Uncertainty surrounding future tax policy can make wealth planning challenging. However, with the possibility of new taxes, higher rates and the restoration of deduction limits on the horizon, a reevaluation of one’s current road map is essential. Unless Congress passes new legislation, tax rate changes taking effect in 2013 could result in a significantly larger portion of income owed to the government at tax season. And though it’s never easy to predict fiscal policy, it is particularly difficult this year because so much depends on the outcome of the U.S. presidential election in November.

A familiar situation, with less clarity

Two years ago investors faced a possible expiration of the Bush-era tax cuts, but the Tax Relief Act of 2010 essentially extended those benefits and introduced others for high-income earners through the end of 2012. As in 2010, if the cuts are allowed to expire, rates will return to pre-2001 levels (see Figure 1), taking the top federal income tax rate from 35% to 39.6%. As Figure 2 on the following page shows, qualified dividends, now taxed at 15%, would be treated as ordinary income, and the rate for long-term capital gains would rise from 15% to 20%. Finally, the current estate and lifetime gift tax exclusion amount of $5.12 million would revert to $1 million in 2013.

Although there is a chance that cuts could be fully or partly extended again, policymakers have an important factor to consider as they make upcoming legislative decisions: the economic recovery is strengthening—albeit at a sluggish pace—so Congress may feel more pressure to show it is serious about lowering the deficit. According to the latest estimates from the Congressional Budget Office, if no efforts are taken, the U.S. debt-to-GDP ratio will rise to 93% in 2022. Failure to prevent the shortfall from spiraling to such unsustainable levels would pose a serious risk to the U.S. credit rating and make it more costly for the government to issue debt.

In addition to higher income tax rates, the recent U.S. Supreme Court decision upholding health care reform means that the Medicare payroll tax will increase by 0.9% in 2013. At the same time, a new, 3.8% Medicare surtax to investment income is set to kick in, impacting certain taxpayers with high taxable income. Specifically, the surtax applies to the lesser of 1) personal investment income (including interest, dividends, capital gains, annuity income, rents, royalties and passive activity income), or 2) modified adjusted gross income (MAGI) exceeding the threshold of $200,000 for single taxpayers or $250,000 for married couples filing jointly. For the surtax to apply, taxpayers must have 1) net investment income and 2) MAGI that exceeds the threshold amount.

Though it’s impossible to predict exactly what the new tax rates will look like (see our “Changes on the Horizon for Tax Rates” piece for some thoughts on the potential outcome from one of our analysts), it’s clear that 2013 could place a hefty burden on high-income taxpayers. Bear in mind that these potential tax policies would come on top of the higher rates and income tax surcharges that struggling states have already enacted in recent years, as shown in Figure 3.

Legislators are well aware that enacting all of these changes at once could have a disastrous effect on the nascent economic recovery, so they are likely to take a more measured approach. However, this would require a compromise plan from a notoriously divided Congress. In other words: a solution is unlikely to be quick or easy.

Assuming a worst-case scenario in which all scheduled tax changes move forward as planned, our Wealth Advisory Group has identified four planning opportunities to help cushion investors from higher tax rates. There is a high probability that at least some of the aforementioned changes will take effect in 2013, so the following strategies could be beneficial in your particular circumstances:

• Accelerate the sale of highly appreciated, concentrated stock
• Advance the realization of ordinary income and defer deductible payments, if possible
• Utilize the higher lifetime gifting exclusion amount available in 2012
• Convert a regular IRA to a Roth IRA

Hasten the sale of concentrated stock

Some investors have amassed their wealth through holding concentrated stock positions. These holdings may have been inherited from family members or earned through working at a company. However, concentrated stock positions are subject to specific risks associated with holding a single company, such as management problems or disappointing product lines, in addition to general market risks.

With higher capital gains rates and a 3.8% surtax on those gains scheduled to take effect in 2013, it may be worth hastening the sale of some or all of these shares before next year. But it is important to consider your risk capacity—a financial measure of how much risk you can comfortably take without jeopardizing core goals and objectives over your investment horizon. Transitioning out of a concentrated stock position and into a broadly diversified portfolio could also result in a better risk/reward trade-off, mitigating the downside risk that may compromise your lifestyle. Our Wealth Advisory Group can work with you to assess the trade-offs of various liquidation strategies based on your unique circumstances and specific stock holding.

Accelerate income and defer payments

With ordinary income tax rates expected to rise and the scheduled addition of a Medicare surtax in 2013, investors should consider realizing any potential taxable income in 2012. For example, acceleration of IRA distributions (taxable allocation from IRAs in excess of required minimum distributions) or collection of rent and self-employment income before the end of the year.

Another alternative to consider is exercising nonqualified stock options (NQSOs) in 2012. When the option is exercised, the fair market value (the price) of the stock less the exercise price (what is referred to as the bargain element) is taxable as compensation income (including for Medicare payroll tax purposes). Therefore, the tax savings from exercising the options in 2012 rather than in 2013 could be 5.5%, which is the difference between the current federal earned income tax rate (with the highest level currently at 36.45%) and the new rate (scheduled to be 41.95% at the highest level). On a percentage change basis, this difference is 15%. When the stock is subsequently sold, if the price of the stock at the time of the sale exceeds the price of the stock on the exercise date, the excess is reported as a capital gain.

However, expectations of higher tax rates don’t automatically mean that in-the-money NQSOs should be exercised. To determine whether this strategy makes sense, one should first consider his or her financial goals and objectives, need for cash flow and diversification, and the outlook for the company stock. Each grant of options should be evaluated separately, considering the bargain element, time to expiration, current versus expected future tax rates, and anticipated reinvestment rate if applicable.

The potential for increased tax rates is just one consideration in contemplating whether to exercise NQSOs in 2012. Since this decision is highly individual, a thorough assessment  from a tax advisor should be conducted before any action is taken.

Another potential way to mitigate higher future tax rates is to defer certain deductible payments until the increased rates take effect. This strategy can prove advantageous because the benefit of tax deductions grows as tax rates rise. However, this decision is further complicated by the Pease Limitation, which is scheduled to resume in 2013. This rule limits the amount of certain itemized deductions a taxpayer can take if adjusted gross income exceeds a certain threshold (currently anticipated to be approximately $170,000 for both singles and married couples filing jointly). Those who are subject to the Pease Limitation should realize that the law could reduce tax savings by either 3% of adjusted gross income above the threshold amount or 80% of itemized deductions subject to the limit, whichever is less.

Deferring deductible payments in 2012 is a strategy that could be beneficial to some taxpayers and detrimental to others. For this reason, those who are seriously considering this approach should seek additional support from a tax advisor to evaluate their unique situations.

Consider utilizing the higher lifetime exclusion amount

There is a tax advantage to making large gifts in 2012 because of the generous lifetime gift tax exclusions in effect for the remainder of the year. Individuals now have the opportunity to gift as much as $5.12 million ($10.24 million for couples) tax-free. Gifts beyond these limits are taxed at a rate of 35%. Unless new legislation is passed before the end of the year, large tax-free gifts will be capped at $1 million for individuals and $2 million for couples in 2013, while the tax rate on gifts beyond these limits will rise to 55%.

Gifting assets has the added benefit of removing the growth of those assets from the taxable estate, as shown in Figure 4. However, just because current laws offer a convincing reason to establish a substantial gift this year, it may not make sense for everyone. The decision to gift a portion of one’s assets is irrevocable, so investors must consider all of the variables involved in determining their gifting capacity. This represents the amount that individuals can reasonably gift without jeopardizing their own goals and objectives given their time horizons. Our Wealth Advisory Group specializes in evaluating individual financial situations and long-term investment goals, and can help estimate an appropriate gifting level. The choice of whether to take advantage of higher lifetime gift exclusions in 2012 is dependent on individual circumstances, and taxpayers should seek advice from their independent legal and tax advisors before making this decision.

Convert to a Roth IRA

The potential tax benefits of switching to a Roth IRA from a traditional IRA became a popular topic after income restrictions on conversions were lifted in 2010. However, this issue merits further discussion because the potential for higher tax rates next year strengthens the case for making the conversion in 2012.

A Roth IRA has distinct advantages over a traditional IRA: distributions are generally tax-free^*, there are no minimum distribution requirements for the owner and spousal beneficiary, and gains compound tax-free (not merely tax-deferred as in traditional IRAs). That makes Roth IRAs an excellent choice for transferring wealth to future generations.

Traditional IRA distributions are not considered investment income, but they raise modified adjusted gross income (MAGI). If investment income is also present, then higher MAGI  increases the likelihood that the Medicare surtax will apply. Roth distributions, however, are not included in MAGI.

If one is unsure or doesn’t want to pay all of the taxes associated with converting the entire traditional IRA value, he or she can choose to make a partial conversion. Investors also have the opportunity to reverse the process if circumstances change in a way that makes the conversion economically unappealing.

The importance of tax management

With so many possible tax changes on the horizon and the presidential election contributing to heightened uncertainty about the political environment, it is especially important for investors to be conscious of how their investment plans may be impacted. Whether these scheduled tax increases go into effect completely, partly or not at all in 2013, they aren’t likely to disappear. Policymakers may need to demonstrate that they are taking definitive steps to lower the deficit in order to remain in good standing with U.S. creditors.

At Capital Group Private Client Services, we take pride in our tax management expertise. As one of the only firms in the industry to publish an after-tax track record of investment results that complies with Global Investment Performance Standards (GIPS), we recognize that strategies to minimize tax burdens are intrinsic to maximizing long-term wealth management.

Tax rules are often complex and have diverse applications for different individuals. That is why it is extremely important to consult your tax or legal advisor before implementing any of the strategies outlined above. We would be happy to evaluate your situation through a customized planning analysis with our Wealth Advisory Group. Just contact an Investment Counselor for further information. n

Circular 230 Notice: Any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within. Taxpayers are strongly encouraged to seek advice from their independent tax advisor based on their particular circumstances.

*Distributions from a Roth IRA are tax-free 1) if they are a return of regular participant contributions to the Roth IRA, or 2) If the owner is at least 59½ and the regular contribution or conversion to the Roth was made at least five years prior.

The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.