Tax planning is never simple, and right now, it’s more complicated than ever, as the upcoming election has left a large fraction of America’s lawmakers unwilling to tackle the fiscal cliff we’re hurtling toward, or the automatic tax increases that are part of it.
Although the outcome of the elections will obviously have a big impact on tax policy going forward, for now, a host of tax increases are slated to take effect that will hit higher-income taxpayers hard.
Of course, it’s possible that Congress will get its act together and solve all these problems before Jan. 1. But if you’re as skeptical as I am about that prospect, it’s time to start doing some contingency planning. And there are steps you can take to reduce the impact of those higher taxes.
Let’s take a look at three promising strategies for you to prepare — just in case.
1. Pay tax now to save more later.
Usually, the name of the game with the IRS is to avoid paying taxes for as long as possible. The whole idea behind tax-favored retirement accounts is that they let you defer taxes now — presumably at higher rates — in favor of using the money and paying tax on it after you retire, when presumably you’ll be earning less money and therefore paying Uncle Sam at a lower tax rate.
But right before a major jump in taxes, it can make sense to pay tax sooner than later. Currently, the highest tax bracket is 35%. Next year, that’s slated to revert to 39.6%, with an additional 3.8% surtax on investment income.
There are a number of things you can do to increase your taxable income this year:
- Work more. If you’re self-employed or work on a commission that you have some control over, boosting your earnings this year could save you in the long run.
- Save your deductions. Putting off charitable deductions from late December to early January won’t hurt charities much, but it lets you move income freely. Same for things like tax payments, medical expenses, and other deductible bills.
- Consider a Roth conversion now. Converting a regular IRA to a Roth IRA gives you tax-free treatment for the life of your Roth account, but you have to pay tax on the amount you convert. Doing it now lets you take advantage of low rates.
- Sell stocks with gains. Ordinarily, you’d want to defer paying capital gains tax as long as possible. But with a change in maximum rates from 15% to 20% next year — not including the 3.8% surtax — it can be a better deal to take your gains and run this year, rather than doing so in 2013.
2. Plan to boost your retirement contributions next year.
Every dollar you contribute to a traditional retirement account, whether it’s an IRA or a 401(k), can reduce your taxable income. With taxes going up, you’ll get even more bang for your buck than you do this year, especially if doing so next year helps you avoid going over the threshold for surtaxes and higher tax brackets.
That doesn’t mean you should skimp on current year contributions, though, if you can possibly help it. Still, other things being equal, you’ll be better off boosting your 2013 retirement savings to take maximum advantage of a break from higher taxes.
3. Shelter your income.
Another reason to boost your retirement account balances is that they’ll give you more ability to shelter investment income from higher tax rates. In particular, if you can move high-yield dividend stocks and other income-producing investments into retirement accounts, you can cut your future taxes substantially while still enjoying the growth that they’ll produce.
With all of these strategies, there’s no need to jump the gun and do anything irreversible at this point. After all, depending on what happens in November — and December, during Congress’ lame duck session — you might not actually need these strategies. But getting them ready now will mean that if it comes time to pull the trigger a couple months down the road, you won’t be scurrying to get everything done before a Dec. 31 deadline. That peace of mind is worth at least as much as the potential tax savings from making these smart moves.