Get a Head Start on Your 2012 Taxes

EDITOR'S NOTE: This article was originally published in the July 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

The tax code is not exactly a gripping beach read. But by getting a head start on your tax planning this summer, you can employ a number of maneuvers that could trim your 2012 payment to Uncle Sam. Perhaps you can fine-tune your charitable giving or arrange for tax-deductible elective surgery.

Tax strategizing could be especially tricky this year, though. Bush-era tax cuts are set to expire on January 1, boosting rates for ordinary income, qualified dividends and long-term capital gains. Although Congress is expected to intervene, lawmakers won't make key decisions until a lame-duck session, or even later. And with Republicans opposing President Obama's insistence on hikes on upper-incomers, the outcome of the presidential election "could be one of the most important factors in tax planning," says Bob Meighan, vice-president of TurboTax.

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Such uncertainty will have its biggest impact on your investment strategies. Typically it's best to defer income -- and the tax bill -- to a later year. But if tax rates rise next year, maybe 2012 is the time to sell some appreciated stock. Future tax rates also could affect the timing of Roth conversions (which would be more costly if rates go up) and large charitable gifts (the deduction for which would deliver bigger tax savings if rates rise). While many taxpayers will hold off until year-end to make investment moves, Meighan says they should take time now to prepare "what-if scenarios" for both tax hikes and continued tax cuts.

The uncertainty doesn't end with tax rates. Several popular tax breaks expired at the end of 2011, including the deduction for state and local sales taxes, the credit for energy-related home improvements, and the break for direct contributions from traditional IRAs to charity. There's a "good probability" that lawmakers will vote to extend these benefits before the end of the year, says Bob Scharin, senior tax analyst for Thomson Reuters, a publisher of business and tax information.

Of course, you can make many tax moves now even if you don't know what the future holds. Here are some of them.

Do good deeds. Be sure you have the documentation to back up your charitable deductions. For cash contributions, save canceled checks or credit-card statements. For non-cash donations, such as clothing and household goods, keep a written record describing each item and its fair market value. For all donations of more than $250, you must get an acknowledgement from the charitable organization.

Meighan suggests taking photos of your non-cash gifts before you send them off to the Salvation Army or other qualifying group. "The IRS is becoming more diligent in challenging donations," he says.

Congress has not yet extended the popular tax break that allows individuals 70 1/2 and older to make a tax-free distribution of up to $100,000 from an IRA directly to a charity. But if you want to use your IRA to make a charitable donation this year, you don't have to wait for Capitol Hill to act. Just tell your IRA custodian to transfer the funds directly to your favorite charity. If lawmakers retroactively reinstate the provision, direct transfers anytime in 2012 will qualify. If for some reason Congress fails to make the retroactive fix, the payout is taxable, and you can deduct the donation as a charitable gift if you itemize deductions.

If you're planning to use appreciated stock for a donation, it "makes more sense to contribute the property rather than selling it and giving the cash," says Marc List, a certified public accountant at CBIZ in Boca Raton, Fla. Say the stock you bought at $1,000 is now worth $1,500. If you have owned the stock for more than a year, giving it directly to the charity earns you a deduction equal to $1,500. If you sell it and give cash, you'd pay a 15% long-term capital-gains tax on the $500 profit, meaning part of your intended generosity goes to Uncle Sam rather than the charity.

Remember to save receipts for out-of-pocket expenses for any volunteer work you perform. You can take a write-off for office supplies, the costs related to fund-raising events and even the ingredients for meals you make for charities serving the poor. Keep a log of the number of miles you drive your car for charity; you can deduct 14 cents per mile. (Read IRS Publication 526, Charitable Contributions, at www.irs.gov.)

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Create tax-free income. Thinking of converting part of your traditional IRA to a Roth? If you believe you'll be in a higher tax bracket in the future -- and thus incur a bigger tax bill when you convert -- now may be the time. A mid-year conversion could make sense if you think the market will rise in future months. You'll pay tax on the current value, and the assets in the Roth will grow tax-free.

If you converted in 2010 and split the tax bill over two years, you'll need to report the second year's income on your 2012 return. Keep that extra income in mind if you plan another conversion this year, says Scharin. "You want to make sure you won't move into a higher bracket," he says.

Stash pretax money. You can reduce your taxable income by boosting pretax contributions to retirement plans. Contribution limits for 401(k) plans rose this year for the first time since 2009. If you're at least 50, you can sock away $22,500 in a 401(k), up slightly from last year. For someone in the 25% tax bracket, the out-of-pocket cost will be $16,875.

The self-employed can also take advantage of higher contribution levels. Owners of SEP-IRAs can contribute up to 20% of earnings up to a maximum pay-in of $50,000. For solo 401(k) plans, the limit is now $50,000 ($55,500 for plan participants 50 and older).

Tax-deductible contributions to traditional IRAs and after-tax deposits into Roth IRAs remain at $5,000 plus another $1,000 if you're 50 or older. You can contribute the same amount for a non-working spouse if you have enough income to cover the contribution and you file a joint return.

Monitor medical expenses. If you're younger than 65, this may be the year to make medically necessary home improvements, such as installing a wheelchair ramp or widening a doorway. Also consider accelerating elective medical procedures that you may have been planning for 2013.

The reason: Under the health care overhaul law, the threshold for the itemized deduction for unreimbursed medical expenses is scheduled to rise to 10% of adjusted gross income on January 1. The threshold will remain at 7.5% for individuals who turn 65 and older in tax years 2013 through 2016. In 2017, the threshold will rise to 10% for everyone. (If you're hit by the alternative minimum tax, your medical deductions are already squeezed by the 10% of AGI threshold.)

During the year, toss unreimbursed medical bills into a special folder. You can deduct insurance premiums, including what you paid for Medicare Part B and Part D and part of long-term-care insurance premiums. You can take write-offs for hospital and doctor services, acupuncture, eyeglasses, ambulances and hearing aids. (Read IRS Publication 502, Medical and Dental Expenses to learn of other deductions.)

If you live in a continuing-care retirement community, you can write off the portion of the entrance fee and monthly fee that the facility allocates to medical care costs. You also can deduct travel costs for medically related reasons, including up to $50 per person per night for the cost of lodging.

Review your investments. If Bush-era tax cuts expire, the top ordinary-income tax rate will increase to 39.6%, from 35% now. The rate on long-term capital gains will rise to 20%, from 15%, and qualified dividends, now taxed at 15%, will be taxed at ordinary rates. Plus, higher-income taxpayers will pay a new 3.8% "Medicare surtax" on certain investments, raising the top marginal rate to 43.4%.

With the possibility of a higher capital-gains rate looming, you may want to accelerate the sale of real estate or a business, List says. "If you were thinking of selling a business, try doing it this year," he says. "You still have time to act."

Taxpayers in the 10% or 15% bracket should take a close look at their portfolios in the next few months. These taxpayers have a long-term capital-gains rate of 0% -- a great deal that's set to expire. To qualify, your 2012 taxable income cannot exceed $35,350 for individuals and $70,700 for couples.

The 0% rate only applies until your income exceeds the 15% bracket. Say you're a married couple with a taxable income of $60,000 and you sell stock for a $25,000 profit. The first $10,700 in profit is tax-free, and you will pay a 15% capital-gains tax on the $14,300 balance.

Scharin suggests this strategy for those eligible for the 0% rate: Sell just enough appreciated stock this year to take you to the top of the 15% bracket. If you like the stock, buy new shares from the same company. The capital-gains tax when you eventually sell those new shares will be based on the gain above the cost of the replacement shares. "It's a no-lose move," he says. He notes, however, if your income unexpectedly rises later in the year, some of the profits could exceed the threshold.