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Saturday
Nov202010

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

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