YEAR-END TAX PLANNING FOR INDIVIDUALS
As a turbulent 2010 comes quickly to a close, President Obama has finally signed legislation that resolves taxpayer uncertainty regarding 2011 taxes. And, not a moment too soon, details in this huge, expansive new tax law are known and planning can commence.
The Bush tax cuts were scheduled to expire effective January 1, 2011, but the new law extends those tax rates for two more years to all taxpayers. Because of the temporary nature of the extension, any financial planning needs to consider both the short- and long-term effect of likely future rate increases. Additionally, an extension of an "AMT patch" will keep approximately 25% of taxpayers, many middle-income, from being subject to the Alternative Minimum Tax (AMT) in 2010 and 2011.
Income Tax Planning
Timing of Income and Deductions
The across-the-board extension of the "Bush tax cuts" and the 2010 AMT patch present planning opportunities at the end of 2010 that are similar to traditional year-end strategies. Typically, this entails accelerating deductions and deferring income to the extent that a taxpayer is still able to avoid the AMT. However, it is extremely important for taxpayers to consider not only comparative tax rates/brackets, but also the economics of transactions, meaning the opportunity cost associated with accelerating deductions or deferring income. Some types of deductions that may be within the control of individual taxpayers include completed charitable contributions, paid state income taxes, and elective medical expenses. Types of income that may allow a taxpayer to affect the timing include compensation and bonus income, the exercise of stock options, entity income, to the extent that a taxpayer has control of the entity, and Roth IRA conversions (see below for further details).
However, when considering the timing of tax items, AMT analysis is extremely important. A taxpayer who is subject to the AMT in 2010, or who might be moving in or out of the AMT in 2011, has different timing considerations:
· Subject to AMT in both 2010 and 2011 à generally best not to accelerate income and defer deductions
· Subject to AMT in 2010 but not in 2011 à generally best to accelerate income and defer deductions (Note: this is the opposite recommendation for "regular-tax taxpayers" above; i.e., those who will not be subject to AMT in either 2010 or 2011.)
A comprehensive multi-year tax projection is the best way to determine the correct strategy when the AMT is involved.
Roth IRA Conversion
For 2010 and beyond, the AGI limits for those converting from a traditional IRA to a Roth IRA have been eliminated. What that means is that all taxpayers, regardless of income, may convert. Doing so in 2010, however, may be particularly effective due to a special election available to taxpayers in this year only. Income from conversions made in 2010 are split evenly between the taxpayer's 2011 and 2012 income tax returns. However, taxpayers have the option of recognizing all of the income from a 2010 conversion in 2010. Because the income recognition will increase the taxpayer's AGI, it is important to consider the conversion and election in light of changing tax brackets, the AMT, and the acceleration or deferral of income and deductions (see above).
In addition to converting traditional IRAs, taxpayers may be permitted to rollover traditional 401(k) accounts to Roth 401(k) accounts. This is a new development made possible in September 2010 by the Small Business Jobs and Credit Act of 2010. Under this new law, employees can rollover their traditional 401(k) account to a Roth 401(k) account, provided that the 401(k) plan allows for this rollover — typically when the employee is over age 59½ or separated from service.
Conversion of IRAs or 401(k)s to Roth accounts always makes the most economic sense when a taxpayer can use funds outside the converted amount to pay for any resulting taxes, rather than drawing upon funds within the IRA. For some individuals, special planning can be executed for those that want to convert only a portion of existing IRA balances.
Additionally, for all 2010 Roth IRA conversions, taxpayers reserve the right to reverse the conversion (called a recharacterization) if completed by the due date of their 2010 return (including extensions). Such a change can be beneficial when a taxpayer converted a regular IRA into a Roth IRA at a time when stock market values were high and then subsequently dropped in value. Taxpayers can avoid paying tax on the "vanished" profits by recharacterizing the Roth IRA as a regular IRA. They can even "reconvert" the account back to a Roth IRA if stock values stay low (as long as the reconversion occurs in a year following the year of the original conversion and at least 30 days after the recharacterization was made). If a taxpayer chooses to forego the one-time tax deferral option available in 2010 and instead completes a conversion in January of 2011, that taxpayer would have until October 15, 2012, almost 22 months, to reverse the conversion. It is important to note that the rollover to a Roth 401(k) differs from a Roth IRA conversion because a Roth 401(k) rollover cannot be reversed.
Planning tip: For those taxpayers expecting to be subject to the AMT in 2010, a conversion equal to an amount that would lift the taxpayer out of AMT could effectively result in a 28% tax rate, which is the top AMT rate, paid on the Roth conversion.
Other Planning Ideas
Regardless of the fast-paced tax law changes occurring at the end of this year, there are other important planning opportunities that all taxpayers should address:
· Check income tax withholding to date and make adjustments as necessary. Overpaying taxes during the year amounts to an interest-free loan to the government. Underpaying throughout the year could be costly in terms of interest and/or penalties.
· Maximize 401K contributions.
· Empty Flexible Spending Accounts if the plan has a 12/31 deadline (that is, no grace period). These accounts have a "use it or lose it" feature.
· Take minimum required IRA and qualified plan distributions.
Long-Term Considerations
While the new Act settles tax rates for the next two years, many expect that income taxes will likely be higher in 2013 and beyond. Historically, federal tax rates are at an all-time low. Future changes could also depend on the outcome of the 2012 elections, the U.S. economy, and many global factors. As it currently stands, high-income taxpayers can expect new taxes due to take effect in 2013 as part of the recently enacted healthcare law to affect their financial status significantly. These include a new 3.8% Medicare tax on investment income and a 0.9% increase in the self-employment and employee portion of Medicare payroll taxes for individuals above a certain income level.
Tax Extenders of Previously Expired Provisions
In addition to the extension of the Bush tax cuts through 2012, the new Act also extends through 2010 and 2011 multiple tax provisions that had already expired at the end of 2009. Key extenders affecting individual taxpayers include a two-year AMT patch that increases AMT exemptions for inflation and restores AMT relief for personal tax credits. Other provisions extend the deductions for state and local general sales taxes and mortgage insurance premiums, the increased charitable contribution limits, and carryforward period for donations of qualified conversation property, the credit for energy-efficient improvements to existing homes, and the above-the-line deductions for qualified education expenses and certain expenses of elementary and secondary school teachers. Other extenders include continuing to allow tax-free distributions from individual retirement plans for charitable purposes, and the special rule for S corporations making charitable contributions of property.
Payroll Tax Reduction
While high-income earners can expect an increase in payroll and self employment taxes come 2013 (see above regarding 0.9% Medicare tax increase), all wage earners and self employed individuals will benefit from a one year reduction in employee payroll and self employment taxes in 2011. The new Act has established a two percentage point reduction in the employee portion of payroll (FICA) taxes — 4.2% instead of 6.2% on wages up to $106,800 per worker. Self-employed taxpayers will pay 10.4% instead of 12.4% on self-employment income. This translates into a maximum tax reduction per person of $2,136 in 2011.
Taxpayers should begin to think about how to put this payroll/self employment tax reduction to use towards their financial goals. Typically, tax cuts that provide a little bit back to taxpayers over a period of time, as the payroll tax reduction does, end up being spent by consumers. While this may provide a much-needed infusion in to the economy, savvy taxpayers can set their own agenda for using this 2% "windfall." Some options to consider:
· Contribute the extra 2% to a 401(k) or IRA, if not already maximizing contributions. From a cash flow perspective, the money will never be "missed," as employees have become accustomed to the payroll tax withholding coming out of their gross income. An extra 2% contribution may also be eligible for an employer match, providing even an extra retirement savings boost. And assuming that tax rates will rise after 2012, contributing after-tax dollars today (for example to a Roth 401(k) or IRA) is essentially a "cheaper" investment than it will be in a couple of years.
· Contribute the extra 2% to a 529 Plan. Again, the money will never be "missed," but would provide additional savings towards college costs with tax-free growth.
· Contribute to a non-deductible or spousal IRA. Earnings can grow tax-deferred for retirement. Alternatively, the non-deductible or spousal IRA can be converted to a Roth IRA in 2011.
· Create a personal health care pot. The costs of health care are expected to increase in 2011, starting with higher insurance premiums, deductibles and co-pays. In addition, the items that can be purchased using tax-favored money in Flexible Spending Accounts have been reduced — for example, no more over-the-counter medications will qualify without a prescription. Many taxpayers haven't anticipated how these increased costs will affect their budget. The 2% payroll/self employment tax reduction could go a long way towards offsetting increased health care costs.
· Consider expenditures that result in savings over time or take advantage of tax credits. While not all tax credits for 2011 are currently known, credits for items such as energy-efficient appliances or fuel-efficient vehicles are often available. Even without such tax credits, replacing certain appliances or windows with more energy-efficient varieties can pay off over the long term with decreased utility bills and/or repair costs.
Whatever a taxpayer's individual goals, some thought needs to be given to using this tax reduction productively, rather than just spending the increased take-home pay.
Summary
The tax legislative environment continues to be very fluid and is likely to remain so for some time as the president and Congress consider ways to gain control over historic U.S. budget deficits. Adding to the mix is the continuing volatility of global investment markets and, of course, the implications of both the 2010 and forthcoming 2012 elections that will shape future policies for taxing and spending. Taxpayers need to take care not to take short-term, tax-driven decisions today that may undermine their overall financial goals for tomorrow.
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