The Investment Scientist

2012 year end tax tips: Accelerate income and capital gain recognition

Posted on: December 20, 2012

Tax planning tips

Tax planning tips

In the past, I have advised my clients to defer income recognition and capital gain realization so that they can pay taxes later. Not this year! Under current law, major tax changes are set to happen at the end of the year. These include:

  • Tax rates on ordinary income will rise. The rates for most brackets will increase by 3%. The highest top marginal tax rate (which was for income above $388,350 for both single and married filing joint filers in 2012) will go from 35.0% (in 2012) to 39.6% (in 2013).

  • Tax rates on capital gains will rise. Most capital gains will be taxed at 20%, instead of 15%.
  • Qualified dividends will be taxed at ordinary, instead of capital gains, rates.
  • The medicare surtaxes (3.8% on net investment income, and 0.9% on wages and self-employment income) will come into effect for higher-income taxpayers (above $250,000 for married filing joint and $200,000 for single filers).
  • The child tax credit and education credits will become less generous.
  • Limitations on itemized deductions and dependency exemptions will return for higher-income taxpayers.
  • A number of other favorable tax provisions will either expire or become significantly less favorable.

The president and the Congress may yet come to an agreement to avert these across the board tax increase as the result of the expiration of Bush era tax cuts, but under no circumstance will tax rates stay the same or go down. Thus, it is advantageous to

  1. accelerate recognition of income,
  2. defer recognition of expenses, and
  3. realize capital gains before year end.

I will leave 1 and 2 to your CPA – make sure you bring those up with him or her. I will give an example of how to do 3.

Take my client Tim, for example. He started with me in 2010 with $3.7mm and now he has $870k in capital gains – about $500k in his brokerage account, and the rest in his retirement accounts.  What I would do for Tim is to realize those gains in his brokerage account before year end. He will need to pay long-term capital gain taxes on that to the tune of $500k x 15% = $75k.

If I realize the gains after the New Year, he will have to pay a higher capital gain tax rate of 20% plus the Obamacare surtax of 3.8%.  In other word, he will pay $500k x 23.8% = $119k. Realizing the gains this year saves this client $44k in taxes.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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