Year-end planning always involves some educated guesswork; however, planning for 2010 is particularly challenging due to the uncertainty Congress has shown in regard to voting on tax legislation. The “lame-duck” Congress returned this week, and has three options to consider:
- Allow the current tax rates to sunset and return to 2001 levels, which will result in higher tax rates for all tax payers;
- Extend the current tax rates; or
- Extend the current tax rates for all but the top two tax brackets, as proposed by President Obama.
The bottom line is that without Congressional action, all tax payers will face higher tax rates on their income, including capital gains. The illustration below demonstrates how income tax rates would look under the three different scenarios currently on the table. Figures shown are for married couples filing jointly.
Under a complete sunset, qualified dividends would be taxed at ordinary income tax rates and long term capital gain rates would increase from 15% to 20%.
Regardless of the action taken by Congress, here are some tax planning strategies to consider:
Strategy One: Accelerate Income and Postpone Deductions
You may be accustomed to your advisors recommending that you defer the recognition of income. However, there may be cases where you should accelerate the recognition of income into 2010 and postpone deductible expenses until 2011. Applying this strategy is beneficial if you will move into a higher tax bracket based upon one of the scenarios summarized above.
Here are some examples of ways to accelerate your income into this year:
- Take distributions from your IRA or retirement plan if you will not incur an early withdawal penalty (over 59 1/2);
- Convert a traditional IRA to a Roth IRA and elect to recognize income during 2010;
- Collect debts you are owed;
- Sell assets that would result in a capital gain during 2010 which would be subject to the current 15% tax rate; and
- Arrange to receive dividends.
Here are some examples of ways to postpone your deductions into 2011:
- Pay December’s deductible expenses on January 1 (i.e. property taxes);
- Postpone nonemergency medical expenses until next year;
- Postpone charitable gifts.
Strategy Two: Accelerate Deductions and Postpone Income
On the flip side, if you believe you will be in a lower tax bracket next year due to an event such as retirement, you may want to consider the opposite strategies from those listed above. You may choose to postpone your income in the following year and accelerate your deductions into this year.
Here are some examples of ways to accelerate your deductions into this year:
- Elect to make next year’s charitable contributions this year;
- Prepay deductible interest; and
- Accelerate capital losses.
Here are some examples of ways to postpone your income into 2011:
- Defer compensation;
- Defer year-end bonuses;
- Delay the exercise of incentive stock options;
- Convert a traditional IRA to a Roth IRA and recognize the income during 2011 and 2012;
- Defer the sale of capital gain property, or take installment payments rather than a lump-sum payment;
- Postpone receipt of distributions that are over the required minimum from retirement accounts; and
- Increase your contributions to your company’s 401(k) or other tax-deferred plan to reach the maximums.
Another potential change in the tax code involves itemized deductions and personal/dependency exemptions. Based on current legislation, these are not reduced for higher-income taxpayers. Therefore, if you “bunch” your itemized deductions during 2010, a larger amount will be deductible due to the elimination of the phase-out. Depending upon how Congress votes, these deductions will once again be subject to a phase-out in 2011 based on adjusted gross income.
Strategy Three: Roth Conversions
You still have the opportunity to take advantage of the special rule that applies to Roth conversions in 2010. If you convert funds in a traditional IRA or an employer plan to a Roth in 2010, half of the income that results from the conversion can be reported on your 2011 federal income tax return and half on your 2012 return.
If you will fall into a higher tax bracket in 2011, you may elect to report all of the income resulting from the conversion on your 2010 return. The ability to postpone tax on resulting income to 2011 and 2012, combined with the flexibility of being able to wait until you file your 2010 return to decide whether or not you want to do so, makes a Roth conversion a strategy worth considering before year-end.
Strategy Four: Gifting of Assets
Unless Congress changes the rules, the top gift tax rate will increase from the 2010 rate of 35% to 55% beginning January 1, 2011. This increase in rate will only apply if you have fully utilized your $1 million lifetime exemption for gift tax purposes.
If you still have all or a portion of your lifetime exemption remaining during 2010, you may want to consider gifting any assets which you believe have potential to increase significantly in value during future years. Gifting these assets while they are undervalued provides you an opportunity to maximize the amount of wealth transferred. You are also allowed to exclude a maximum of $13,000 per individual in gifts each year. This exclusion does not count against your $1 million lifetime exemption.
It is also important to remember that any tuition or medical payments made directly to the institution or physician are free from gift tax. These direct payments do not apply against your $13,000 exclusion or $1 million lifetime exemption.
A Word about the Estate Tax
Another topic of great interest is what Congress will decide regarding the estate tax. The estate tax was repealed during 2010; however, it is scheduled to return next year with a $1 million exemption and a top estate tax rate of 55%. This is compared to the 2009 exemption of $3.5 million and top tax rate of 45%. There has been much speculation regarding what action, if any, Congress will take regarding the estate tax. We hope to have some guidance as to their intentions before the end of the year.
IRA Required Minimum Distributions Return for 2010
During 2009, required minimum distibutions (RMDs) from a traditional IRA were suspended for those age 70 1/2 and older. RMD requirements are back for 2010 and the penalty is a steep 50% for failing to take an RMD by the end of the year. If you are a Kanaly Trust client, we will be in touch if you have not taken your 2010 RMD from your account.
Take Action Now
As you can see, there are several possibilities to be aware of as you prepare for taxes this year. It is important to consult with your advisors now to maximize tax savings in light of potential challenges the new tax code may present.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.