Year-end tax planning is stressful under ordinary circumstances, and this year is anything but ordinary. Unless Congress reaches an agreement by December 31, tax rates on wages and investments will rise, the exemption from the estate tax will shrink, and dozens of tax breaks will disappear.
Without a compromise, nearly 90% of Americans will pay higher taxes next year, and the average household’s tax bill will increase by $3,500, according to an analysis by the Tax Policy Center.
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The most likely fix is a temporary extension of the current tax rates, but the odds that a lame-duck Congress will reach a deal are fading. With that in mind, focus on these 12 year-end tactics that will trim your tax bill no matter what Congress does.
1. Feed Your 401(k)
A good place to start is with your 401(k) or similar employer-based retirement plan. Money you contribute to your plan (if it's not a Roth) is excluded from your income, lowering your tax bill.
If you're not yet on track to max out your contributions by year-end, you can direct some extra dollars to your retirement plan during your last few pay periods -- or, if you get a year-end bonus, use it to fatten your savings.
This year, workers can contribute up to $17,000 to employer-based plans. Workers 50 and older can contribute up to $22,500.
2. Safeguard Your Refund (By Shrinking It)
When you file your tax return each year, the amount of tax withheld from your paycheck or submitted through estimated quarterly tax payments ideally should match the amount of tax you owe. In reality, that seldom happens.
The majority of Americans are addicted to refunds. More than 75% of U.S. taxpayers give Uncle Sam an interest-free loan year after year, with an average refund of about $3,000 -- that's $250 per month. Wouldn't you rather get your money when you earn it instead of waiting a year for a refund? What’s more, that fat refund represents a security risk -- identity thieves have been filing fraudulent returns and stealing the refund.
There's an easy fix. Just file a revised Form W-4 with your employer. The more "allowances" you claim on the W-4, the less tax will be withheld.
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If your current financial situation is similar to last year's, just use our Tax Withholding Calculator. Answer three simple questions (you'll find the answers on your 2011 tax return), and we'll estimate how many additional allowances you deserve -- and how much your take-home pay could rise.
However, this tool won't be much help if your tax situation has changed since last year because, for example, you got married, had a baby or switched jobs. In that case, you might want to give the more-complicated IRS online withholding calculator a whirl.
3. Penalty-Proof Your Return
If you expect that you'll owe money when you file your 2012 tax return next spring, you can avoid an underpayment penalty by boosting your withholding now.
You needn't pay every penny of the tax you expect to owe. As long as you prepay 90% of this year's tax bill, you're off the hook for the penalty. Or you can escape its reach, in most cases, by prepaying 100% of last year's tax liability. However, note that if your 2011 adjusted gross income topped $150,000, you'll have to prepay 110% of last year's tax liability to avoid a penalty.
Taking these steps to boost your withholding at year-end will shield you from an underpayment penalty on your 2012 return, no matter how much you actually owe when you file your return.
If you have both wage and consulting income and expect to owe money on your tax return, you'll do better by boosting the taxes withheld from your last few paychecks rather than trying to make up the shortfall with your final estimated quarterly payment, due January 17, 2013.
Taxes that are withheld are treated as if they were spread out evenly throughout the year, so that approach sidesteps an underpayment penalty; the estimated-tax-payment approach does not.
4. Boost Your 2012 Income
Deferring discretionary income, such as year-end bonuses, is a popular tax strategy when tax rates are expected to remain the same or decline. This year, though, high-income taxpayers may want to accelerate discretionary income to avoid a tax hike created by the health-care reform law. Starting in 2013, taxpayers will pay an additional 0.9% Medicare tax on income from wages over $200,000 ($250,000 for married couples.) Of course, if tax reform leads to lower rates, deferring income would still make sense. But that may not happen right away: rate cuts in the Tax Reform Act of 1986 didn’t take effect until 1987 and 1988.
5. Plan Your Itemized Deductions
If tax rates increase next year, deductions will be more valuable. That would seem to argue in favor of postponing your charitable gifts until 2013.
Much depends, though, on your personal situation. If you expect your income to drop next year -- you plan to retire, for example -- the deductions will probably be more valuable this year, no matter what happens with tax rates.
And for high earners, there’s another twist. Before 2001, the tax code limited itemized deductions and personal exemptions for taxpayers whose income exceeded a certain threshold. The Bush tax cuts phased out those limits and repealed them in 2010. The reductions are scheduled to be reinstated in 2013. If Congress doesn’t act, high-income taxpayers could lose up to 80% of their itemized deductions. For that reason, a charitable gift made in 2012 may produce greater tax savings than one made in future years, even if tax rates increase.
You may want to pay other deductible expenses before year-end, such as your January mortgage, 2013 real estate taxes and fourth-quarter estimated state income taxes. Be careful, though: If you're a candidate for the Alternative Minimum Tax, some of those deductions could be disallowed.