THE BLOG
11/13/2012 03:50 pm ET Updated Jan 13, 2013

Taxes! After the Election - Now What?

Income taxes are going up next year and not just for those who earn more than $200,000. Americans are facing an unprecedented tax increase of nearly $500 billion on Jan. 1, 2013 if the Tax Relief Act of 2010 is allowed to expire. Congress and the president will most likely pare back some of the increase as they work out a compromise to avoid the "fiscal cliff." It's likely the agreement will be temporary because tax reform is needed to avoid the patch and postpone tax policy that has become the norm over the past 10 years.

How can anyone make long-term tax planning decisions in such an environment?

American taxpayers have been told deferring their income is all they need to do to minimize taxes. A common recommendation is to maximize 401(k) plan and IRA contributions because you will be in a lower tax bracket when you retire. This strategy has worked over the past 25 years as tax rates have come down. It may not work as we move forward. Nearly everyone should prepare to pay more as Congress attempts to close the gap on a $1.3 trillion deficit. The tax-planning challenge will be to remain flexible so you can change your taxable income as tax policy changes.

The key to planning in this environment is diversification. Don't abandon the great tax-deferred tools we have, but don't make them the cornerstone of a long-term strategy. Tax planning should be built around three types of savings -- tax-deferred, tax-free (Roth IRA) and after-tax. This is called the New Three-Legged Stool approach to achieving tax efficiency. The goal is to hold your savings equally among the three legs. The tax-deferred leg gives you immediate tax benefits but will be the most costly place to take money from in the future. The tax-free leg offers the best source of future income and the after-tax leg has the least amount of restrictions.

Start diversifying your savings today while tax rates are still low. The good news is there still time to take advantage of 2012 tax rates, which may turn out to be the lowest we see in some time. Here are three strategies to help diversify before the end of the year:

Roth Conversion --The most flexible tool on your list of tax-planning strategies is the Roth conversion. Converting a traditional IRA to a Roth IRA creates a taxable event in 2012. All future earnings in the account will be tax-free, as long as you wait five years and are age 59½ or older when you take withdrawals. The biggest advantage is the ability to "undo" the transaction as late as Oct. 15, 2013. Should the new Congress lower tax rates across the board, you can put the money back into your IRA. It will be like the transaction never happened.

Harvest capital gains -- Harvesting gains is similar to harvesting losses. Sell appreciated securities that you've held for at least 12 months to realize the long-term gain for tax purposes. You can immediately repurchase the same asset because there is no wash sale rule for realizing gains. This allows you to pay tax on the gain in 2012 when rates are low. This strategy should appeal to anyone in the 15-percent tax bracket because capital gains are taxed at zero and may increasein 2013. The strategy is also appealing to anyone subject to the Medicare surtax. If the current tax laws expire, the tax rate on long-term capital gains will jump from 15 percent to 23.8 percent (21.8 percent for assets held more than five years).

Pay medical expenses. Anyone who normally itemizes medical expenses on their tax return should accelerate those expenses into 2012. Medical expenses are deductible only if they exceed 7½ percent of adjusted gross income (AGI). Next year the threshold jumps to 10 percent of AGI. Pay your January medical insurance premium in December to move this deduction to 2012. Any routine eye exams or dental visits should be moved up to December.

Don't wait to see what happens. Congress has been known to make significant changes to the tax code late in December, leaving taxpayers little time to react. Make a partial Roth conversion, harvest some capital gains but don't wait until it's too late to do anything about rising taxes. Tax planning can be tricky. Consult a tax professional or wealth manager who will consider your individual circumstances and counsel you on the best way to take advantage of current tax laws.

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