Change No. 1: New $2,500 Cap on Healthcare FSA Contributions

Before the Healthcare Act, there was no tax-law limit on the amount you could contribute each year to your employer's healthcare Flexible Spending Account (FSA) plan. That said, many plans have always imposed their own annual limits. Amounts that you are allowed to contribute to the FSA plan are subtracted from your taxable salary. Then, you can use the FSA funds to reimburse yourself tax-free to cover qualified medical expenses. Good deal! Starting in 2013, however, the maximum annual FSA contribution for each employee will be capped at $2,500.

Change No. 2: New Higher Threshold for Itemized Medical Expense Deductions

Starting in 2013, the deduction threshold will be raised to 10% of adjusted gross income (AGI) for most individuals. However, if either you or your spouse will be age 65 or older as of 12/31/13, the new 10%-of-AGI threshold will not take effect until 2017 (in other words, the longstanding 7.5%-of-AGI threshold will continue to apply for 2013-2016). Also, if you or your spouse turns age 65 in any year 2014-2016, the long-standing 7.5%-of-AGI threshold will apply for that year through 2016. Starting in 2017, the 10%-of-AGI threshold will apply to everyone.

Tax Planning Implications: If you will be affected by the new 10%-of-AGI threshold next year, consider accelerating elective qualifying unreimbursed medical expenses into 2012 so that your allowable medical expense deduction for this year will be based on the more taxpayer-friendly 7.5%-of-AGI threshold.

Change No. 3: New 0.9% Medicare Tax on Compensation and/or Self-Employment Income

Currently, the Medicare tax on employee compensation and/or net self-employment (SE) income is 2.9%. If you are an employee, 1.45% is withheld from your paychecks, and the other 1.45% is paid by your employer. If you are self-employed, you pay the whole 2.9% yourself.

Thanks to the Healthcare Act, starting in 2013, an extra 0.9% Medicare tax will be charged on employee compensation and/or net SE income above $200,000 if you are unmarried or $125,000 if you use married filing separate status. If you are married and file jointly, the extra 0.9% Medicare tax will be charged on you and your spouse's combined employee compensation income and/or net SE income above $250,000. These thresholds will not be adjusted for inflation in post-2013 years.

Important: If you are self-employed, the additional 0.9% Medicare tax hit will come in the form of a higher SE bill. However, the additional Medicare tax will not qualify for the deduction for 50% of SE tax that you are allowed to claim on page 1 of your Form 1040. Finally, if you owe the 0.9% Medicare tax, it should be taken into account in determining if you need to make quarterly estimated tax payments starting in 2013.

Tax Planning Implications: If you have the ability to shift some employee compensation and/or net SE income from 2013 into this year, the new 0.9% Medicare tax will not apply to that amount. However the income shift might have negative effects on your 2012 tax situation, so this is a tricky issue. Contact us if you have questions.

Change No. 4: New 3.8% Medicare Tax on Investment Income

Through 2012, the maximum federal income tax rate on long-term capital gains and dividends is only 15%. Starting in 2013, the maximum rate on long-term gains is scheduled to rise to 20% and the maximum rate on dividends is scheduled to rise to 39.6% as the so-called Bush tax cuts expire.

But that's not all. Starting in 2013, all or part of the net investment income, including long-term capital gains and dividends, collected by higher-income individuals can be hit with an additional 3.8% "Medicare contribution tax." Therefore, the maximum federal rate on long-term gains for 2013 and beyond will actually be 23.8% (versus the current 15%) and the maximum rate on dividends will be 43.4% (versus the current 15%).

The additional 3.8% Medicare contribution tax will not apply unless your modified adjusted gross income (MAGI) exceeds: (1) $200,000 if you are unmarried, (2) $250,000 if you are a married joint-filer, or (3) $125,000 if you use married filing separate status. Furthermore, the additional 3.8% Medicare contribution tax will only apply to the lesser of your net investment income or the amount of MAGI in excess of the applicable threshold.

Important: If you owe the additional 3.8% Medicare contribution tax, it should be taken into account in determining if you need to make quarterly estimated tax payments starting in 2013.

Here are more details on this new tax.

Net Investment Income Defined: Net investment income for purposes of the additional 3.8% Medicare contribution tax is gross investment income less properly allocable deductions. Gross investment income equals the sum of-

1. Net taxable gains from assets held for investment, including gains from selling stocks and mutual fund shares and the taxable portion of gains from selling personal residences. Gains from property held in a trade or business in which you actively participate (other than the business of trading in financial instruments or commodities) are not included.
2. Gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a business in which you actively participate (other than the business of trading in financial instruments or commodities). However, interest from tax-exempt bond interest is not included.
3. Gross income from passive business activities and the business of trading in financial instruments or commodities.

Impact on Maximum Tax Rates: Thanks to the additional 3.8% Medicare contribution tax in conjunction with rate increases from the scheduled demise of the Bush tax cuts, the following maximum federal rates will apply in 2013 unless something changes:

• 23.8% (20% + 3.8%) on long-term capital gains in excess of short term capital losses (versus 15% for 2012).
• 43.4% (39.6% + 3.8%) on short-term capital gains in excess of long term capital losses (versus 35% for 2012).
• 43.4% (39.6% + 3.8%) on ordinary income from dividends, interest, rental activities, royalties, and annuities not derived from your active business (versus 15% on qualified dividends for 2012 and 35% on the other types of income for 2012).
• 43.4% (39.6% + 3.8%) on ordinary income from passive business activities and ordinary income from the business of trading in financial instruments or commodities (versus 35% for 2012).

Planning Implications: Investment gains that would be subject to these higher tax rates if they are recognized in 2013 won't be hit with the higher tax rates if you trigger the gains this year. Therefore, consider triggering gains by selling affected appreciated assets by 12/31/12 instead of hanging onto them. That said, the tax tail should not wag the investment dog. You should only sell assets that you are thinking about selling anyway.

Since tax exempt interest is not subject to the 3.8% Medicare contribution tax while taxable interest is, now may be a good time to review your investment portfolio to see if investing in tax exempt municipal bonds might make sense. Retirement plan distributions are also exempt from the 3.8% Medicare contribution tax, so it may pay to maximize your contributions to these accounts.

You may also want to do things that would increase your AGI (such as a Roth IRA conversion or a retirement account withdrawal) this year instead of next year. Doing so will reduce or eliminate your exposure to the additional 3.8% Medicare contribution tax next year.  

Contact us if you want more information on this new tax and ideas on how to minimize it.

Are your 2012 itemized deductions likely to be just under, or just over, the standard deduction amount? If so, consider the strategy of bunching together expenditures for itemized deduction items every other year, while claiming the standard deduction in the intervening years. The 2012 standard deduction for married joint filers is $11,900; the magic number for single and married filing separate filers is $5,950; it's $8,700 for heads of households.

For example, say you're a joint filer whose only itemized deductions are about $4,000 of annual property taxes and about $8,000 of home mortgage interest. If you prepay your 2013 property taxes by December 31 of this year, you could claim $16,000 of itemized deductions on your 2012 return ($4,000 of 2012 property taxes, plus another $4,000 for the 2013 property tax bill, plus the $8,000 of mortgage interest). Next year, you would only have the $8,000 of interest, but you could claim the standard deduction (it will probably around $12,500 for 2013). Following this strategy will cut your taxable income by a meaningful amount over the two-year period (this year and next). You can repeat the drill all over again in future years.

Examples of other deductible items that can be bunched together every other year to lower your taxes include charitable donations and state income tax payments.

Time Investment Gains and Losses and Consider Being Bold about It

As you evaluate investments held in your taxable brokerage firm accounts, consider the impact of selling appreciated securities this year. The maximum federal income tax rate on long-term capital gains from 2012 sales is only 15%. Therefore, it often makes sense to hold appreciated securities for at least a year and a day before selling. On the other hand, now may be a good time to cash in some long-term winners to benefit from today's historically low capital gains tax rates.

Biting the bullet and selling some loser securities (currently worth less than you paid for them) before year-end can also be a good idea. The resulting capital losses will offset capital gains from other sales this year, including short-term gains from securities owned for one year or less that would otherwise be taxed at ordinary income tax rates. The bottom line is that you don't have to worry about paying a higher tax rate on short-term gains if you have enough capital losses to shelter them.

If capital losses for this year exceed capital gains, you will have a net capital loss for 2012. You can use that net capital loss to shelter up to $3,000 of this year's high-taxed ordinary income from salaries, bonuses, self-employment, and so forth ($1,500 if you're married and file separately). Any excess net capital loss is carried forward to next year.

Important Point: Selling enough loser securities to create a bigger net capital loss that exceeds what you can use this year might make sense. You can carry forward the excess net capital loss to 2013 and later years and use it to shelter both short-term gains and long-term gains recognized in those years. That will give you extra investing flexibility in 2013 and beyond because you won't have to hold appreciated securities for over a year to get better tax results. Remember: The maximum federal income tax rate on long-term capital gains is scheduled to increase to 20% starting in 2013 (up from the current 15%) while the maximum rate on short-term gains is scheduled to increase to 39.6% (up from the current 35%). Contact us if you want help in identifying the best tax-smart options in a world where future tax rates are uncertain.

Take Advantage of Generous But Temporary Business Tax Breaks

Several favorable business tax provisions have a limited shelf life that may dictate taking action between now and year-end.  

Bigger Section 179 Deduction. Your business may be able to take advantage of the temporarily increased Section 179 deduction. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions. For tax years beginning in 2012, the maximum Section 179 deduction is $139,000. For tax years beginning in 2013, however, the maximum deduction is scheduled to drop back to only $25,000.

Note: Watch out if your business is already expected to have a tax loss for the year (or close) before considering any Section 179 deduction. You cannot claim a Section 179 write-off that would create or increase an overall business tax loss. Please contact us if you think this might be an issue for your operation.

50% First-year Bonus Depreciation. Above and beyond the Section 179 deduction, your business can also claim first-year bonus depreciation equal to 50% of the cost of most new (not used) equipment and software placed in service by December 31 of this year. For a new passenger auto or light truck that's used for business and is subject to the luxury auto depreciation limitations, the 50% bonus depreciation break increases the maximum first-year depreciation deduction by $8,000 for vehicles placed in service this year. The 50% bonus depreciation break will expire at year-end unless Congress extends it. Contact us if you want more details about this generous, but temporary, tax break.

Note: 50% bonus depreciation deductions can create or increase a Net Operating Loss (NOL) for your business's 2012 tax year. You can then carry back the NOL to 2012 and/or 2011 to collect a refund of taxes paid in one or both those years. Please contact us for details on the interaction between asset additions and NOLs.

Don't Overlook Estate Planning

For 2012, the unified federal gift and estate tax exemption is a historically generous $5.12 million. However, the exemption will drop back to only $1 million in 2013 unless Congress takes action. In addition, the maximum federal estate tax rate for 2013 and beyond is scheduled to rise from the current 35% to a painfully high 55%. Therefore, planning to avoid or minimize the federal estate tax should still be part of your overall financial game plan. Even if you already have a good plan, it may need updating to reflect the current $5.12 million exemption and the uncertainty about next year's rules. 

Eligible Illinois businesses (and not-for-profit businesses) are those with 50 or fewer full-time employees. Eligible jobs are those that pay at least $10/hour or $18,200/annually and the position must be sustained for one full year from the hire date.

After creating one (or more) new, full-time positions that meet the eligibility requirements, employers are eligible to receive a $2,500 per job tax credit. The credit will be applied to the employer's Illinois withholding tax account via the payroll returns that are filed.

For more information, please contact our office or you can go to https://jobstaxcredit.illinois.gov/Default.aspx.

As we said at the beginning, this letter is to get you started thinking about tax planning moves for the rest of this year. Please don't hesitate to contact us if you want more details or would like to schedule a tax planning strategy session.

There are many unknowns heading into the 2012 elections, especially in the tax arena.  We are here to help in any way possible, so PLEASE reach out to us if you need help in planning for 2012 taxes and beyond.  Although there are so many uncertainties, planning for this year is the best way to help minimize your current year tax bill.  Please remember that planning should be done before December to ensure enough time to put recommendations in place.  Thanks again for the trust you place in our firm and our staff.