There's little agreement as to how the politicians in Washington will resolve the debate over the federal deficit. But taxes don't seem to be falling any time soon, and advisers say it's not too soon to start preparing.
Regardless of political promises to keep taxes steady, experts say budget cuts alone won't be enough to eliminate the more than $1.3 trillion national deficit, and states are facing their own massive shortfalls. Even if no new policies are enacted to raise taxes, several provisions are set to expire within the next two years. The one-year payroll tax cut expires in January. The Bush-era tax cuts, which lowered the income tax rate for all brackets and cut capital gains taxes, among other things, are scheduled to expire in 2013. That same year, new taxes will kick in to fund the new federal healthcare law. Individuals earning at least $200,000 and households earning $250,000 will pay an extra 0.9% levy on wages and a new 3.8% tax on investment income.
For taxpayers, just those scheduled hikes (or the expiration of the cuts, depending on which side you're on) may pinch. For example, someone with a spouse and two kids who made $175,000 last year would have paid about $36,700 in taxes, assuming no deductions, says Nick Kasprak, an analyst at the Tax Foundation, a nonprofit tax policy group. Within two years, that bill will jump 20% to $44,160, if the Bush-era tax cuts lapse. If the ultimate deal in Washington adds additional tax increases, the bill could go up even further. "There is a broad consensus that taxes will go up," says Chris Johnson, wealth advisory expert for Barclays Wealth. When and to what extent "remains difficult to predict."
Of course, nothing has been finalized, which is why some advisers say it's better to wait and see. Dustin Stamper, a manager in Grant Thornton's Washington tax office, points out that those who planned for the expiration of the Bush-era tax cuts in 2010 "jumped the gun," because the tax cuts were extended. "You could have waited a couple more years and enjoyed deferring the tax a bit more," he says. Congress could, for example, decide to extend the one-year 2-percentage-point cut in the employee portion of Social Security, which otherwise ends by January. "This tends to make tax planning very hard," says Stamper.
Even so, there are a handful of strategies that make particular sense now. If taxes don't rise, as anticipated, they don't do much harm. But taxes do increase, these moves could add up to savings for taxpayers.
Take gains. The economy may still be sluggish, but the stock market has come back almost to pre-crash levels. For investors, that's good news and a signal to consider selling winning stocks while capital gains tax rates are still relatively low. Currently, short-term gains are taxed as ordinary income, longer-term gains at 15%, but in 2013 rates are scheduled to revert to their pre-Bush levels (the top rate for ordinary income taxes will rise to 39.6%; long-term gains will be taxed at rates up to 20%). Add the additional taxes on investment income for high-income individuals and households, and some could pay as much as 43.4% on short-term capital gains. Linda Leitz, a financial adviser in Colorado Springs, Colo., says that if an investor takes profits at the current low 15% rate, he could use the proceed to rebalance, or replace his position with similar stocks or an exchange-traded fund.
Convert to a Roth IRA. Until last year, only individuals with a modified adjusted gross income under $100,000 were eligible to convert a traditional Individual Retirement Account into a Roth IRA, a move that may save significant taxes in the long run. Now anyone can make that conversion, and for people who have the money to pay the sometimes hefty tax bill that can go with such a move, it might be worth it. With a Roth IRA, savers pay income taxes on their contributions today, then make tax-free withdrawals; a traditional IRA works the other way. And if tax rates are lower today than they will be tomorrow, the thinking goes, better to get them out of the way now, which is what a Roth does. It's an especially good idea for Generation Xers, who are likely to be in lower tax brackets now than they will be in the future, whether or not taxes rise, says financial adviser Chris Hobart of Charlotte, N.C.
Make more money. For people at the upper echelons of businesses, there are often ways to manipulate income -- exercising stock options -- or making elections on restricted stock. If that's an option, and doing so doesn't push you into a higher tax bracket overall, it's smart to plan to do so this year or next, says Joan Crain, wealth strategist at BNY Mellon Wealth Management in Fort Lauderdale, Fla.: "The goal is to pay taxes now while the rates are low." It's important to run the numbers first: some types of stock options are taxed as ordinary income the minute they are exercised; others don't trigger a tax bill until the stock is sold.
Stay calm. With the recent market volatility and uncertainty at home and abroad, many investors have abandoned tax-advantaged investment accounts in favor of cash. Participation in 401(k) plans is down, one in four people has a 401(k) loan outstanding, and cash savings is at a record high of almost $7 trillion. That's not such a good idea, says Hobart, and not just because he advocates buying-and-holding over the long term. Over time, the tax advantages of these kinds of accounts can enhance investment returns substantially. Over 18 years, someone in the 25% tax bracket saving almost $5,000 per year in a 529 college savings account with an average 8% annual return could net an additional $22,000, compared to the same investment made in a taxable account, according to T. Rowe Price. And that doesn't include additional tax benefits many states offer for contributions.
Correction: An earlier version of this story incorrectly stated the amount of the national deficit.