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Plan Now for Higher Taxes Ahead

The re-election of President Barack Obama, along with a Republican-controlled House of Representatives and a Democratic majority in the Senate, seems to leave Washington almost as it was before - but big changes are coming for people who pay a lot of income tax.

Have you considered what you can do to put yourself in the best tax position as the current year ends and the new one begins?

A 0.9 percent increase in Medicare payroll taxes will apply to employees and self-employed individuals who earn more than $200,000 a year, and to married couples who earn more than $250,000 a year. The extra tax will only affect earned income, such as wages, salaries, and self-employment income, above these thresholds.

There’s also a 3.8 percent tax on unearned net investment income for high-income taxpayers. Unearned investment income includes interest, dividends, annuities, royalties, rents and capital gains that are not derived in the ordinary course of trade or business. The tax is assessed on the lesser of net investment income or the modified adjusted gross income (often abbreviated MAGI) above the previously mentioned $200,000/$250,000 thresholds.

For example, say a married couple has $300,000 of MAGI, including $70,000 of net investment income. The couple would pay the 3.8 percent tax ($1,900) on $50,000, which is the amount of investment income that pushes the MAGI above the $250,000 threshold, rather than the entire $70,000.

Of course, the year is not over. Something might happen to change these taxes as part of the forthcoming negotiations over the “fiscal cliff,” which includes the expiration of the Bush-era tax rates at the end of 2012. Or the taxes might be revisited later as part of a broader overhaul of the tax code, which both parties say they would like to consider in 2013.

So you might want to delay action for at least a few weeks, to see what happens before Congress takes its year-end break. Yet it is still important to have a plan in place so you can act quickly if necessary. The big question is: What sort of plan should you develop? While the answer will depend on your particular situation, there are a few logical strategies to consider. Here are some steps you can take to prepare.

Accelerate your income and defer your expenses.
If possible, it may be wise to take steps to move income you would have received in 2013 into 2012 instead, in order to avoid the new taxes. You may not have this option if you work for someone else, but it is a discussion worth having with your employer, especially if you expect to receive a bonus in early 2013.

If you are self-employed and think you will be affected, you can request that your customers pay year-end invoices before 2012 is over. You can also delay purchasing costly equipment or incurring other large expenses until 2013, to reduce income and thus exposure to the new taxes next year.

Maximize your retirement plan contributions.
Contributions to employer-sponsored plans reduce taxable income and can help cut the net investment income tax. For instance, a couple making $275,000 who jointly contribute a total of $34,000 to their 401(k)s reduce their taxable income to $241,000, putting them below the threshold. Contributions to Simplified Employee Pension (SEP), SIMPLE IRAs and other qualified plans would also be subtracted from taxable income.

Try to realize capital gains this year and losses next year.
What remains of 2012 may be the right time to sell appreciated investments in your non-retirement accounts, especially if you were planning to sell those securities in the near future anyway. Today’s top long-term capital gains rate of 15 percent is set to increase to 20 percent in 2013 unless Congress acts to extend the Bush-era tax cuts. So selling this year may save you as much as 8.8 percent in taxes.

While this may sound like a slam-dunk, your particular situation will dictate whether this is as good a deal as it sounds. Take a close look at your portfolio and tax situation before taking any action. If you are not likely to be subject to the maximum capital gains rates in both years, or if you are likely to realize significant losses next year regardless of tax strategies, your own best course of action might be different.

In a related strategy, consider selling underperforming stocks in your taxable accounts and taking the resulting investment losses next year. Losses will offset your 2013 capital gains, in addition to offsetting up to $3,000 in ordinary income if your losses exceed your gains overall. Taking losses next year will help you reduce your exposure to the new and higher taxes on both capital gains and earned income.

Shift income-producing investments.
If you are not dependent on the investment income generated in your taxable accounts, strongly consider holding most of your income-producing securities in retirement accounts. Sell some of your interest- and dividend-paying securities in your taxable accounts and repurchase them in an IRA or a 401(k) account in order to minimize your exposure to the new tax rate.

You can also reinvest the proceeds in growth investments that pay little or no dividends, and in tax-exempt municipal bonds. This will reduce net investment income, MAGI and taxes. In a recent Wall Street Journal article, I suggested high-income taxpayers consider this strategy as part of a financial housekeeping checklist for this fall, considering next year’s anticipated tax changes.

Attempt a tax triple-play.
Consider giving appreciated income-producing investments to charity. You’ll get an income tax deduction for the fair market value of the security (as long as you’ve owned it for more than a year), avoid the capital-gains tax and cut your future investment income.

Convert your traditional IRA to a Roth IRA.
While distributions from traditional IRAs are excluded in calculating net investment income, they are included when calculating MAGI, potentially increasing your exposure to the new tax. With a Roth IRA, distributions are income-tax free and are also excluded from both net investment income and MAGI.

The conversion amount is taxable income, but it may well be worth paying a one-time tax in 2012 in order to secure future Roth tax benefits, especially if: you expect your income tax rates to stay the same or to rise in the future; you won’t need to access the Roth IRA assets in retirement; and you can pay the tax liability resulting from the conversion with non-IRA assets.

Not all these strategies will be suitable for everyone, but if you consider them in the context of your situation, one or more may help you weather a change in the tax climate.

Executive Vice President and Chief Operating Officer Shomari D. Hearn, based in our Fort Lauderdale, Florida headquarters, is among the authors of Looking Ahead: Life, Family, Wealth and Business After 55. He contribued Chapter 2, “Relationships With Adult Children”; Chapter 9, "Life Insurance"; and Chapter 17, "Retiring Abroad." He also contributed a chapter to the firm’s book for young professionals, The High Achiever’s Guide To Wealth.