Investors and advisors often turn to tax planning only during the fourth quarter, but such tunnel vision may prove to be a mistake in 2012.

Unless Congress takes action before year-end, the 2001 Bush tax cuts will expire on December 31-pushing the top income tax rate in 2013 up to 39.6% (from 35%); the rate on long-term capital gains to 20% (from 15%); and eliminating the preferential 15% rate on qualified dividends altogether. In addition, a 3.8% surtax on investment income in excess of $200,000 will take effect in 2013.

For clients with substantial investment income, the effects will feel Draconian. Worst-case scenario: The marginal tax rate on qualified dividends-those paid by most U.S. corporations-could jump as high as 43.4%, almost triple the current 15% rate. And long-term capital gains will be taxed at 23.8%, up dramatically from today's 15%.

The optimum tax strategy for 2012 may be counterintuitive. For years, advisors have told clients to defer income and accelerate deductions to minimize their tax liability for the current year. If Congress does not act-or if it does, but tax rates still go up in 2013-it may make sense for clients to do the reverse: Accelerate income while rates are low and defer deductions that will be more valuable when rates are higher.

"Wealthy investors should look at taking gains earlier in the fall," says Baker Crow, a trust officer in the Birmingham, Ala., headquarters of Regions Financial, a $130 billion commercial bank. "If there is a fear these taxes will be imposed, you could see December be a down month."

Selling pressure could push equity prices down in December if people want to lock in the lower, long-term capital gains rate this year, he says. "People will take gains to avoid extra tax in 2013, so it could artificially drive down prices for a time."

Clients who have held highly appreciated stock for a long time, for example, can sell this year to lock in a 15% tax rate on the gain. "If they feel good about the security and still want to own it, we will put the proceeds into an ETF that is similar and then buy the original stock back once the wash-sale period is over," Crow says.

Taxpayers in the top tax bracket get the biggest benefit from the preferential 15% tax rate on qualified dividends too. Mutual funds and exchange-traded funds are conduits for tax purposes. That is, they have no separate existence as far as the IRS is concerned. The tax consequences of any trading they do and the dividends or interest they receive flow straight through to the shareholder of the fund in a pro-rata basis.

Nevertheless, Crow points out that clients need to be careful about the timing of fund purchases. Most funds distribute capital gains only once a year, and while some funds distribute dividends every month, others do so quarterly or annually. A client who puts money into a fund shortly before it makes a substantial distribution will owe tax on the full amount paid out. "If you buy a mutual fund in December and it realized substantial gains during the year, you will be taxed on those gains even though you did not benefit from them," says Crow. "Timing is important."

Tax Implications
Although advisors and their clients have to consider the tax implications of every investment, taxes never drive the investment process-or shouldn't. Crow says clients must first evaluate why a particular investment is attractive and how it fits into their portfolio before they look at the tax implications.

But attitudes toward taxes can interfere with dispassionate analysis.

Matthew Smith, a portfolio manager in the wealth management division of Regions Bank says clients sometimes hold on to concentrated positions that are underperforming the market or even declining in value just to avoid realizing a capital gain. "That makes no sense," he says, "particularly when capital gains are taxed at a lower rate than ordinary income."

Some clients go to the opposite extreme: They ignore the tax implications of their investments altogether.

Rex Macey, chief investment officer at Wilmington Trust, a subsidiary of $78 billion Buffalo, N.Y.-based M&T Bank, has seen people invest in complex vehicles like hedge funds without considering the effect on after-tax returns. "I have also had clients say they would rather flush money down the toilet than give it to the government," he says. "People are irrational when it comes to taxes."

Wilmington's clients skew toward ultra-high-net-worth individuals, but no two clients are in the same tax position.

For example, some have almost all their money in tax-deferred accounts like traditional IRAs and 401(k)s. Although these clients care about tax rates in later years when they have to take distributions taxed as ordinary income, taxes generally don't affect their investment strategy during the accumulation phase. Other clients may have sold a business and have their assets concentrated in taxable accounts, while still others have a mix of taxable and tax-deferred assets, and perhaps a tax-exempt Roth IRA.