Year-End Tax Tips
November 14, 2012
- These tax tips for 2012 address key areas of your financial life: portfolio planning, retirement, education planning, and charitable giving.
- Sometimes it makes sense to defer income until next year and sometimes it doesn't, particularly if you're subject to the alternative minimum tax (AMT) – so it may be helpful to consult with a tax professional about your unique situation.
- Be aware of changes to cost-basis reporting rules and how they affect different securities you may own.
If you find yourself stressed come tax time, read on. First, take heart that you can act before the end of the year to help minimize the pain of April 15. Then, consider the tax tips below affecting key areas of your financial life—from your portfolio to your retirement and education planning to gifting and more.
Whether you do your own taxes or rely on a tax professional, these tried-and-true strategies may help you keep more of your hard-earned income and boost your after-tax returns. After all, it's what you keep that counts!
Get started: six simple steps
Dust off last year's return. Using it as a starting point, begin this year's process by updating some of the key inputs: your salary and other income, deductions, and the dependents you'll claim. If you use tax preparation software, it's easy to run a quick estimate of where you stand. Alternatively, you can ask your accountant for an early read. If the initial estimate seems high, don't panic. Get going by taking these six simple steps.
- Double-check your withholding. You want to pay the IRS its due but not a penny more. So make sure you're not having too much (or too little) taken out of each paycheck. The same holds if you make quarterly estimated tax payments.
- Consolidate debt. Consider replacing credit card debt, which generally has a higher interest rate, with a lower-rate, tax-deductible home equity loan or line of credit (HELOC).
- Account for refinancings. If you lowered your mortgage interest rate in the past year, you may now have a lower-interest deduction. Also, if you used any of the proceeds for something other than physical improvements to your home, that amount may be subject to the alternative minimum tax (AMT). On the brighter side, remember that points paid in prior refinancings that you didn't already deduct can be deducted in the year you refinanced again.
- Prepay quarterly estimated state tax payments. If you're not likely to be subject to the AMT, consider paying your fourth-quarter 2012 estimated state income taxes (plus any estimated balance due) by December 31 so you can take the deduction on your 2012 taxes.
- Prepay property taxes. Many counties bill taxpayers twice, in November and February. If you pay your February installment by December 31, you can take it as a deduction on your 2012 return. Again, watch out for the AMT, which disallows these deductions.
- Avoid the AMT if you can. More taxpayers are facing the AMT, particularly two-earner homeowners who have children and live in high-tax states. If you're one of these taxpayers, you might want to flip the typical strategy of deferring income and accelerating certain deductions. Instead, try to defer payment of state and local taxes and accelerate income to the point where you're no longer subject to the AMT. Multiyear planning is a must—talk to a tax professional.
Portfolio planning: three tax-smart rebalancing strategies
Year-end is a great time to give your portfolio a checkup. Consider these tax-smart strategies to help boost your after-tax returns.
- Harvest losses. No one likes a losing investment. But at tax time, they can be blessings in disguise, as you can use capital losses to offset taxable capital gains, plus up to $3,000 in ordinary income ($1,500 for married couples filing separately). Look in your taxable accounts for investments with relatively large losses where you don't expect a comeback. Remember, any losses you can't use to offset gains this year can be carried over into future tax years. One word of caution: Watch out for the so-called wash sale rule, which prohibits taxpayers from recognizing losses on sales of securities that are repurchased within 30 days.
- Make the most of tax-advantaged accounts. You might be able to further bring your asset allocation back in line without incurring taxes by rebalancing in tax-deferred retirement accounts like IRAs or 401(k)s.
- Consider cash flow. If you're living off your portfolio in retirement, remember to set aside any cash you might need for the next 12 months as you rebalance. For example, if your portfolio is overweight to stocks, you could take out what you need to live on from that overweight portion and then reinvest the rest in bonds until you're back on target.
Cost basis changes
Starting back in 2011, financial institutions (including Schwab) were required to begin reporting gain/loss details to you and the IRS for investments you sell that are covered by Emergency Economic Stabilization Act regulations. Because the changes could impact the cost basis used to compute your gains and losses, it's important to understand when and how they apply to you.
Many of the reporting changes have already rolled out, but a few—including requirements for fixed income securities and options—have not. The requirements only cover investments you sell that were acquired on or after certain dates, as shown below:
- Equities acquired on or after January 1, 2011.
- Mutual funds, ETFs and dividend reinvestment plans acquired on or after January 1, 2012.
- Other specified securities, including fixed income and options acquired on or after January 1, 2014 (the original deadline of January 1, 2013 was extended).
It's still a good idea to save your purchase and sale documentation, including records of any automatic reinvestments, to make sure it matches the information financial institutions will report to the IRS. You should also make sure your financial provider is reporting using the accounting method of your choice. Even though FIFO (first in, first out) is the IRS default method for both individual securities and mutual funds, most institutions (including Schwab) will report individual securities using the FIFO default method and report mutual funds using the average cost single-category method.
Retirement: four tax-savvy planning ideas
- Take full advantage of your employee retirement plan, at least to the point of any employer match. And if you're 50 or older, make a catch-up contribution (see table). If you expect to be in a higher tax bracket down the road (for example, if you're a younger worker who has yet to reach peak earning years) and your employer offers the new Roth 401(k), consider it. You won't get any up-front tax benefit. But after you retire, qualified distributions will be tax-free.
2012 federal limits for retirement accounts
|Account||Contribution limit||Catch-up contribution|
|401(k), 403(b) and 457*||$17,000||$5,500|
|Qualified Retirement Plans/Keogh and SEP-IRA*||20% of net self-employment income (or 25% of compensation), up to $50,000||None|
|Individual 401(k)**||20% of net self-employment income (or 25% of compensation) plus $17,000, up to $50,000||$5,500|
|Traditional IRA and Roth IRA***||$5,000||$1,000|
* Source: http://www.irs.gov/uac/IRS-Announces-Pension-Plan-Limitations-for-2012
** Source: http://www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans
*** Source: http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits
- If you're self-employed, consider a small business retirement account such as a SEP-IRA, SIMPLE IRA, Individual 401(k) or other qualified retirement plan. Contributions are tax-deductible and grow tax-deferred. If you open a qualified retirement account by December 31, you have until the day you file next year, including extensions, to make this year's contribution.
- Be sure to make your annual IRA contribution. Even though you have until next April 15 to make your 2012 contribution, the sooner the better—your money will have more time to benefit from potential long-term compound growth. Then, make your 2013 contribution early next year. Consider a Roth IRA if you're eligible, especially if you're not eligible for a deductible traditional IRA contribution.
- If you're age 70½ or older and required to take minimum distributions from your retirement accounts, you need to do so before year-end (if you just turned 70½ this year, you have until April 1, 2013, to take your first required minimum distribution).
Education: two tax-preferred savings plans
- Coverdell Education Savings Accounts. If you're eligible, for 2012 you can contribute up to $2,000 to a Coverdell account on behalf of a child (the contribution limit will reduce to $500 in 2013 unless Congress extends the law). Contributions grow tax-free and qualified K-12 and higher-education-related withdrawals are tax-free. You have until next April 15 to contribute for income-tax purposes, but if you make the contribution by December 31, it will count as a gift for this year instead of next year for gift-tax purposes.
- State-sponsored 529 plans. Anyone, regardless of income, can contribute up to $65,000 ($130,000 for a married couple) in 2012, without incurring gift taxes, if you elect to have the gift treated as though it were made over five years. You don't have to invest in your own state's plan; however, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan. But if your state offers an income tax deduction on in-state 529 plan contributions, then that's another reason to make your contribution by December 31. Still, it's a good idea to compare state plans—especially if you live in a state with no deduction (such as California) or one with no state income tax.
Giving: four tax-smart tips
- Act before year-end. For 2012, you can give up to $13,000 each to as many individuals as you wish this year and pay no gift tax. Spouses can "split" gifts for a total of $26,000 per beneficiary, per year. Gifts beyond that are taxable, but only to the extent they exceed the lifetime gift tax exemption of $5.12 million over a donor's life (set to revert to $1 million in 2013 unless Congress acts before then). The lucky recipient of the gift owes no gift or income tax, and doesn't even have to report the gift unless it comes from outside the United States.
- Pay someone's education or medical bills. You can also make unlimited payments directly to medical providers or educational institutions on behalf of others without incurring a taxable gift or dipping into your $5.12 million lifetime gift-tax exemption.
- Shift income to tax-advantaged children. Consider gifting appreciated securities and stocks whose dividends are taxed at low long-term capital gains rates to children, at least to the extent that the "kiddie tax" will not apply. Up to a limit, even younger kids will pay tax at their own rate—likely 0% (through 2012, expiring in 2013 unless Congress extends lower tax rates on capital gains). Kids over the age of 18 (or 24 if a full-time student relying on you for more than half of their support) aren’t subject to the kiddie tax at all.1
- Give appreciated securities to charities by year-end. Consider donating appreciated securities that you've held for more than a year for a full fair-market-value deduction and no capital gains tax. If you give to a donor-advised fund (such as Schwab Charitable Fund™) by December 31, you get the tax break this year and can take your time deciding how best to distribute your gift.
Consider donating appreciated securities
Let's say you'd like to donate $10,000 this year. If you have appreciated stock (or bonds or mutual funds) that you've held for many years, consider donating that instead of cash.
Why? If you sell your appreciated stock first and then give the cash, you'll pay the 15% capital gains tax on the gain (state taxes may also apply). But if you donate the stock to a charity, there's no capital gains tax. The charity gets the full $10,000, and you get to claim a $10,000 tax deduction. In this example, if the long-term gain would have been $5,000, you would save $750 versus selling first and then donating cash.
On the other hand, if you're holding securities at a loss, sell them first and then donate the cash. That way, you can claim the capital loss on your tax return.
All of the above?
Whether some or all of these suggestions fit your situation, we're only scratching the surface here. Get advice from a qualified tax professional if you need it.
After you decide what to do this year, resolve to make financial planning a year-round exercise going forward (you've probably got better things to do around the holidays). That way, it'll be easier to check your progress, update your plan and, if necessary, take action long before the ball falls in Times Square on New Year's Eve.
1. The so-called kiddie tax applies to children under 19. In addition, full-time college students under the age of 24 will also be taxed at their parents' rate on unearned income in excess of $1,900 unless the students' earned income is greater than one-half of their support.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
The Schwab Fund for Charitable Giving has entered into service agreements with certain affiliates of The Charles Schwab Corporation (Charles Schwab & Co., Inc. and Charles Schwab Investment Management, Inc.). It is an independent nonprofit organization.