For now, the best approach is to focus on how to limit your exposure to the many new or increased taxes in 2013 and beyond.
1. Manage higher taxes
Many taxpayers will be faced with higher tax bills in 2013 as a result of:
* The temporary reduction in the Social Security tax from 6.2 percent to 4.2 percent that expired at the end of 2012. This means an increase of $2,000 in taxes for $100,000 of wages.
* The tax rate on wage income that increased from 35 percent in 2012 to 40.5 percent in 2013. The tax rate on interest income that increased from 35 percent to 43.4 percent and the tax rate on capital gains and dividends that rose from 15 percent to 23.8 percent for high-income taxpayers.
* The Affordable Care Act, which was passed in 2010, that increased the Medicare tax from 1.45 percent to 2.35 percent for high-income taxpayers starting in 2013.
Strategies that can help minimize these taxes:
* Avoid a transaction, such as selling stock, which would push you into a higher tax bracket.
* Accelerate any deductions that you control, for example, pay your January mortgage in December to get the interest deduction in 2013.
Note that tax considerations are only one factor when determining whether to buy, hold or sell an investment.
2. Understand the new investment income tax.
The new 3.8 percent tax on investment income was created under the Affordable Care Act and became effective in 2013. The income threshold for this tax is $200,000 for individuals and $250,000 for joint filers.
For those affected, there are short-term and long-term strategies that can help minimize this tax burden.
A short-term strategy involves trying to manage your tax position to keep below the threshold for the 3.8 percent tax or to minimize investment income in any year where you will exceed the threshold.
A long-term strategy is to consider investment options that avoid the tax or change the types of investments you hold to include more that are not subject to the tax.
People who think they cannot be affected by high-income thresholds need to understand that the income amounts are not indexed for inflation. Over time, more and more taxpayers will be subject to the tax - even if their real or inflation-adjusted earnings are the same.
3. Consider converting retirement assets.
Recent increasing tax rates created a unique opportunity to accelerate gain and pay taxes at lower rates. Individuals who converted assets from a traditional before-tax IRA to an after-tax Roth likely benefitted.
After-tax Roth IRAs generate tax-free income, subject to you holding the account for five tax years and reaching age 59.5. If you have a traditional 401(k) or IRA, you can convert that asset to a Roth IRA by paying the tax on the gain or before-tax value of the asset. While any conversion tax liability in 2013 will need to be paid with your 2013 income tax return, it may make sense to convert some funds to a Roth IRA and diversify your retirement assets from a tax perspective. In addition to possibly paying tax on the gain at lower rates, a Roth IRA offers other benefits, such as not being subject to age 70.5 required minimum distributions, and limiting the impact of Medicare surcharges and the 3.8 percent investment tax.
4. Contribute to an IRA.
Many individuals do not realize they can contribute to an IRA each year regardless of their income or whether they have a retirement plan at work. The only requirements for making a contribution to an IRA are that you have earned income of at least the amount contributed and you have not reached age 70.5.
While you have until the due date of your income tax return in April of 2014 to make your 2013 IRA contribution, delaying the contribution until then results in you losing some of the opportunity for tax-favored growth. So consider making your 2013 contribution now and your 2014 contribution in January 2014. Depending on your income, you may be able to contribute directly to a Roth IRA and enjoy tax-free growth. Even if you earn too much to contribute directly to a Roth IRA, you can fund a traditional IRA and then convert some or all of the funds to a Roth IRA.
Prudential Financial, its affiliates and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances.