As you might imagine, whether I’m sitting at my financial planning office in Dallas or Keller, I’m having a lot of conversations right now about the tax changes scheduled for the end of the year. Following are some of the most common questions, as well as my perspective on them.
Q: Do I need to sell my house before the end of the year to avoid paying the new 3.8% tax on it?
A: Not likely. Married couples will still be able to exclude up to $500,000 of gain on the sale of their primary residence, single people $250,000. Even if your gain exceeded the exclusion levels, the 3.8% tax would only apply to the lesser of how much your adjusted gross income exceeded $250,000 (for married filing joint) or your total investment income (excess gain is included in this total).
Q: Do we need to add a trust to our estate plan?
A: Possibly, but I wouldn’t suggest doing it today based solely on the possible estate tax exemption reductions scheduled to go into effect for 2013. The estate tax exemption is scheduled to drop from $5.15 million per person to $1 million per person on January 1. If this occurs, then bypass trust planning will become relevant for a lot more couples than today. However, the lowest exemption advocated by either political party is $3.5 million. So while it’s possible that a solution might not be reached by January 1, it seems unlikely that the exemption will permanently stay at the $1 million level.
Q: Should I harvest long term capital gains in my taxable investment accounts to pay capital gains taxes at 20% vs. 15%?
A: Take a wait and see approach on this. The 15% long-term capital gains tax rate has already been extended once before; it’s quite possible it will be extended again. If you harvest gains now, it’s possible you will have incurred taxes earlier than necessary. Also keep in mind that if you have carry-forward losses, harvested gains will be completely offset by those losses before you pay any taxes at the 15% rate. So if you have a substantial amount of carry-forward losses, the strategy of harvesting gains could have little or no benefit for you.
Q: Do I need to plan on my paycheck going down next year because of the expiring payroll tax cut?
A: Yes, definitely. The payroll tax cut provided all employees a 2% reduction on their social security taxes on the first $110,100 of income this year. While it’s possible this could be extended again, you shouldn’t count on it. Make your plans and set your budget with the assumption that you will be paying the full social security tax again.
Q: Should I do Roth conversion this year before taxes go up?
A: Possibly. Like the long term capital gain rate, it’s possible that today’s income tax rates may be extended again. So if this is the only reason you’re considering Roth conversion this year, you may want to wait until closer to the end of the year to actually convert. Roth conversion allows you to pay the taxes today on all or a portion of your traditional (or rollover) IRA balances, and then, as long as you follow the rules, benefit from tax-free growth on both the principal and earnings for the rest of your life with no required minimum distributions. It can be a tremendously powerful strategy, but each individual’s situation needs to be analyzed to determine if it’s right for them.
Q: Do I need to adjust my investment strategy based on upcoming tax changes?
A: Quite possibly. Today, qualified dividends are taxed at the same rate as long-term capital gains. Beginning next year, if nothing changes, they will again be taxed as ordinary income. Based on your marginal tax bracket, this change could be a big deal. But you shouldn’t change your investment strategy now — you need to wait until later this year/early next year to see what will happen.
These answers are short to focus on the highlights. In the interest of making this Q&A brief and readable, I’ve omitted a lot of details and caveats that could be extremely important to your situation. Please do your own research or contact me to discuss your specific situation before taking action. If you have other questions about the upcoming tax changes not covered here, please let me know. I’d be happy to feature them in next month’s newsletter.