Tax Savvy Moves Retirees Should Make Before the New Year

EDITOR'S NOTE: This article was originally published in the November 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

As a shaky 2011 comes to a close, your nest egg may be smaller. But there is still time to bolster the bottom line by trimming your 2011 tax bill.

If you invest the time, your year-end tax planning may reward you with extra cash in your pocket. One of your first decisions is whether you'll take the standard deduction or itemize. You may be a longtime itemizer, but if you no longer pay mortgage interest and your medical expenses and charitable contributions are relatively small, there may be no reason to go through the hassle. Plus, if you're 65 and older, you get a supersized standard deduction.

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For 2011, the basic standard deduction is $11,600 for married couples filing jointly, and $5,800 for singles and married individuals filing separately. Married folks age 65 and older get an extra $1,150 each -- bringing the write-off to $13,900 if both spouses get the age bonus -- and older singles get a $1,450 boost, to $7,250.

Itemizing only makes sense if your qualifying expenses exceed your standard deduction. In toting up possible write-offs, keep in mind that some deductions are available only for the portion of expenses above a certain percentage of your adjusted gross income. For example, dues to professional clubs, investment-management fees and other miscellaneous expenses can be deducted only to the extent that those expenses exceed 2% of your AGI. If, say, your AGI is $200,000, and you have $4,200 in miscellaneous expenses, you can deduct only $200. (See IRS Publication 529, “Miscellaneous Deductions,” for details at www.irs.gov.)

If you'll be itemizing for 2011, you can engage in some tax-trimming maneuvers. For all the tax talk in Washington, there is little to no chance that the tax brackets will change in 2012. If you believe you'll be in the same bracket both this year and next, it makes sense to hold down your 2011 tax bill by deferring income and pulling any deductions you can into 2011. If you're a consultant, for instance, delay your billings until late December. Reverse the strategy if you think you'll be in a higher bracket next year: Deductions will be more valuable against the higher rate.

One strategy for accelerating deductions, says Melissa Labant, tax manager at the American Institute of CPAs, is to "prepay the state income taxes that are due in January and perhaps part of the balance due next April." However, notes Labant, deductions for state and local taxes do not count under the alternative minimum tax. "I would not accelerate the payments if you're in the AMT," she says. "Perhaps you can use the deduction in 2012."

Investment maneuvers. Whether you take the standard deduction or itemize, your investment portfolio may be a treasure trove of opportunities. Start by toting up where sales of stocks, bonds and mutual funds have left you so far this year. Even if you haven't sold any stock funds, they may be planning to declare taxable distributions, which include capital gains realized on the sale of fund holdings as well as interest and dividends earned on securities within the fund. These distributions will take place on the fund's "ex-dividend" date. Check your funds' Web sites for estimates of this year's expected payouts.

If your gains are larger than your losses, you might want to do some "harvesting." Don't let taxes determine investment moves, but consider selling if you have an asset that's a laggard. And perhaps you have some unused carryover losses from past years that can offset the gains. You also can use $3,000 in net capital losses to offset ordinary income, such as your salary or an IRA distribution.

Knowing the "tax basis" of the shares in your mutual funds is essential for harvesting, says Mary McGrath, executive vice-president at Cozad Asset Management, in Champaign, Ill. (The basis is the value of the shares at the time you bought them.) When a fund reinvests your dividends, you're actually buying more shares, and the basis of those shares is determined by their price on the day the money is reinvested.

Let's say you bought a mutual fund for $25,000. In the years since the purchase, $5,000 in reinvested dividends and capital gains have boosted the total basis to $30,000. If you sell your entire stake, you'll have a capital gain on any profit above $30,000, not $25,000, says McGrath, a certified public accountant. That can mean a smaller tax tab than you thought, or maybe even a loss. "Many times, people don't consider the cost for reinvested shares when they sell a mutual fund," she says.

0% capital gains. If you're in the 10% or 15% tax bracket, the tax rate for long-term capital gains is 0%. To qualify for this sweet deal, your 2011 taxable income cannot exceed $34,500 for singles and $69,000 for married joint filers. The 0% capital-gains rate is set to expire at the end of 2012.

However, the 0% rate only applies until your income breaks through the 15% bracket. Say you're a married couple with taxable income of $50,000 and you sell stock for a profit of $30,000. The first $19,000 in gains is tax-free, and you'll pay the 15% capital-gains tax on the $11,000 balance.

For those eligible for the 0% capital-gains rate, Labant suggests this strategy: Sell appreciated stock to take advantage of the break even if you don't want to part with the stock. Sell just enough so your profit pushes your income to the top of the 15% bracket. Then buy new shares in the same company; the shares will have a higher basis than the shares you sold. The capital-gains tax you pay when you eventually sell these shares will be based on the gain above this new value. "This allows you to take advantage of the 0% rate now," says Labant. "When the 0% rate goes away, you won't have to pay tax on the appreciation that occurred from when you first bought the stock."

Flexible spending accounts. If you're thinking of cleaning out your 2011 flexible spending account to avoid the "use it or lose it" rule, remember that starting this year, you can't use flex funds to pay for over-the-counter medicines, such as aspirin, 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. "You can't stock up on over-the-counter allergy medicine, but you can still use the funds to buy a new spiffy thermometer," says Bob Scharin, senior tax analyst at Thomson Reuters, a publisher of tax and business information. (For a list of what is allowed by law, see IRS Publication 502.) The same rules on eligible purchases apply to health savings accounts.

If you're about to sign up for a flex account for 2012, keep in mind that it will be the last year before a congressionally mandated $2,500 limit goes into effect in 2013. (Currently, there is no statutory limit, and many employers set limits above $2,500.) Consider signing on for a larger-than-usual spending amount for 2012 with the plan of accelerating some medical expenses, such as eye laser surgery or teeth capping, Scharin suggests.

Charitable giving. For the sixth year in a row, taxpayers age 70 1/2 and older can transfer up to $100,000 directly from an IRA to charity. You can satisfy all or part of your required minimum distribution with the IRA-to-charity maneuver. This popular break is scheduled to end at the end of 2011 (although it might well be extended).

You don't pay income tax on the distribution, and you can't deduct the charitable donation. But nonitemizers, who don't get to write off a donation anyway, can benefit. By transferring funds directly to charity, they reduce their adjusted gross income. By keeping AGI down, they could qualify to deduct medical expenses that otherwise would fail to exceed 7.5% of their AGI or reduce the amount of their Social Security benefits that are taxed, says Scharin.

Some taxpayers may want to postpone giving until 2012. Take a close look at your expected donations for this year and next. If you think you're better off taking the standard deduction this year and itemizing in 2012, write checks to charity after the New Year.

Before responding to any solicitation, check out the group at Charity Navigator (www.charitynavigator.org) or with the Better Business Bureau's Wise Giving Alliance (www.bbb.org/charity). Also, make sure that your charities are not among the 275,000 groups that lost their tax-exempt status this year.

Roth conversions. If your investments have taken a tumble, consider converting part of your traditional IRA to a Roth, says McGrath. "The lower the stock market, the more tax-free appreciation" when the market rebounds, she says. Only convert an amount that you won't need for many years or would like to leave to your estate. There's little point in paying tax on the conversion if you're going to tap the Roth quickly.

You can also time a conversion with a large charitable donation. "A Roth conversion would increase the amount of income to report," says Scharin. "A charitable contribution could offset that income, and perhaps protect you from being pushed into a higher tax bracket."