Many people are feeling head-splitting pressure this year to "do something" about income taxes before year-end. Are you feeling lost about what, if anything, you should do in the midst of this year's tax uncertainty? Here are four simple truths to keep in mind before you act.
1. Get the sequence right.
Don't let taxes drive financial decisions, but do consider taxes when implementing a financial decision. For instance, it doesn't matter if you will save a lot of taxes by making a large charitable gift this year if you do not want or cannot afford to make the gift at this time. However, if you are already considering a gift program because it matches your personal values and finances, then use available information to make the gift in the most tax-efficient manner.
This year accelerating regular gifts, especially of appreciated securities, to a charity or Donor Advised Trust makes sense if tax laws are changed that limit your ability to take charitable deductions in the future. This strategy would not be optimal if tax rates stay the same or increase and/or if there is no substantive change in your ability to deduct charitable contributions next year. No one really knows how the tax rules will unfold, but you can use your personal circumstances as a potential tie breaker. For example, expecting to have high income now but not later, everything else being equal, is a point in favor of accelerating gifts to 2012.
Bottom line: Integrate tax planning into your overall financial planning, not the reverse.
2. Tax planning strategies don't always work out as planned.
Tax payers are currently being urged to consider Roth conversions in order to accelerate income tax liability to this year in light of presumed higher rates in the future. But it is also possible to create several scenarios where a Roth conversion in retrospect would be regrettable, or at least suboptimal.
(NOTE: Roth conversions imply transferring funds from a tax-sheltered retirement account such as an IRA to a Roth account. Ordinary income taxes must be paid on any transferred wealth that has not been previously taxed. Once housed in a Roth account, wealth grows tax-deferred and can then be withdrawn free of income tax in later years.)
A few of those scenarios include: Tax rates are in fact lower at the time you or your heirs make a withdrawal from the Roth account. The government enacts a consumption tax between now and when you start using Roth funds. A reversal in your own finances makes you wish you had not paid taxes early in the hope of capturing a possible future tax benefit. The government finds a way to levy a tax on Roth accounts.
Because no one really knows whether a Roth conversion will look good in hindsight, it helps to have more reasons for converting wealth than a simple prediction of future tax rates. For example, everything else being equal, Roth conversions are more appealing for tax payers whose investments are already heavily skewed towards tax-sheltered retirement accounts, e.g. the stereotypical physician holding mainly IRA assets. For them, a Roth conversion means improving long-term tax diversification of their portfolio; the Roth conversion tax strategy makes them better positioned for future uncertainty.
Bottom line: Excellent tax planning, like excellent investment planning, has you ready for a variety of possible futures, not just a specifically predicted exact future that may or may not come true.
3. It's prudent and protective to know your own tax position.
Income taxes are likely your largest single expense, and so they are certainly worthy of your focused attention. A good start is to know some of your basic tax numbers. For example, the tax rates that are being so hotly debated in Washington this month are applied against your taxable income in order to determine your tax liability. You can find the dollar amount of your 2011 taxable income on Line 43 of your 2011 tax return. Knowing that number, and also how it might change between 2011 and 2013, will be useful to you when we get the news about what the tax rates will be for 2013.
Similarly, as Washington negotiates whether or not to trim allowable deductions from income, remind yourself how much you are in fact deducting. For example, there is a lot of talk about the fate of the mortgage deduction but only about a quarter of taxpayers even take a mortgage deduction. (Check your 2011 tax return for Schedule A: Itemized Deductions to see what you deducted in 2011, and notice how the total from that schedule carries over to Line 40 on page two of your 2011 return.) NOTE: For those already steeped in knowledge of their own tax return, here's a reference to a calculator you can use to estimate how much you might pay in taxes under several different tax scenarios.
Bottom line: Knowing how much you pay in taxes and understanding, at least in general, how that number is calculated is fundamental to good planning.
4. If you have good overall planning in place, you are likely well-positioned for policy changes.
Good overall planning implies, for example, that portfolio accounts are arranged to be tax-efficient and that employee benefits are optimized and debt appropriately incurred. Plus, if you are financially able and inclined to make large gifts to charity and/or family members, it is likely that you are already in conversation with your advisors and are working together to optimize taxes in light of those personal preferences.
Bottom line: If you have good overall planning in place, you are already reasonably well-positioned for whatever the policy makers in Washington decide to do and to deal with a variety of actual outcomes. That's the point of good planning.
In light of these ideas, year-end tax planning in 2012 is similar to other years: Continue to implement decisions that you have already made for personal reasons in the most tax-efficient manner. Be in touch with your advisors with any change in your personal circumstances and preferences. For transactions that can easily be placed either in this year or next, aim to tilt in the best-guess right direction after considering your personal circumstances. For example, if you have large medical deductions and are able to bring some of them forward into 2012, you might consider doing so since the hurdle for taking medical deductions increases from 7.5% to 10% of income next year—but only for tax payers under the age of 65.
If you have good planning already in place, congratulations, you may just need a bit of fine-tuning before year-end.
If you do not already have good planning in place, consider the spike in tax uncertainty this year as a call to action. Good planning is protective of your most cherished hopes and dreams. It also reduces stress and anxiety about finances.
For all of us, no matter how long and how hard Washington debates the size and nature of government, individual tax payers continue to be well-advised to keep their financial planning lean and resilient and their hand on their wallet. Change is definitely coming.