part about the fiscal cliff is that our tax rates [4] may be changing next year. You may be paying a higher or lower tax rate next year so it might make sense to delay certain moves because you might benefit more from that move next year. If you’re in one of the higher brackets, with an extremely high likelihood that your tax rate will increase next year, you may not want to accelerate your expenses because you want the deduction for 2013, when you have a higher tax rate.

What complicates it even more is the idea of the time value of money. Let’s say you have the option of claiming a $1,000 deduction this year or waiting until next year. If you’re a single filer with an AGI of $100,000 then you’re in the 28% bracket today. If no resolution is reached and the current law takes effect, you move up into the 31% bracket. Your deduction would be worth $280 today or $310 in a year. That’s a difference of $30 over the course of a year. Do you want $280 today or $310 in a year? (if you stick strictly with the time value of money, $310 is worth more in a year given today’s interest rates… but it’s just $30!)

My approach to all this is to not change anything I’m doing because of taxes… with one exception.

So where does this matter? If you have any big winners in stocks, here’s where things actually start to matter a little bit more. After you do the typical wash sale [5] stuff, it might make sense for you to realize any long term capital gains you may have in your portfolio.

Long term capital gains rates are set to go up from 15% to 20% for most taxpayers – that’s a 25% increase in that tax rate. There’s also the “guaranteed to still be there” 3.8% unearned investment income medicare tax [6] from the health care reform law. That applies to single filers with an AGI above $200,000 and married filing jointly AGI of $250,000 but one to consider if you have some really big winners, rental income, or plan to sell your house and aren’t above the exclusion. So potentially you’re looking a rate that’s a 8.8% higher (nominally).

If you were planning on doing anything for strictly tax purposes, this might be it – sell some winners. Personally, I’m not going to sell anything I wasn’t going to sell anyway (for other reasons) but I’m going to keep an eye on the market because we might see some some volatility as we get closer to the end of the year.

Summarize it for me Jim – what are you doing differently and what do you think will happen? First, I personally believe that we’re going to see tax rates rise on the wealthy, whether that’s $250k+ or $500k+ or $1mm+ [7], (or $400k [8]!) and an extension of the Bush era tax cuts for everyone else. Long term capital gains will go up to 20% as scheduled.

As for what I’m doing, I’m not changing anything. I never believed in accelerating expenses (like paying my mortgage early) because it’s little more than a shell game. It really only accelerates the first time you do it (the first year you pull Jan into December, you get a benefit… the next year, you’re forced to pull Jan into December just to keep up with 12 payments a year!) and it’s just more hassle than it’s worth.

What about you?

(Photo: davedugdale [9])