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Stalemate in Congress makes tax planning nearly impossible

Here we are less than six months away from the "fiscal cliff" and Congress shows little sign of pulling the country back from the brink.

The fiscal cliff is the result of the Bush-era tax cuts expiring at year's end combined with $1.2 trillion in mandatory federal spending reductions set to begin next year. If Congress doesn't act and lets these events unfold, economists say, the country will be thrown back into a recession.

But, level-headed readers might ask, won't lawmakers rush to prevent this from happening?

Yeah, right.

These are some of the same politicians who brought the government to near default last summer, leading to a downgrade in the country's credit rating. And, later, they couldn't agree on reducing the deficit — triggering the draconian spending cuts planned for next year.

Many tax professionals don't expect Congress to act until after the November election. Even then, they say, action — fast or slow — will depend on the outcome of congressional races and on whether Republican Mitt Romney or President Barack Obama wins the White House.

"If Republicans feel strengthened by the election, they might continue to hold out for an across-the-board extension of the Bush tax cuts," says Mark Luscombe, principal tax analyst with CCH, an Illinois provider of tax information. "If Obama wins, unlike 2010, all indication is that Obama is not going to compromise again and do a temporary extension."

But all this uncertainty is unfair to those of us who must make financial decisions this year — with no idea where taxes are headed. Maryland accountants are hearing from frustrated clients.

"Small businesses would just like things to be left alone so they can catch their breath … and plan," says Robert Kober, a certified public accountant in Salisbury.

Clients ask for his prediction.

"It's really difficult to tell them what to do because nobody really knows," Kober says. "What I usually do is present my clients with their options, and they are the ones that have to choose."

Susan Jeter, a Lutherville CPA, says some of her small-business clients are doing well but are reluctant to hire because of the uncertainty. Instead, they have current employees work extra hours.

Lawmakers are "trying to scare people to get votes, but it's making them look like fools," Jeter says. "You don't threaten [people] with falling off the cliff; you just don't do that."

As difficult as planning is this year, tax professionals offer some strategies to consider:

Income tax rates Regular income-tax rates now are 10, 15, 25, 28, 33 and 35 percent. Next year, they're set to revert to 15, 28, 31, 36 and 39.6 percent.

The usual tax strategy is to postpone income into the next year and accelerate deductions into the current year. With tax rates possibly heading up, the opposite strategy might work this year.

One exception: The health care law raised the threshold for deducting medical expenses starting next year. You now can deduct expenses that exceed 7.5 percent of income, but next year that goes up to 10 percent for everyone except those 65 and over, says Joanne Gretz, a certified public accountant with Katz Abosch in Timonium.

So if you have been thinking about Lasik eye surgery or braces for the kids, doing it this year could increase your chances of meeting the deduction threshold.

Roth conversions Gretz says some of her clients are converting traditional IRAs into Roth IRAs, given the prospect of higher income-tax rates.

In a conversion, investors pay ordinary income tax on some or all of the money coming out of the traditional IRA. Once the money is invested in the Roth, though, it can grow and won't be taxed when withdrawn in retirement.

But what if tax rates don't go up? Unlike other tax strategies, an IRA conversion permits a do-over.

Say President Romney comes through with his promise to cut tax rates across the board by 20 percent — reducing today's top rate of 35 percent to 28 percent, Luscombe says. Investors who converted to a Roth this year would have until next October to switch back to a traditional IRA and avoid the tax hit.

Estate planning This year, an individual can shelter up to $5.12 million from federal estate taxes. Next year that's scheduled to drop to $1 million, although Obama has suggested $3.5 million.

Gretz says she's been recommending that clients use this year to give away assets to family and others to reduce the size of their estates.

"There is no downside to making the gift now," even if there are no changes to the estate tax, Gretz says.

The maximum you can give away over your lifetime without triggering the gift tax is also $5.12 million this year. The gift tax was created to keep the rich from giving away all their money to avoid taxes.

Next year, the lifetime limit you can give away without gift tax consequences is scheduled to drop to $1 million.

Reducing capital gains tax The tax rate on long-term capital gains for most investors is 15 percent. That's set to go to 20 percent next year.

If you're thinking about selling appreciated stock in the next couple of years, you might do so by the end of this year and pay the lower tax on the gain, Luscombe says. Then you can repurchase the shares and sell them later.

Dividends Currently, dividend income is taxed like long-term capital gains.

But next year, dividends will be taxed as regular income — which, again, could be as high as 39.6 percent.

Investors might want to consider switching from dividend-paying stocks to growth stocks, which typically don't pay dividends but have the potential to rise in value, Gretz says. That way, investors won't pay taxes until they sell the stock.

Health care taxes Most of these tax increases remain iffy, but new Medicare taxes taking effect next year are likely unavoidable.

The health care act introduces two taxes that take effect in January on high-income households. These taxes apply to adjusted gross income above $200,000 for singles and $250,000 for joint filers.

The first Medicare tax is 0.9 percent on wages above those thresholds. This is in addition to the 1.45 percent workers pay toward Medicare on all wages.

Also, these high-income households will pay a 3.8 percent Medicare tax on unearned income that's above the $200,000 and $250,000 thresholds. Unearned income includes interest, dividends, rental income, annuity payments and the gains on the sale of investments and a second home. (On a principal residence, sellers can shelter the first $250,000 of gains from taxes if single and twice that if they're married.)

High-income individuals thinking of selling securities or a vacation home should consider doing so this year, when the tax rate on the gain will be 15 percent. Wait until next year and it's possible the tax rate could be as high as 23.8 percent — the 3.8 percent Medicare tax plus the 20 percent rate on capital gains.

Luscombe says this 3.8 percent tax and higher income-tax rates may cause wealthier households to consider putting money into municipal bonds and converting to a Roth IRA, which won't be subject to these taxes.

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