Planning for Coming Income Tax Changes
Tax changes are in the works, and you need to take action in 2010 to avoid paying more than you have to this year and in coming years. Strategies in 2010 will be different from past years because of the way the law will change. Consider these unique or overlooked strategies.
Consider accelerating income. Tax rates are slated to rise in 2011 and later years. That’s why it might make sense to have some income taxed in 2010 instead of later years. Income that can be accelerated includes IRA distributions, deferred compensation, and any other income you have some flexibility over.
Likewise, long-term capital gains rates are set to rise from 15% to 20%. Examine appreciated assets you might sell in the next few years, and consider selling in 2010 instead.
Suppose you own an asset worth $1,000 with a tax basis of $500. Selling in 2010 means you’ll pay $75 in capital gains taxes and have $925 in after-tax cash. Sell in 2011 and you’ll pay $100 in taxes and have $900 in after-tax cash. You save $25 in taxes, or 2.5% of the value of the asset by selling in 2010.
But suppose you hold the asset, it appreciates 10%, and you sell it in 2011. It would be worth $1,100. You would pay taxes of $120 and have $980 of after-tax cash. You give up $55, or 5.5% of the initial value, by selling in 2010.
Consider the investment’s potential and compare it to alternate investments. Don’t give up an asset you believe has good appreciation potential to pay a lower tax rate today. Compute your after-tax cash in 2010 and what it might be in later years after different rates of appreciation.
Remember a Medicare surtax of 3.8% will be imposed on most investment income, including capital gains, of individuals with modified adjusted gross income over $200,000 and married couples filing jointly with MAGI above $250,000. This will raise the rate on long-term capital gains to 23.8%.
There could be big advantages to making charitable contributions in 2010 for those with higher incomes.
For a number of years, itemized deductions – mortgage interest, state and local taxes, and charitable contributions – were reduced as income increased. This provision is temporarily suspended for 2010. It returns in 2011. Higher income taxpayers could receive a higher tax benefit from making charitable contributions in 2010 than in 2011. You won’t lose the benefit of some of your charitable contributions in 2010 but will in later years.
You also should carefully calculate withholding for state income taxes. Changes in the law are about to penalize those who have too much withheld or overpay their estimated state income taxes.
Here’s how it works. When you itemize deductions, you deduct state income taxes in the year they are paid or withheld. So you deduct on your 2010 return the state taxes withheld in 2010. When too much was withheld for your state taxes, you receive a refund in 2011 and include the refund in your gross income on your 2011 federal income tax return filed in 2012. When tax rates are stable, the result is a wash to both you and the federal government, except for the time value of money.
The trick is that income tax rates are likely to be higher in 2011 than in 2010. You’ll deduct the state taxes paid in 2010 at the lower tax rate and include the refund in gross income in 2011 at a higher rate. You lose money over the two-year period because of the rise in federal tax rates.
To avoid this stealth cash drain, carefully calculate your state income tax withholding or estimated tax payments. You don’t want to overpay, because doing so will cost you extra tax dollars next year. Ideally you’ll have withheld or prepay just enough state income taxes to avoid a penalty for failure to pay estimated taxes. You want to owe taxes rather than be due a refund if you itemized deductions on your federal income tax return.
June 2010. RW
