As the end of 2010 quickly approaches, individual taxpayers should start to execute valuable year-end tax strategies. However, year-end tax planning for 2010 is especially unique, and a bit more complicated, due to the current uncertainty looming over a number of expiring tax cuts.
Several individual tax incentives in the form of deductions, credits, and exemptions, as well as reduced tax rates for long-term capital gains and qualified dividends, are scheduled to expire at the end of 2010. Moreover, the marginal income tax rates for most taxpayers – especially individuals in the top two income tax brackets – are scheduled to rise. The 10 percent tax rate bracket is scheduled to disappear. Another complication to year-end tax planning is the uncertainty caused by the estate and gift tax laws, and their future.
Take advantage of lower income tax rates through 2010
The individual marginal income tax rates for 2010 are: 10, 15, 25, 28, 33, and 35 percent. These rates are set to expire at the end of the year and revert to higher rates, unless Congress acts to extend them. As things stand now, however, for 2011 and beyond, the tax rate brackets will be: 15, 28, 31, 36, and 39.6 percent. The 10 percent rate will disappear entirely. Thus, the federal income tax brackets as scheduled for 2011 will result in the following:
2010: 10% 15% 25% 28% 33% 35%
2011: 15% 15% 28% 31% 36% 39.6%
In light of the scheduled rate increases, individuals that will be affected by the higher tax rates – particularly higher-income taxpayers falling into the top two brackets – may want to consider opportunities to accelerate taxable income into 2010. Accelerating income into 2010 allows you to take advantage of the current lower tax rates and avoid having some of that income taxed at higher rates next year (as the law currently stands). Although tax considerations should not be the only reason to accelerate income into 2010, if you anticipate that you will fall into a higher tax bracket in 2011 as the law currently stands, you should explore acceleration opportunities.
At the same time as you take advantage of opportunities to accelerate your income into 2010, you may want to defer deductions into 2011 to help ease the impact of the scheduled 2011 increases in the tax rates. Deductions may be more valuable in 2011 when the tax rates will be higher for many individuals and particular higher-income taxpayers. For example, consider postponing charitable giving until 2011, or delay making your mortgage payment until January 1, 2011 or later if your grace period allows.
However, higher-income taxpayers considering deferring deductions until 2011 need to weigh the potential benefit of using these deductions to help offset potentially higher taxable income with the pitfall of the re-emergence of the limit on itemized deductions. The limit on itemized deductions for higher-income taxpayers is completely eliminated for 2010, but effective again in 2011. The limitation threshold amount is generally $100,000 for most taxpayers and $50,000 for married taxpayers filing separately. Thus, if you anticipate being in a higher rate bracket in 2011 you need to carefully weigh the benefits of getting a reduced deduction that offsets income taxed at a higher rate in 2011, against a full deduction that offsets income taxed at a lower rate in 2010.
While accelerating income and deferring deductions are two generally intertwined tax planning strategies, they take on increasing importance in light of the scheduled rates increases. You should talk with your tax advisor about the benefits and pitfalls of using this technique in your particular situation.
Sell investments at lower capital gains rates
The favorable tax rates for capital gains and qualified dividends also continue through December 31, 2010, but will revert to higher levels beginning in 2011. For individuals in the 25 percent or higher income tax brackets, long-term capital gains and qualified dividends are taxed at a maximum rate of 15 percent. For individuals in the 10 and 15 percent brackets, gains are taxed at a generous five percent and zero percent. Unless Congress extends these lower rates, the maximum tax rate on long-term capital gains will increase to 20 percent, and the zero percent rate will be replaced with a 10 percent rate beginning in 2011. Also beginning in 2011, qualified dividends will be taxed at ordinary income tax rates, which could be as high as 39.6 percent.
If you have appreciated investments that you have been considering selling, now may be the time to do so in light of the increased capital gains rates. For higher-income taxpayers this is especially important since the maximum amount of tax on long-term capital gains is 15 percent for 2010, but come 2011 they will be taxed at 20 percent.
Contribute to your retirement plan
Individuals with a traditional IRA or an employer-sponsored retirement plan, such as a 401(k) plan, should consider making a contribution to the plan before year-end, if he or she has not already done so. Making a contribution to a traditional IRA or employer-sponsored retirement plan will reduce your taxable income since funds are contributed before tax. Additionally, you may be able to deduct the contribution on your return.
For 2010, the contribution limit is $5,000 for individuals under age 50 (or $6,000 for individuals older than 50 years of age who qualify for the catch-up contribution). The maximum amount an employee can contribute to a 401(k) in 2010 is $16,500 (and for individuals over the age of 50, their catch-up contribution will remain unchanged at $5,500).
Roth IRA conversions
If you convert your traditional IRA into a Roth in 2010, a special rule allows you to defer paying federal income tax on the conversion income until 2011 and 2012. In lieu of including the conversion income in your 2010 taxable income, you can choose to report half the income in 2011 and half the income in 2012. However, if you make this election, that income will be taxed at the income tax rates in effect in 2011 and 2012, which under current law, is set to be higher for the majority of taxpayers. If you want to convert your traditional IRA into a Roth before the end of the year, you will need to determine whether recognizing all the income in 2010 or spreading it between 2011 and 2012 will garner you a better tax result.
Congress has not enacted an alternative minimum tax (AMT) “patch” for 2010. Be aware, unless Congress enacts an AMT patch retroactive for 2010, the exempt amounts are $33,750 for individuals; $45,000 for married couples filing jointly; and $22,500 for married individuals filing separately. Planning for the AMT is complicated due to Congress’s inaction on passing a patch, unfortunately. Taxpayers should, therefore, begin planning with the 2010 amounts in the alternative.
Tax breaks not available in 2010
Certain tax breaks that you may have taken advantage of in 2009, when they were around, are not available this year because they expired December 31, 2009 and have not been extended by Congress. While Congress may act to retroactively extend some, or all, of these incentives for 2010, unless Congress acts, you should be aware that the following tax breaks may not be available for your 2010 tax return:
- The additional standard deduction for state and local property taxes for non-itemizers;
- The deduction for qualified tuition and fees of up to $4,000 for higher education (the higher education expense deduction);
- The deduction of up to $250 in classroom supplies (available to teachers, other educators)
- The election to itemize state and local sales taxes in lieu of state and local income taxes (which mainly benefits individuals in states without state income taxes); and
- The exclusion from gross income of up to $2,400 of unemployment benefits.
Although these, and many other, tax incentives have not been renewed for 2010, taxpayers that have utilized these incentives in the past should include in their year-end tax planning contingencies for both outcomes: you should compute your tentative tax liability under a plan that does not take the applicable incentives into consideration and also compute your liability under a plan that does, in case Congress retroactively extends them.
Despite the complexity caused by the uncertain state of the tax law as of now, individuals can take a number of steps to help minimize their tax liability this year. Depending on your particular situation, you may be able to employ one or more of the planning opportunities discussed above.