With the end of 2011 rapidly approaching, it's now officially time to consider making some moves that will lower this year's tax bill. However you don't want to take actions that would increase your 2012 tax bill by more than you would save this year.
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In this regard, the key question is whether you will make as much or more money next year. The answer will determine your 2012 marginal federal income tax bracket, which you will need to know to do the best job of planning for the rest of this year.
Sell Loser Stocks Held in Taxable Accounts
Selling loser investments (currently worth less than you paid for them) held in taxable brokerage firm accounts can lower your 2011 tax bill because you can deduct the resulting capital losses against any capital gains from earlier in the year. Plus you can deduct up to another $3,000 of net capital loss (or $1,500 if you are married and file separately) against ordinary income from salary, bonus payments, self-employment activities, alimony, or whatever.
Any excess net capital loss is carried forward to future years and puts you in position for tax savings in 2012 and beyond.
Set Up Loved Ones to Pay 0% Tax Rate on Investment Income
For 2011, the federal income tax rate on long-term capital gains and qualified dividends is 0% for gains and dividends that fall inside the 10% or 15% rate brackets.
While your tax bracket may be too high to take advantage of the 0% rate, you probably have loved ones or family members who are in the bottom two brackets. Consider giving these folks appreciated stock or mutual fund shares. They can sell the shares and 0% tax on the resulting long-term gains. Remember: their gains will be long-term as long as your ownership period plus the gift recipient's ownership period equals at least a year and a day.
Giving away dividend-paying stocks that pay dividends is another tax-smart idea. As long as the dividends fall within the gift recipient's 10% or 15% rate bracket, they will qualify for the 0% federal income tax rate. However be aware that if you give away assets worth over $13,000 during 2011 to an individual gift recipient, it will cut into your $5 million unified federal gift and estate tax exemption ($5.12 million for 2012). However, you and your spouse can together give away up to $26,000 without any adverse effects on your respective exemptions.
Warning: If your gift recipient is under age 24, the dreaded Kiddie Tax rules could potentially cause some of his or her capital gains and dividends to be taxed at the parent's higher rates. That would defeat the purpose.
Convert Traditional IRA into Roth IRA
The best scenario for this strategy is when: (1) your traditional IRA is (or was) loaded with equities and got shellacked by the 2008 stock market meltdown and/or this year's stock market volatility and (2) you expect to be in the same or higher tax bracket during retirement.
If your traditional IRA is worth substantially less than it once was, the tax hit from converting it into a Roth account is also substantially less. That's because a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a non-deductible contribution to the new Roth account.
After the conversion, all the income and gains that accumulate in the Roth account, and all withdrawals, will be federal-income-tax-free, assuming you meet the requirements for tax-free withdrawals. So you avoid having pay high tax rates on withdrawals taken during your retirement years.
As was the case last year, there is no longer any income restriction on Roth conversions. Even billionaires can do them!
Warning: The special deal for 2010 conversions that allowed you to spread the resulting taxable income over two years (50% in 2011 and the remaining 50% in 2012) is not available for 2011 conversions. You must report all the conversion income on your 2011 return. So if you did a conversion last year and are considering doing another one this year, remember that you would have a double helping of conversion income on this year's return. That could push you into a higher tax bracket and make the idea of a 2011 conversion less attractive.
Give to Charities
For those whose charitable instincts are stronger than the economy, here are two suggestions:
Donate Appreciated Stock to Charity; Sell Losers and Donate Cash
If by some miracle, you have appreciated stock shares (meaning they're currently worth more than you paid for them) that you've owned for more than a year, consider donating them to IRS-approved charities. You can generally claim an itemized charitable contribution deduction for the full market value at the time of the donation and avoid any capital gains tax hit. On the other hand, don't donate loser stocks. Sell them, book the resulting capital loss, and give away the cash sales proceeds. That way, you can generally write off the full amount of the cash donation while keeping the tax-saving capital loss for yourself.
Warning: You must itemize deductions to gain any tax-saving benefit from charitable donations, unless you make them out of IRAs.
Make Charitable Donations Out of Your IRA
Congress restored a provision that allows you to make up to $100,000 in charitable cash donations directly out of your IRA for 2011 — if you'll be age 70 or older by year-end. Such direct-from-IRA donations are called qualified charitable distributions, or QCDs. Donations made in this fashion don't directly affect your tax bill, because QCDs are tax-free and no deductions are allowed for them. However, QCDs count as withdrawals for purposes of meeting the required minimum distribution (RMD) rules that apply to traditional IRAs. Therefore, taxes can be avoided by arranging for tax-free QCDs in place of taxable RMDs, and this advantage is available whether you itemize deductions or not. If your spouse owns IRAs and is over age 70 , he or she is entitled to a separate $100,000 QCD for 2011.