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Shifting Income

Yesterday, we looked at whether it makes sense to sell investments that have gone up in value, and pay capital gains at the current rates, rather than the potentially higher rates in 2013 and thereafter.  The answer, of course, was: “it depends.”  But generally speaking, if you don’t plan to sell the investment in the near future–if you have an investment time horizon of more than 5-7 years in investment-speak–then harvesting gains may not make sense for you.

But there are other tax planning considerations that are short-term in nature, and therefore may offer more attractive ways to reduce your tax bill.

For instance?  Suppose you have the choice of taking a $50,000 IRA withdrawal for retirement income either in December or January, and you believe your tax rate will go up from, say, 28% to 31%.  If you take the distribution in December, you would pay roughly $14,000 in federal taxes in April, 2013.  If you wait until January, you would pay $15,500 in taxes in April 2014, but you would also have the right to any returns you might have earned on that $14,000 for an additional year.

You come out almost exactly even if you earn 10.7% during the 12 months from one April 15 to the next.  The same, of course, is true of any other type of income you can manage to defer out of 2012 into 2013.  If you’re in the 35% bracket and expect to jump to the 39.6% bracket in 2013, the you would come out almost exactly even if you earned 13.2% on your investment in the intervening tax year.  In both cases, if you think your investments will earn less, then you are better off to pay the taxes now at the lesser rate.

Another way to pull future income into this tax year is to convert some of your IRA account into a Roth IRA.  You pay taxes this year
on the amount shifted over into the Roth, but that money is never taxed again.

Unfortunately, accelerating income into the current year can only go so far; if you add too much money, it can cause you to go into a higher tax rate.  To make this strategy effective, you have to determine how much room is left on your current tax bracket based on income already received and what you expect to receive before year-end.  Prepare to be sympathetic; a full analysis will require determining how much you would owe under the standard tax system compared with how much your AMT tax bill would be, with state taxes factored in as well.

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