This will be the most difficult year-end tax planning session most of us ever will face. Since 1994 tax rates declined and tax breaks increased for the most part. Now, a raft full of tax increases is scheduled to take effect Jan. 1, 2011. But Congress could act to at least delay some of the tax increases.
The pressing problem is in October Congress decided it won’t act on taxes until after the Nov. 2 election. We don’t know exactly when they may act or what actions they’ll take. It’s likely that many of those voting will have lost their re-election campaigns. Will they vote in line with their successor’s preferences, or will they vote their own views one more time?
Good year-end tax planning coordinates multiple years at once. You don’t want to slash this year’s taxes if it means increasing next year’s taxes and generating a higher overall tax bill. Making a move prematurely in 2010 could do just that.
Right now, the best advice is to watch, wait, and plan for contingencies. Lay your plans for actions to take under different scenarios of congressional action. When Congress finally acts (or fails to act), implement the appropriate plan. Here are the key provisions to watch.
– Ordinary income. The usual rule is to defer income whenever possible. Don’t pay taxes today when you can pay them later with dollars that declined in value and you’ve been able to keep and invest.
The traditional rule will make sense in 2010 if Congress extends all the expiring tax breaks. Tax rates will be the same in 2011 as in 2010, so it makes sense to defer taxes whenever you can. It’s a different story if key tax breaks for you are allowed to expire. Here are key variables:
– Phaseouts. In 2010, the phaseouts of personal exemptions and itemized deductions for higher income taxpayers are suspended. They are scheduled to re-appear in 2011, effectively increasing tax rates for affected taxpayers. If Congress lets the phaseouts return in 2011, try to move into 2010 some of your 2011 itemized deductions. You can increase charitable contributions. You also may be able to prepay January installments of property taxes and mortgage interest.
– Alternative minimum tax. Foremost for many taxpayers is the AMT. This is the second tax system that takes away most of your tax breaks and imposes a two-rate tax structure. You pay the higher of the AMT and the regular tax.
In recent years a “patch” increased the exemption for the AMT and limited the number of people snared in the AMT. The patch expired after 2009. Congress should extend it by Dec. 31 but might not. If the patch is not extended, more people will pay the AMT in 2010. When you’re subject to the AMT you want to avoid increasing deductions or taking other tax breaks that won’t be allowed under the AMT. There’s no point in making tax planning moves that reduce regular income taxes if you are mired in the AMT.
– Tax rates. When you’re facing higher tax rates in 2011 than 2010, try to move income into 2010 and deductions into 2011. When you’re employed, you might be able to change the timing of bonuses or pay raises. Distributions from IRAs, 401(k)s, and annuities could be changed to reduce taxes. You also may be able to shift deductible expenses between 2010 or 2011, depending on which decreases your tax bill.
– Capital gains. The maximum tax rate on long-term capital gains is scheduled to rise to 20% in 2011 from 15% in 2010. We addressed the planning implications in our January 2010 visit. Generally, you should consider selling in 2010 an asset you were planning to sell in the next few years and that has a lot of appreciation in it. But before acting you want to compare the expected return from continuing to own that asset with the expected return from reinvesting the after-tax proceeds. If you expect a higher return from the current asset, you could end up with more after-tax proceeds by holding and selling later, even at the higher tax rate.
Of course, you won’t need to consider this move if Congress extends the 15% tax rate before the year ends.
No matter what Congress does with the capital gains rate, don’t forget to sell losing investments in taxable accounts by Dec. 31. This allows you to offset any gains with the losses, deduct up to $3,000 of additional losses against other types of income, and carry over unused losses to future years to be used the same way.
– Charitable gifts. Maximizing the tax benefits of charitable contributions requires special attention this year. If tax rates will be higher for you in 2011, you probably want to defer some charitable giving until then.
There are two caveats. One caveat is that the limitation on itemized deductions might be effective in 2011; that would reduce the benefit of charitable contribution deductions. Another caveat is the President proposed reducing the maximum charitable contribution from 50% of adjusted gross income to something lower. Big givers shouldn’t give until they determine if the proposal became law.
Those who want to give from IRAs also need to follow Congress carefully. The special provision for charitable contributions from IRAs for those over age 70½ expired at the end of 2009. Congress could extend it before the end of 2010. Until it does, you have to assume it is expired. Even worse, if Congress does extend it you have to be sure your IRA custodian will be able to process your gift directions by Dec. 31.
– Dividends. The 15% maximum tax rate on corporate dividends also is set to expire at the end of 2010. The tax uncertainty probably has held back the stocks of high dividend payers, so I don’t think expiration of the provision will result in a big sell off. But you have to know that a change in the rate will alter your after-tax income and also affect your estimated tax payment requirements.
– Estimated taxes. When your tax rates and deductions change, so do your required estimated tax payments. You need to plan 2011 estimated taxes carefully after Congress acts and also get the last 2010 payment right if you want to avoid a penalty. When in doubt, to be safe, pay at least 110% of last year’s tax bill by Dec. 31. When you’re employed or receive other money subject to withholding, it’s better to have withholding increased. You might be able to have withholding taken from late-year IRA and annuity distributions.
November 2010. RW