In our rapidly changing economy, tax planning is never easy, but this year it may be all but impossible.
The reason: 2010 is the final year of the big Bush-era tax bill that brought a decade of rate cuts, new and improved credits and exclusions, rollbacks of limits on deductions for some taxpayers, and even the repeal, at least for this year, of the estate tax.
Many major changes vanish or "sunset" on Dec. 31, leaving taxpayers to wonder what the tax law will be like next year, and what might be done this year to take some of the sting out of increases that might take place.
A huge fight is brewing in Washington.
On the one hand, many Americans have grown comfortable with the lower, Republican-backed tax rates, which have brought the top marginal income-tax rate down to 35 percent and the top capital gains rate to 15 percent. On the other hand, the nation is facing some of the largest budget deficits in history, and now Congress and the Obama administration are looking for revenue to bring those deficits down.
Simply allowing the 2001 law to expire would be a big revenue-raiser and might appeal to many Democrats as a soak-the-rich measure. And in a Congress where it is much easier to do nothing than something, allowing the law to sunset would probably be achievable.
President Obama has said he’d like to boost taxes on the wealthiest Americans. To accomplish this, all he’d have to do is let the 2001 law expire. That would take the top marginal rate back to 39.6 percent, and the next highest rate, now 33 percent, back to 36 percent. It would also boost the top capital gains rate to 20 percent and return most stock dividends to being taxed at ordinary income rates.
In addition, failure to act would cause the estate tax, which the 2001 law repealed at the beginning of this year, to spring back to life, taxing estates over $1 million at rates as high as 55 percent on the largest estates.
Republicans think all of that would be a really bad idea, and while they have limited leverage, there are some factors on their side.
There is worry that too much of a tax rise might stifle the still-wobbly economic recovery. Also, Obama has repeatedly said he won’t raise taxes on the middle class, and a number of provisions facing expiration have also held down taxes on low- and moderate-income taxpayers. For example, the 10 percent bracket created by the 2001 bill would disappear, making the lowest bracket 15 percent. And unless Congress acts, more than 25 million people will be ensnared by the alternative minimum tax.
Thus it seems likely that a deal will be struck—but what will it look like? No one knows.
"It will be an interesting year," said Barry Glassman, head of Glassman Wealth Services in McLean, Va.
So what’s a poor—or not-so-poor—taxpayer to do?
The first move, several experts said, should be to separate what you know from what you can only speculate about. That is fairly easy, since there isn’t much you can be truly confident about, and there are some things you can do.
One thing to check is your own situation. Will your income be higher or lower next year? Perhaps you are about to retire, meaning your income will be lower in future years. Or maybe you’re planning to sell a business or piece of property, which would cause a spike in your income.
Next you match that up with where you think tax rates are headed.
Glassman said, and many advisers agree, "Tax rates aren’t going down. They’ll either stay the same or go higher. You can plan under that assumption."
In addition, Obama has proposed reviving a provision that reduces the value of deductions for upper-income taxpayers. If all that comes to pass, 2011 will be a year of higher tax rates and less valuable deductions, at least for the well-to-do.
If that strikes you as likely, "I think one thing you do is reverse the normal…strategy, which is to accelerate deductions and postpone income," said Mark Luscombe, principal tax analyst in the tax and accounting group at CCH, Inc., a tax and business information and software publisher in Riverwoods, Ill. The usual strategy is based on the principle that tax money saved this year is more valuable than tax money saved next year, other things being equal. But if things aren’t equal, "if the situation is that there will be higher rates in 2011, consider accelerating income and postponing deductions," he said. The income will be taxed at lower rates, and the deductions will be worth more when rates are higher.
That applies particularly to sales of assets that would qualify for long-term capital gain treatment because rates might well climb by a third (to 20 percent from 15) for gains recognized next year. (Long-term refers to gains on stocks, bonds and other assets that are held for more than a year.)
Finally, since there is so much uncertainty about the details of next year’s taxes, experts are counseling clients to arrange their assets and income as much as possible to cover all bases.
Planners have long talked about diversification of assets, and now "we think tax diversification is a really good idea," said Christine Fahlund, senior financial planner at T. Rowe Price, the big Baltimore-based mutual fund company.
This means spreading investments among "each kind of account, tax-free, tax-deferred, and taxable," she said.
This kind of shuffle is a bit easier this year, since now, for the first time, there is no income ceiling that in the past prevented higher-income taxpayers from converting traditional tax-deferred IRAs to tax-free Roth IRAs. And the higher contributions limits on IRAs and 401(k) plans and other retirement plans are among the few provisions of the 2001 law that have been made permanent, so workers will be able to continue to add to them in the coming years at the rates we have become used to.
However, a holder of a traditional IRA who converts it to a Roth must pay tax on all the deductible contributions he or she made in the past and on any gains that haven’t been taxed. That can take an awfully big bite out of a big conversion, so many planners suggest converting a portion of your traditional account, but not all of it.
"We are not saying you go all to a Roth, because you are paying so much" in taxes on the conversion and "you’d give up the growth on that tax dollar amount," Fahlund said. But having some of your assets in a Roth account would give you added flexibility to adjust to tax law changes.
One other twist, which Fahlund noted, is that taxpayers who convert during 2010 have the option of paying the resulting taxes on their 2010 returns or deferring them and paying in two installments on their 2011 and 2012 returns. Normally, such a deferral would be a no-brainer, but if rates are higher in the later years, maybe not. Perhaps the law will become clear in time to run the numbers, but again, maybe not.
Finally, for those who have converted their traditional IRAs entirely to Roths, or who never had a traditional IRA, it will now be possible to contribute to a Roth no matter how high your income. You still can’t contribute directly to a Roth if you’re single and your modified adjusted gross income is $120,000 or more ($177,000 or more, if you’re married filing jointly). But it is possible to make a non-deductible contribution to a traditional IRA on one day and convert it to a Roth the next.
NOTE: There are literally dozens of tax-law provisions that expire at the end of this year. Taxpayers interested in checking the list to see which ones are important to them, can look at a recent report by Congress’s Joint Committee on Taxation, which lists and briefly describes the expiring provisions. It’s publication number JCX-3-10, available at www.jct.gov.