Timing gains and losses: selloff before rising rates
In 2012, many taxpayers will have additional considerations when analyzing whether to sell investments before the end of the year or retain them in 2013. First, the Bush-era tax cuts are scheduled to expire at the end of 2012. This affects ordinary income rates, as well as rates on capital gains and dividends. Second, under the health care law, a new 3.8 percent Medicare tax on unearned income, including interest, dividends and capital gains, will take effect in 2013. Together, these real and potential changes may add up to hefty new taxes in 2013, unless Congress takes action otherwise.
Income tax rates
Current income tax rates continue through the end of 2012. These include the overall individual income tax rates, currently at 10, 15, 25, 28, 33 and 35 percent. If Congress does not take any action, these rates revert to the higher rates that used to apply: 15, 28, 31, 36, and 39.6 percent. Republicans favor retaining all of the Bush-era rates. President Obama and many Democrats support retaining the 10, 15, 25, and 28 percent rates for lower- and middle-income taxpayers, while reinstating the 36 and 39.6 percent rates for taxpayers with income over $200,000 (single taxpayers) or $250,000 for joint filers.
Additionally, there are calls for tax reform and for an overall lowering of income tax rates, in exchange for ending unspecified tax deductions and benefits. For example, House Republicans have called for replacing current income tax rates with two brackets, of 10 and 25 percent.
Capital gains and dividends
Current income tax rates that extend through the end of 2012 also include the 15 percent rate on capital gains and qualified dividends for qualified taxpayers. If Congress does not act, these rates revert to much higher ordinary income rates, in the case of dividends, and to the 20 percent rate that formerly applied to capital gains. Again, the President and the Republicans would both extend the current rates, but disagree on whether to apply the extensions to all taxpayers (the Republicans) or only to lower- and middle-income taxpayers under the $200,000/$250,000 thresholds (the President).
3.8 percent tax
Adding to the mix is the impending 3.8 percent tax on unearned income. Under the health care law, this tax will apply to 2013 income (and beyond) of single taxpayers with income exceeding $200,000 and joint filers with income exceeding $250,000. The tax is imposed on the lesser of net investment income or the excess of adjusted gross income about the $200,000/$250,000 thresholds.
Net investment income also includes rents, royalties, gain from disposing of property used in a passive activity, and income from a trade or business that is a passive activity. The tax does not apply to distributions from retirement plans and IRAs. Taxpayers cannot necessarily avoid the tax by moving assets to a trust, because the tax will apply if trust income exceeds a threshold currently set at only $11,200.
Sell or hold
Generally, taxpayers should make investment decisions based on economics, holding on to a "good" investment and selling a "bad" investment. This involves looking at past performance and perhaps gazing into a crystal ball. Taxpayers that are debating whether to sell appreciated assets or assets that pay qualified dividends may want to act in 2012, when income tax rates are lower and before the 3.8 percent tax takes effect. Taxpayers considering the sale of declining assets may want to consider holding off until 2013, when losses can offset more highly-taxed gains and reduce the income potentially subject to the 3.8 percent tax.
Because the 3.8 percent tax does not apply to tax-free income, such as municipal bonds and distributions from a Roth IRA, taxpayers may want to shift some of their investments to yield nontaxable income. While the income from converting a traditional IRA to a Roth IRA would be included in the income calculations, qualifying distributions after the conversion would not be included.
Again, the decision must make economic sense. If the taxpayer expects an asset to continue to decline in value during 2012, he or she should sell the asset soon and not wait until 2013. Another consideration is the bunching of income. Taxpayers that sell substantial capital gains assets in 2013 may push their income up to the $200,000/$250,000 thresholds that trigger higher taxes. If the taxpayer is considering a sell-off of assets, it may make more sense to sell assets before 2013.
If a taxpayer wants to shift to more conservative investments, income yields may decline, but so will the incidence of the dividend, capital gains, and unearned income taxes described above. On the other hand, taxpayers looking at more speculative investments should understand that a successful investment may generate income taxed at higher rates in 2013.
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