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.
[More from Kiplinger: Tax Withholding: The Do-It-Yourself Pay Raise]
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.
[More from Kiplinger: What’s Your Share of the Nation’s Tax Burden?]
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.
6. Review Your Portfolio
Allowing taxes to dictate your investment strategy is rarely a good idea. But if you’re already considering selling appreciated securities or other assets -- even if you don’t have losses to offset them -- cutting them loose by year-end could save you money (you can harvest losses to offset investment gains, plus shield up to $3,000 of ordinary income from taxes).
Unless Congress extends the Bush tax cuts, the top rate on capital gains will rise to 20%, and the top rate for dividends will jump to 39.6%. Even if Congress extends current rates, the new 3.8% surtax on unearned income, levied on singles with adjusted gross income over $200,000 (over $250,000 for married couples), will boost the top rate for long-term capital gains and dividends to 18.8%.
If you think you’re going to need to sell some of your investments to raise cash next year, do it before December 31. And if you're an investor in the two lowest income tax brackets, 2012 is the last year you will pay zero tax on capital gains and dividends.
[More from Kiplinger: 8 Tax Breaks for the Middle Class]
To take advantage of the 0% capital-gains rate for 2012, your taxable income can't exceed $35,350 if you are single; $47,350 if you are a single head of household with dependents; or $70,700 if you are married filing jointly.
7. Convert Your IRA to a Roth
If you think your tax rate is going to rise sometime in the future, converting to a Roth makes a lot of sense. Withdrawals from traditional IRAs are taxed at your ordinary income tax rate, while all withdrawals from Roths are tax-free and penalty-free as long as you're at least 59½ and the converted account has been open at least five years. You do have to pay taxes on any pretax contributions and earnings in your traditional IRA for the year you convert. That's why converting before New Year's Eve is smart: You'll pay taxes at current tax rates, which are unlikely to go any lower.
If you're an upper-income taxpayer -- with modified adjusted gross income of at least $200,000 if you're single or $250,000 if you're married filing jointly -- you have an even greater incentive to convert in 2012 because converting next year could trigger a new 3.8% surtax on unearned income. (The surtax was enacted to pay for some of the costs of the health-care reform law.) Withdrawals from an IRA aren't subject to the surtax, but they're counted as adjusted gross income and could lift your AGI above the threshold.
There is a major caveat, though. We think a major tax reform package could be enacted as early as next year that would lower overall tax rates, while eliminating tax credits and deductions. If that happens, you'd be better off converting after December 31.
Fortunately, when you convert to a Roth, you can change your mind. If it looks like tax reform is going to lower your tax rate, you have until October 15, 2013, to undo the conversion and turn your Roth back into a regular IRA.
8. Beware End-of-Year Mutual Fund Purchases
Sometime in December, many funds pay out dividends and capital gains that have built up during the year, and the payout goes to investors who own shares on what's known as the ex-dividend date. It might sound like a savvy move to buy just before that day so you get a whole year's worth of income.
That's not how it works, though. Yes, you'd get the payout, but at the time of the payout, the share price falls by exactly the same amount. If you get $2 a share in dividends, for example, the share price drops by two bucks. In effect, the fund is simply refunding part of your purchase price.
But the IRS doesn't see it that way. You have to report the payouts as income on your 2012 return -- and pay taxes on them -- even if the money is automatically reinvested in extra shares. (The tax threat does not apply to mutual funds held in 401(k) plans or other tax-deferred retirement accounts.)
Before you buy shares for a nonretirement account in December, check the fund company's Web site to find out exactly when the dividend will be paid.
9. Give to Charity
This is a great time of year to clean out your closets and garage, but you can write off donations to a charitable organization only if you itemize deductions. A few bags full of gently used clothes and household items can add up to hundreds of dollars in tax deductions, but valuing those donations can be difficult. (Try Turbo Tax's free tool).
If you donate a used car worth more than $500 to charity, your deduction will be limited to the amount the organization receives when it sells it. But you may be able to claim a bigger deduction based on the vehicle's fair-market value if the charity uses it to deliver meals, for example, or gives it to a needy individual. The charity will list the vehicle's sale price, or whether an exception allowing a higher deduction applies, on Form 1098-C, which you must attach to your tax return. Because of previous abuses, donations of used cars and other noncash items may attract extra scrutiny from the IRS. So keep scrupulous records.
Send cash donations to your favorite charity by December 31 and hang on to your canceled check or credit card receipt as proof of your donation. If you contribute $250 or more, you'll also need an acknowledgment from the charity.
10. Give Really Big to Charity
If you plan to make a significant gift to charity this year, consider giving appreciated stocks or mutual fund shares that you've owned for more than one year. Doing so boosts the savings on your tax return. Your charitable-contribution deduction is the fair-market value of the securities on the date of the gift, not the amount you paid for the asset, and you never have to pay tax on the profit.
Another tax-wise giving strategy that allowed individuals age 70½ to make a tax-free distribution of up to $100,000 from their IRAs directly to charity expired at the end of 2011. Congress has extended this tax break several times and may do so again for 2012. If you're interested in taking advantage of this provision, you'll need to hold off until you see what Congress does.
11. Give to Your Family (Or Other Lucky People)
The clock is ticking on the very generous estate and gift tax exclusions that allow you to give up to $13,000 this year to any number of recipients -- and a total of $5.12 million over your lifetime -- without owing any federal gift tax. The $5.12 million lifetime exclusion expires at the end of 2012 and is scheduled to drop to $1 million, barring action by Congress. Plus, the maximum estate tax rate will jump to 55% from 35%.
Gifts must be irrevocable (otherwise, the IRS doesn't consider them gifts), so you can't ask for the money back if you come up short. But if you have more than $1 million in assets, review your estate plan before year-end. Talk to an estate-planning attorney about setting up trusts and other vehicles that will allow you to take advantage of the current exemption to transfer wealth to your children or grandchildren, tax-free. You could also take advantage of this exclusion to forgive family loans that the borrowers may be unable to repay.
Even the less well-heeled should consider taking advantage of the annual $13,000 gift tax exclusion. This exclusion disappears if you fail to use it by the end of the year. In 2012, you can give $13,000 to as many individuals as you like, tax-free; if you're married, you and your spouse can give $26,000 per recipient. And if you're feeling really generous, you could do it all over again on January 1, 2013, when you can give up to $14,000 per person.
12. Spend Down your Flex Plan (If You Need to)
If you're thinking of cleaning out your 2012 flexible spending account to avoid the "use it or lose it" rule, remember that you can no longer use flex funds to pay for over-the-counter medicines, such as aspirin, ibuprofen or allergy meds, without a prescription (except for insulin).
But that restriction does not apply to other nonprescription medical items, such as crutches, contact-lens solution or bandages. (For a list of what is allowed by law, see IRS Publication 502.) The same rules on eligible purchases apply to health savings accounts.
In most cases, you have until March 15, 2013, to use your 2012 funds, but some employers still adhere to the December 31 deadline for using the money or forfeiting the balance. Check with your employer to verify your plan's deadline.
And, as you plan next year's set-asides, note that a new $2,500 limit is in effect for 2013.