The Writing is On the Wall!
July 12, 2010
Higher income taxes are in our future. I hope I am wrong, but Congress can take no action and still raise our personal income taxes for 2011 and beyond. How does this change our thinking and strategies for minimizing income taxes?
The Bush tax cuts enacted in 2001 are set to expire on December 31, 2010, unless Congress takes action to extend them. To date, there has been no strong evidence that this will occur. This means that your personal income tax rates for 2011 will be higher than they were in 2010.
Anticipated Tax Rate Increases for 2011
Both the ordinary income tax and capital gain rates will increase. Under current law, the individual tax rates range from 10% to 35%. Next year the lowest rate will be 15% and the highest will increase to 39.6%. The long-term capital gain rates will increase from 15% to 20% (from 0% to 10% for low AGI). Also, qualified dividends will no longer be taxed at the capital gain rate, but rather as ordinary income subject to an individual’s highest marginal tax rate.
Strategies to Consider
If you believe that your personal income tax rates will increase next year, you may need to look for ways to make the most of this year’s lower rates as well as reconsider the tax planning strategies that you have always followed in the past. Taxpayers who are retiring by the end of this year or for some other reason are fairly confident that their tax bill will be less next year should review their individual situations to determine which, if any, of the following strategies are appropriate.
1. Sell assets in 2010. If you are contemplating a sale of an asset in which you have a capital gain, such as a farm, building, or business, by completing the transaction in 2010, you will reduce your capital gain tax liability by 5%. On a sale that creates a $1,000,000 capital gain, this means a savings of $50,000. Likewise, your investment portfolio should be reviewed to determine whether there are securities that are valued higher than their respective purchase prices and whether a sale prior to 2011 would be beneficial.
2. Accelerate income into 2010. Because ordinary income tax rates will be higher in 2011, any earned income that you can count in 2010 instead of 2011 is to your advantage. This may be easier if you are self-employed or have outside business interest, than if you are an employee receiving only W-2 income.
3. Push deductions into 2011. Since lowering your taxable income will be more beneficial in 2011, you should push as many tax deductions into 2011 as reasonable. This may include charitable deductions and payment for other tax deductible services.
4. Consider reducing 401(k) contributions. Making pre-tax contributions to your 401(k) has been the traditional advice for higher income earners. The pre-tax contributions, the tax deferred earnings and the employer matching contributions all add up to make the 401(k) an excellent retirement saving vehicle as well as a sensible tax reducing strategy – or at least it used to. Today, it may be more advantageous from an income tax perspective to contribute to your 401(k) an amount that allows you to get the entire employer match, but to divert the rest of the contribution to other after-tax investment vehicles. Making after-tax contributions to a Roth IRA or a non-deductible Traditional IRA will still allow you to save for retirement, but also pay tax on the contribution based on this year’s tax rates.
5. Conversion to Roth IRA. This year may be the appropriate time to rollover Tradition IRA or 401(k) funds into a Roth IRA. You pay tax on any funds converted in the year of the conversion. Converting funds this year will increase your ordinary income tax, allowing you to take advantage of the lower tax rates that apply to your situation this year. Any funds withdrawn from a Traditional IRA or 401(k) in the future will be subject to the higher tax rates.
6. Municipal Bonds for investing. The higher your marginal tax rate the more beneficial tax free municipal bond interest becomes. For example, if a municipal bond pays a 4% tax-free interest, that is equivalent to a 6.15% taxable return at a 35% marginal income tax rate. Next year, if the marginal rates increase as expected, that same 4% tax-free rate is equivalent to 6.62% for those at the highest marginal rate of 39.6%. Of course, with all personal investing, you do not want taxes to dictate your investment strategy. However, if fixed income is appropriate for your overall asset allocation, then municipals can be a very appropriate substitute for other taxable investment options within your portfolio, especially as tax rates increase next year.
Summary
Congress may surprise us by extending the Bush tax cuts, but conventional wisdom says that will likely not happen. Therefore, it is up to you to “read the writing on the wall”, and put yourself in a position to take advantage of the tax rates applicable to you for the rest of this calendar year. Since these decisions can be influenced by a number of variables, it is advisable to talk with your tax preparer or other qualified professional.
