Year-End Tax Letter

I hope that 2011 has, thus far, been a happy and prosperous one for you and your family.

In terms of legislation, 2011 was a quiet year on the tax front. Barring any last-minute retroactive congressional mischief, rates, deductions and credits are virtually unchanged from 2010.

This means that the usual year-end strategy of deferring gains and income, taking losses, and accelerating deductions holds true.

This doesn’t mean that the taxing agencies at the federal and state level have been idle, however. Both the IRS and the California Franchise Tax Board have new requirements and compliance programs, so here’s a “heads-up” for what to look out for this year.

Sales of stock and securities: If you sold stock or securities through a broker, the broker will issue you a revised form 1099-B. This form is intended to report all the details of each sale including the sales price and cost basis (usually what you paid for the stock) for determining capital gains and losses. This requirement is new, however, and the form provided by the broker will not yet capture all sales.

Most of you have provided excellent detail of your trading activities in the past, and in many cases you’ve been maintaining your own spreadsheets. Please continue to do so, but also please provide copies of any 1099-Bs and all other information provided by your broker that can help establish cost-basis.

Merchant charges, 1099-Ks: Those of you who are in business, rent property, or sell merchandise online will likely receive a new form – Form 1099-K. This form will report credit card or other merchant payments (PayPal for example) over specified amounts. Be on the lookout for this new form and please provide me with any 1099-Ks you receive.

This is no doubt part of a concerted effort by the taxing authorities to focus on the growing problem of unreported income. As this is the first year for this requirement, in all likelihood only PayPal vendors and Amazon affiliates will be affected, but if you maintain a website that serves as a portal for various forms of e-commerce, you will face this reporting requirement in 2012.

Beginning with your 2012 returns, you will have to report sales figures separately, on two separate lines: one for merchant cards and third party payments (generally, credit cards and remittances reported on Form 1099-K); and the other for cash and check payments. This requirement will apply to sole proprietorships (Schedule C) or rental properties (Schedule E), or other business returns (corporation, partnership, etc.).

You will therefore need to start tracking payments by type beginning in January, 2012. If you need any help setting up your accounting systems and procedures to separately track these amounts, please let me know.

Foreign accounts: The reporting requirements for assets held overseas are increasing convoluted, and the penalties for failure to report them are becoming increasingly draconian. Not all foreign holdings must be reported. If, for example you hold stock in a foreign company through a U.S. broker, foreign holdings are already reported. If you directly hold any other types of foreign assets, including bank accounts and securities accounts, please let me know, and if you have any doubt as to whether any of your assets are “foreign” for the purposes of compliance with current requirements, please contact me.

Property tax statements: California’s Franchise Tax Board has stated that they will require parcel numbers and other information pertaining to property taxes for any taxpayer who deducts property tax. Although this requirement isn’t slated to take effect in 2012, I would like you to provide me with copies of your property tax statements this year so I can do a preliminary review of them in preparation for the new requirement.

Use tax: California has long required payment of use tax if you purchase goods out-of-state that are used, consumed or stored in California, when no sales tax is collected on the purchase. Most such purchases are currently made over the internet or by mail order from out-of-state sellers. Taxpayers who don’t hold a California seller’s permit have the option of reporting the use tax on their California income tax returns , and in the past, reporting had been “voluntary,” and therefore ineffective. 

This is no longer the case. You now will have two options. You can total all untaxed out-of-state purchases and I will compute the use tax, or I can use  an official “lookup table” and report an amount due based on your California adjusted gross income. For example, if your adjusted gross income is $75,000, your use tax “due” will be $49. If your purchases are both over and under $1,000, you may elect to total just the purchases that are over $1,000 and I can compute the use tax on those and use the lookup tables for the small purchases.

New tax benefits

Not all the news is bad. There are a number of tax benefits that I can use to reduce your tax liability for this year and the future. There are new tax credits for employers providing health insurance, for small businesses increasing the number of employees, and an amnesty for payroll taxes, which has some major flaws, but could benefit your company.

Roth IRA conversions are still available and can be a useful way to reduce the tax you’ll pay later when you need the money.

Other changes

There are a number of other changes that might affect your tax return this year, including new rules for those who do not wish to file electronically, and a mandatory electronic payment requirement for higher income California individuals.

I anticipate sending out organizers to my returning clients before the end of January. When you receive yours, please take extra care in preparing it and providing all supporting documentation.  

Finally, if you want to file early because you’re expecting a sizable refund or for any other reason, please let me know before mid-January so I can schedule your return for filing before the March-April tsunami.

Thanks once again for letting me be your “tax guy,” and best wishes for the holidays.

Yours very truly,

Rick Zalon, CPA

The Higher Education Bubble

From: The Best Colleges

The Compleat Guide to Roth Conversions

Roth conversions have been getting a lot of publicity this year, for two reasons. First, 2010 is the first year that anyone can do them without being restricted by income limitations. Second, if you do a Roth conversion in 2010, you may report the income in 2010 or defer and spread it 50/50 in 2011 and 2012. 2010 is the only year this special defer/spread provision is available.

Briefly, when you make a contribution to a “traditional” IRA, you get a deduction but when you take a distribution, the amount is taxable. When you contribute to a Roth IRA you don’t get a deduction but distributions are tax free.

When you do a Roth conversion, it’s treated as if you take a distribution from your traditional IRA (taxable) and contribute it to a Roth. As such, the amount converted is taxable but it and any earnings after the conversion are tax-free when distributed.

In other words, do a conversion if your tax bracket will be low in 2010 or if you believe it will be low in 2011 and/or 2012, but recognize that despite their publicity, Roth conversions aren’t for everyone. Don’t do one if your tax rate is higher now than you believe it will be when you take distributions (generally, during retirement when you may have little other income). And remember the time value of money: paying tax now versus paying it later — or not at all — if you pass on the income to your children upon death.

CONVERSIONS – POST 2009

In taxable years beginning after December 31, 2009, the AGI limitation that prevented many taxpayers from converting traditional IRS is eliminated.

In addition, there is a one-time bonus in the law regarding income recognition. The taxpayer who makes a conversion in 2010 may recognize all the income in 2010 or spread the income over the next two years. The wording of the law is a bit odd: “. . . shall be so included ratably over the two-taxable-year period beginning with the first taxable year beginning in 2011.”

What this means is that if a taxpayer makes the conversion in 2010, he or she recognizes half the income in 2011 and half in 2012. Alternatively, the taxpayer may elect to recognize all of the income in the 2010 year of conversion.

One-time opportunity: If making a conversion in a year after 2010, the taxpayer recognizes all the income in the year of conversion.

California Conformity:

California conforms to these provisions. However, a taxpayer may make a separate election on when to report the conversion. The taxpayer may elect to report all the income to California in 2010 or ratably in 2011 and 2012, independent of the federal election.

Example of 2010 conversion:

In 2010, Irene converts her traditional IRA worth $10,000 to a Roth (she has no basis in her IRA). She may recognize $5,000 in 2011 and $5,000 in 2012. She may, however, elect to recognize the full $10,000 in 2010. If she makes the conversion in 2011, she must recognize the entire $10,000 in 2011.

MFS now eligible: Another change beginning in 2010 is that married taxpayers filing separate returns may now do Roth conversions.

Two-year deferral is the default:

Income recognition from a 2010 conversion will take place in 2011 and 2012 unless the taxpayer elects to report all of the income in 2010.

Can I amend?

Wouldn’t it be nice if we could choose one or the other – report the conversion in 2011 and 2012 or report it all in 2010 – and amend later when we know the client’s tax situation for each of those three years? After all, the general statute of limitations is three years, which would mean we’d have until April 15, 2013, to make our final decision. Unfortunately, we don’t have that option. IRC Sec 408A(d)(3)(A) provides in plain language:

Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.

Thus, it would appear that you can amend, but no later than the extended due date of the return (10/15/11).

Can I do both?

Can you elect to report some of the conversion in 2010 and spread the rest over 2011 and 2012? Generally, no. Both the two-year spread and the election are contained in IRC Sec 408A(d)(3)(A)(iii), which states, “unless the taxpayer elects not to have this clause apply . . .” As such, the choice is all or nothing.

It would seem that a taxpayer could not get around that result by converting multiple accounts. First, the IRC makes it clear that the taxpayer has a choice to make the relevant clause apply or not. Second, the IRS did not allow splitting treatment when 1998 conversions were allowed a four-year spread with an election out.

Joint return strategy: In the case of a joint return, there is nothing to prevent once spouse from converting his or her IRA and electing 2010 treatment, and the other from spreading over 2011 and 2012.

Taxpayer dies

If the taxpayer does a conversion and dies, the entire unreported amount is reported in the year of death. As such, if a taxpayer does a conversion in 2010 and dies in 2011, the entire amount of the conversion is recognized in 2011 (assuming the taxpayer did not elect to report income in 2010).

Important caveat

Before implementing this strategy, keep in mind the following: Under distribution rules, all of the taxpayer’s IRAs are combined. This can lead to undesirable results for a high income taxpayer.

Example: Steve makes nondeductible contributions totaling $22,000 in the years 2006 through 2009. He has no other IRA accounts. In 2010, when Steve’s IRA has a value of $26,000, he converts it to a Roth. Unless he elects otherwise, Steve will report no income in 2010, $2,000 in 2011, and the remaining $2,000 in 2012. Or, he may elect to recognize the entire $4,000 “gain” in 2010.

However, suppose in his younger years, he had made deductible IRA contributions. Those accounts now have a combined value of $74,000, bringing the total value of his IRA accounts to $100,000 ($74,000 + $26,000). He converts the account that holds the $26,000 in 2010. In this case, he may only use 22% of his IRA basis ($22,000 divided by $100,000). As such, he uses basis of $4,840 (22% X $22,000). His taxable amount is $21,160 ($26,000 - $4,840).

Conversion Planning—Generally

Contributing to a Roth IRA can be a no-brainer for an individual nearing retirement age with a few extra dollars to save. But does that same taxpayer benefit from a Roth conversion? Sometimes, yes, and sometimes, no. Consider such issues as tax bracket, income fluctuation, and estate tax when making the decision to convert a traditional IRA to a Roth IRA.

Individuals nearing retirement are often in the top tax bracket. If an individual will drop to a lower bracket in the next few years, paying the tax on the Roth conversion now may not compensate for tax-free income later.

But, if a taxpayer currently has a low income year, consider converting the traditional IRA to a Roth. Taxpayers with large business losses, net operating losses (NOLs), or large itemized deductions combined with low income are also good candidates.

NOL opportunity

When a taxpayer has a NOL, itemized deductions and personal exemptions often go unused. This is the perfect opportunity to convert all or a portion of a traditional IRA to a Roth IRA. Estimate how much can be converted without creating taxable income. Converting too much will result in taxable income at the lowest tax bracket. Converting too little will waste those personal deductions

Example of NOL

Terry has a $100,000 NOL carried forward from the prior year. His current AGI is $5,000 after applying the NOL. Terry’s itemized deductions and personal exemptions will be $20,000. Terry should convert at least $15,000 from traditional IRA to a Roth. This will bring his taxable income to zero.

Using charitable contributions

The charitable contribution deduction is limited by federal AGI. For most contributions, the law limits your deduction for charitable contributions to no more than 50% of AGI. Unused contributions may be carried over for five years before they expire. If a taxpayer is in danger of losing charitable contribution carryovers, doing a Roth conversion will

• ·         Increase AGI;
• ·         Increase charitable contributions by 50% of the AGI increase; and
• ·         Increase taxable income by only 50% of the amount of the conversion.

The net effect of this plan is to cut the tax on the Roth conversion in half.

Effects of increased AGI on passive losses and Social Security taxability

The increase in AGI caused by Roth conversions can have negative tax consequences due to the phase-out of the $25,000 passive loss allowance on AGIs in excess of $100,000, and on the taxability of Social Security benefits for AGIs in excess of certain thresholds.

Cash outside the IRA to pay for the tax obligation

Assuming that you don’t have an NOL or other tax break to completely wipe out the income on the conversion, the taxpayer is going to need cash outside the IRA to pay tax on the conversion.

Conversion Planning—Recharacterization (the “Mulligan”)

If having excess deductions is the number one reason to do a conversion, the other number one reason to do a conversion is the “mulligan,” or the “do-over.” In the world or Roth conversions, the mulligan is the “recharacterization.” You make a conversion that you regret, so you recharacterize the conversion. Now you get to pretend that the conversion never happened.

What makes the IRA mulligan so inviting is that the deadline for making it isn’t until the extended due date of the return for the year of the conversion. This is true even if you don’t extend the return.

This means that if you do the conversion on January 1, 2010, you have until October 15, 2011 to decide if you really meant it.

Recharacterizing a high-value conversion to a Roth

When the taxpayer’s IRA consists of stocks and mutual funds, the lowest tax cost to the taxpayer is when a conversion is made at the time the market is at its lowest point since the taxable amount of the conversion is based on fair market value.

A taxpayer who converts from a traditional IRA to a Roth when the market is high will have an artificially high tax bill. If the market drops, the taxpayer may treat the conversion as if it had never been made by recharacterizing it. The taxpayer may later do the traditional-to-Roth conversion when the market is lower and therefore so is the tax cost.

Break into multiple Roths

Most account owners hold their IRAs with diversified portfolios in order to smooth out gains and losses. De-diversifying accomplishes the opposite—it accentuates gains and losses.

If you hold five stocks in your IRA, the probability that at least one of them will gain more than the average of the five is 100% (unless all five gain exactly the same). Thankfully, you can break out the five stocks in the single IRA and do five separate conversions into five separate Roth IRAs. If just one of the five appreciates substantially by the extended due date and the other four remain flat or decline, you can allow that one conversion to go through and recharacterize the other four.

Keep in mind that if you roll funds from a traditional IRA into an existing Roth that has a balance, then you must aggregate the gains and losses on all the assets in the account for the current year. This could diminish the tax benefits of recharacterizing. For the same reason, gains and losses will have to be aggregated if multiple assets are rolled into or acquired within a single Roth, even if the Roth is new.

Example of multiple accounts: Michelle converts $100,000 from her traditional IRA into a Roth. She uses the funds to buy $50,000 of Generic Stock and $50,000 of Plain Stock. By her extended deadline, Generic has gone up in value to $100,000 and Plain has gone down in value to $0. Michelle will have to recognize $100,000 of income if she allows the conversion to go through.

Kat does the same as Michelle, except she uses two separate Roths for the two stocks. Kat can let the conversion holding the Generic stock go through and recharacterize the Roth holding the Plain stock. She will recognize $50,000 of income.

Kat only has to recognize half as much income as Michelle even though their Roth IRAs have equal value.

New Tax Law for 2011-2012

The following is a summary of the bill that passed the Senate on December 15 by a vote of 81-19, and the House on December 16 by a 277-148 margin.  The bill, H.R. 4853, is termed the "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010." 

Income Tax Provisions   Rates.  The EGTRRA rate structure put in place in 2001 would continue through 2012 instead of expiring at the end of 2010.  So, the top individual income tax rate would remain at 35 percent and the rate for capital gains and dividends would stay at 15 percent through 2012.  In addition, the 10 percent bracket will remain in place for two more years instead of increasing to 15 percent.  Likewise, the repeal of the phase-out on personal exemptions in effect for 2010 is extended through 2012 as is the repeal of the limit on itemized deductions which was in effect for 2010 - it has been extended through 2012. 

Other income tax provisions. 

• The bill extends the child tax credit through 2012.
• The bill extends existing marriage penalty relief for the standard deduction, the 15 percent marginal income tax bracket and the earned-income tax credit through 2012.
• The bill extends the dependent care credit through 2012.
• The changes made to the adoption tax credit by the 2010 health care bill would be extended through 2012.
• The bill would extend the credit for employer expenses for child care assistance through 2012.
• The enhanced provisions applicable to the earned-income tax credit added by the 2009 bailout bill would be extended through 2012.

Depreciation Provisions Bonus depreciation.  The bill specifies that for qualified assets placed in service after September 8, 2010 through December 31, 2011, 100 percent bonus depreciation is available.  For 2012, bonus depreciation would be limited to 50 percent of the qualified property's adjusted basis.  Also, the bill specifies that a taxpayer could elect to accelerate some AMT credits in lieu of bonus depreciation for tax years 2011 and 2012. 

Expense method depreciation (Sec 179).  In 2012, expense method depreciation (for federal tax purposes) would be set at $125,000, with the phase-out beginning at $500,000 of qualified property purchases for the year.   The provision is adjusted for inflation.  Without subsequent legislation, the limit will fall to $25,000 beginning in 2013.  The bill also extends the ability to revoke an expense method election on an amended return through 2012.    Automobile depreciation.  The limit on the deduction for new cars (so-called "luxury autos") will be $11,060, with the balance subject to the rules contained in I.R.C. §280F in later years.

Extension of Expiring Provisions   Energy-related provisions.  The bill renews (on a temporary basis) many expiring provisions.  The energy-related provisions that are extended are as follows:

• Biodiesel and "renewable" diesel - extended through 2011 is the $1.00/gallon production tax credit for biodiesel and the $.10/gallon producer credit for small agri-biodiesel producers.  In addition, the $1.00/gallon production tax credit for biomass-created diesel fuel is extended through 2011.
• The placed-in-service deadline for certain refined coal facilities is extended through 2011.
• The suspension on the taxable income limit for marginal oil or gas well depletion is extended through 2011.
• The ethanol subsidy is extended through 2011.  That means the tax credit is extended as is the $.54/gallon tariff on imported ethanol and the $.2267 tariff on ETBE.
• The alternative fuel tax credit is also extended through 2011 at $.50 per gallon.  But, "Black Liquor" is not eligible for the credit.
• Through 2011, the bill extends the 30 percent investment tax credit for "alternative vehicle refueling property."
• Extended through the end of 2011 is the required beginning date for construction so that the taxpayer can receive a cash grant in lieu of a tax credit under Section 1603 of the 2009 bailout bill.
• The bill would extend through 2011 the credit for manufactures of energy-efficient residential homes.
• The bill would extend through 2011, the I.R.C. §45M credit for the manufacture of energy-efficient clothes washers, dishwashers and refrigerators manufactured by U.S.-based companies (and increases the energy efficiency standards)
• The bill would extend through 2011, the I.R.C. §25C credit for energy-efficient improvements to existing homes.

Individual-Related Provisions

• Expenses incurred by elementary and secondary school teachers will be able to  be claimed as an above-the-line deduction for 2010 and 2011.  It's a $250 deduction for expenses paid or incurred for books, supplies, computer equipment and supplemental materials that the teacher uses in the classroom. 
• Restored retroactively for 2010 and extended through 2011 is the ability to make an election to treat as an itemized deduction amounts paid for state and local sales taxes in lieu of an itemized deduction for state and local income taxes.
• Restored retroactively for 2010 and extended through 2011 are the enhanced contributions limits and carry-forward periods for contributions of appreciated real property (including partial interests (i.e., easements)) for conservation purposes.
• Restored retroactively for 2010 and extended through 2011 is the ability to make tax-free withdrawals from an IRA for purposes of distributing the funds to a charity in amounts up to $100,000 per taxpayer, per year.  Transfer made in January of 2011 can be treated as having been made in 2010.

Business-Related Provisions

• The research and development credit is retroactively restored for 2010 and extended through 2011.
• Restored retroactively for 2010 and extended through 2011 is 15-year MACRS treatment for qualified leasehold improvements, qualified restaurant property, and qualified retail improvements. 
• Restored retroactively for 2010 and extended through 2011 is the provision specifying seven-year MACRS treatment of property used for land improvements and associated facilities at "motorsports entertainment complexes."
• The bill retroactively restores for 2010 and extends for 2011 the provisions that provide for enhanced charitable deductions for contributions of book inventories to public schools, corporate contributions of computer equipment for educational purposes and contributions of food inventory.
• The bill retroactively restores for 2010 and extends for 2011 the provision allowing expensing of costs associated with the clean-up of hazardous waste sites.
• Retroactively restored for 2010 and extended for 2011 is the ability of S corporation shareholders to take into account their pro-rata share of charitable deductions (even if it exceeds the shareholder's adjusted basis in the S corporation).
• Extended through 2011 is the American Samoan economic development credit.
• The bill extends for four months (for September 2011 through the end of the year) the Work Opportunity Tax Credit
• The bill extends through 2011 the provision that allows premiums for mortgage insurance to be deducted as interest that is "qualified residence interest" (for taxpayers with AGI of $110,000 or less).
•  Extended through 2011 is the provision contained in the bank bailout bill of September 27, 2010 (Small Business Jobs Act of 2010) which allows non-corporate taxpayers to exclude gain on small business stock acquired after September 27, 2010 and held for more than five years.

Education-Related Tax Provisions

• Restored retroactively for 2010 and extended through 2011 is the provision allowing an above-the-line deduction for qualified education expenses.
• The changes made by EGTRRA to Coverdell Education Savings Accounts (annual contribution of $2,000 and expanded definition of eligible education expenses) would be extended through 2012.
• The bill would extend through 2012 the EGTRRA-enhanced provisions applicable to employer-provided education assistance (exclusion from gross income of up to $5,250 annually for employment and income tax purposes ).
• The bill would extend the existing $2,500 student loan interest deduction through 2012.
• The bill would extend through 2012 the provision that excludes from income amounts received under specified scholarship programs for tuition and related expenses.
• The bill would extend the American Opportunity Tax Credit (formerly the HOPE Credit) through 2012.

 
Alternative Minimum Tax The bill contains a two-year "AMT patch."  The AMT exemption is set at $47,450 for individuals for 2010, $72,450 for those filing as married filing jointly.  In 2011, the exemption will be $48,450 for individuals, $74,450 if filing status is married filing jointly. 

Transfer Tax (Estates and Gifts)   The EGTRRA sunset provisions create uncertainty concerning the income tax basis rule to be utilized for property that is inherited from a 2010 decedent's estate that is sold in a tax year beginning after 2010.  The bill recognizes that lack of clarity by allowing an election to be made to have no estate tax apply for deaths in 2010 or have estate tax apply at a 35 percent rate after a $5 million exemption per decedent.  The gift tax rate would also be 35 percent after a $5 million exemption (up from $1 million).  As for the GSTT, the bill would establish a $5 million exemption and a 35 percent rate for 2010.  For deaths and taxable transfers in 2011 and 2012, the exemption for estate, gift and GSTT purposes would be $5 million and the tax rate would be 35 percent beyond that level.  The bill would also allow portability of the estate tax exemption between spouses for deaths in 2011 and 2012.  Because the exemption for 2011 and 2012 would be $5 million for estates and gifts, the transfer tax rate structure would be re-unified. 

Other Provisions FICA tax.  While the employer portion of the FICA tax would remain at 6.2 percent, the deal is that the employee portion would decline to 4.2 percent on earned wages up to $106,800 - for 2011 only.  Self-employed persons would pay 10.4 percent (down from 12.4 percent) on self-employment income up to $106,800 for 2011.    

Unemployment Benefits.  Reports are that the deal includes an extension of jobless benefits for 13 months (which sets the issue up for a replay just in time for next Christmas).  The extension is for those whose benefits have not already run out. 

If you have any questions about how these changes will effect your situation, contact me as soon as possible.

2010 Year-End Tax Planning Newsletter

To paraphrase a traditional Chinese curse, we do indeed live in interesting times.

I’ve just completed my annual tax refresher courses, and, to quote one of the speakers at the conference I attended yesterday, “what a mess!”

There’s an old saying among us tax guys: “Never let the tax tail wag the economic dog.” While that may still be true, 2010 is a unique tax year because there will be some big changes coming in 2011. So, while we still want to put economic considerations first, tax considerations are more important than ever this year.

There are several factors making the upcoming changes very complex. First, we don’t know yet, for certain, what those changes will be. Second, the interrelationships among those changes are complex.

For example, tax rates are scheduled to go up in 2011. This would indicate that you should hold off on taking deductions until 2011 when you can take those deductions against higher tax rates. However, the itemized deduction phaseout returns in 2011, meaning that if your income is above certain thresholds you lose part of your itemized deductions. Would a deduction be more valuable in 2011 when it can be applied against higher tax rates or less valuable because it would be subject to phaseout? You must balance those two factors while also taking into consideration that those deductions might be limited if you are subject to alternative minimum tax in the year reported.

If you understood the previous paragraph, you should seriously consider sitting for the CPA exam yourself. If not, read on.

Due to the sheer number of changes and their complexity I recommend that you set an appointment for tax planning now.

Even though we don’t know for sure what the final changes will be, we do know that certain important tax benefits are scheduled to expire after 2010. At this time, we have a pretty good guess about which laws are going to be extended and which are going to be allowed to expire based on the bills that have been proposed in Congress recently and the general political and economic climate.

We can set up, now, alternative plans that can be implemented later — close to year-end — when 2011 law becomes more concrete.

For now, let’s discuss both the tax tail and the economic dog.

Higher tax rates

In 2010, individual income tax rates will go up for almost all income levels. Those in the 10% bracket in 2010 will go up to the 15% bracket. Taxpayers in the 35% bracket will go up to 39.6%.

Tax tail: Accelerate income into 2010 and defer deductions into 2011.

Economic dog: It’s not always possible to accelerate income or defer deductions.

Capital gains rates

After ten years of reduced capital gains rates, those rates will go back up. In 2010, the rates are 0% and 15% depending on your tax bracket. In 2011, those rates will be 10% and 20%.

Tax tail: Harvest capital gains before year-end.

Economic dog: Don’t sell all your stock with gains and none with losses if you also have offsetting loss stocks. Also, don’t sell stock just to get lower rates if you believe those stocks may continue to grow. But, on the other hand, if you’re feeling a bit risky, you  can always sell and repurchase: you just have to wait 31 days to avoid “wash-sale” treatment.

Dividends

If you take a close look at your 1099 from your broker, you’ll notice that some or most of your dividends are “qualified” dividends. In recent years, qualified dividends have been, generally, taxed at the same low rate as capital gains. In 2011, however, they go back to being treated as ordinary income.

This means a “double whammy” for qualified dividends. They’re losing their status as de facto capital gains and ordinary income tax rates are going up. An individual could see the tax on these dividends go from 15% to as high as 39.6%.

Tax tail: Consider converting at least part of your portfolio from dividend-generating assets to appreciating assets. If you are in control of the corporation, consider accelerating dividends into 2010.

Economic dog: Don’t change investments just for the tax benefits. Consider earnings potential as a whole.

Deductions haircut

In 2010, there is no reduction in itemized deductions or exemptions for high-income taxpayers. (This reduction is the “phaseout” I referred to earlier.) In 2011, itemized deductions are reduced by 3% of the amount by which your adjusted gross income exceeds a threshold amount. To put that in perspective, the threshold amount for most taxpayers was $166,800 in 2009 (the last year it was applicable).

Tax tail: Accelerate deductions into 2010 when there is no reduction. For purposes of the personal and dependent exemption phaseout, accelerate income into 2010 when there is no phaseout.

Economic dog: Accelerating deductions into 2010 contradicts the advice given, above, regarding tax rates. We must consider many factors.

Roth conversions

Roth conversions have been getting a lot of publicity this year, for two reasons. First, 2010 is the first year that anyone can do them without being restricted by income limitations. Second, if you do a Roth conversion in 2010, you may report the income in 2010 or defer and spread it 50/50 in 2011 and 2012. 2010 is the only year this special defer/spread provision is available.

Briefly, when you make a contribution to a “traditional” IRA, you get a deduction but when you take a distribution, the amount is taxable. When you contribute to a Roth IRA you don’t get a deduction but distributions are tax free.

When you do a Roth conversion, it’s treated as if you take a distribution from your traditional IRA (taxable) and contribute it to a Roth. As such, the amount converted is taxable but it and any earnings after the conversion are tax-free when distributed.

Tax tail: Do a conversion if your tax bracket will be low in 2010 or if you believe it will be low in 2011 and/or 2012.

Economic dog: Despite their publicity, Roth conversions aren’t for everyone. Don’t do one if your tax rate is higher now than you believe it will be when you take distributions (generally, during retirement when you may have little other income). And remember the time value of money: paying tax now versus paying it later — or not at all — if you pass on the income to your children upon death.

Education credits

For qualified higher education expenses paid in 2010 for yourself or your child, education credits are greatly enhanced in the form of the American Opportunity Tax Credit (AOTC). Compared to the Hope Credit, available in 2011, the AOTC is a larger credit available to higher-income earners and is partially refundable.

The credit is available for expenses paid in 2010 if they are for an academic period beginning in the first three months of 2011.

Tax tail: Prepay tuition for the first semester of 2011 in 2010.

Economic dog: Even with the enhanced income limitations of the AOTC, your income may still be too high. Moreover, you may have already paid the maximum applicable expenses before year-end.

Health care reform

The Health Care Acts included many tax provisions. Of greatest concern are the two new additional Medicare taxes. One will impose an additional 0.9% tax on earned income (salaries, wages, self-employment) in excess of certain threshold amounts and the second will impose an additional 3.8% tax on “investment” income in excess of approximately the same threshold amounts. The threshold amounts, generally, are $250,000 for joint returns and $200,000 for unmarried.

Tax tail: Although the new taxes do not go into effect until 2013, there are actions we can take now that may lessen the impact when 2013 arrives.

Economic dog: The new taxes only affect higher-income individuals.

These are just a few of the important issues we must consider together. And, the earlier we start planning, the more opportunity we have to implement the best strategy to reduce your taxes now and in the future.

Contact me today to schedule an appointment.

Sincerely,

Rick Zalon, CPA