The dawn of the second decade of the 21st century will start off with sunsets, at least in the tax world. You may recall that many of the tax acts passed over the last nine years included “sunset” provisions, or built-in expiration dates. The result: 2010 might be the last year to take advantage of certain credits, deductions, and other federal tax breaks.
The biggest change involves tax rates. Current favorable capital gains and ordinary income tax rates are scheduled to expire at the end of 2010. On January 1, 2011, rates will revert to higher pre-2001 levels – unless Congress enacts new legislation. Either way, the potential for increased tax rates in 2011 and beyond calls for advance planning. Two areas in particular need your attention if you want to minimize your taxes.
* Investment planning
For 2010, the maximum long-term capital gains tax rate for most investments and for qualified dividends is 15%. The rate falls to zero if you’re in the 10% or 15% tax brackets for ordinary income. Those two brackets currently apply when you’re married filing jointly and your taxable income is less than $68,000 ($34,000 if you’re single).
After the temporary rules end on December 31, 2010, selling appreciated investments may cost you more in taxes. Yet making sales in the current year to take advantage of lower rates can put you in a higher bracket and affect income-limited deductions and credits.
As an alternative to selling, other forward-looking tax strategies might better suit your overall goals.
For instance, since after this year it’s likely that dividends will once again be taxed at your ordinary income tax rate – which may also be higher than this year’s rates – you could choose to invest in stocks with growth potential instead of those paying current income in the form of dividends.
If tax rates go higher, you might want to consider investing in tax-free municipal bonds. There is an easy way to compare the yield on tax-exempt municipal bonds with the after-tax yield from taxable investments. Subtract your top tax bracket from 100 and divide the tax-exempt interest rate by that number. The result is the equivalent taxable return. In making your investment decision, you’ll want to choose the investment that provides the greater after-tax return.
As you rebalance your portfolio over the course of 2010, you might also consider increasing your investment in mutual funds with low turnover rates. Here again, you’ll reduce taxable capital gains in future years.
Gifts of stock to certain family members in lower tax brackets and donations of appreciated assets to your favorite charity are other viable alternatives for reducing the amount of capital gains tax you’ll pay now and in the future.
* Timing income
When tax rates are expected to increase in the near future, a basic tax planning move is to calculate the effect of shifting income into the current period. This year offers an excellent opportunity to do just that.
Are you aware that you’ll be able to convert your traditional IRA to a Roth during 2010 no matter your income or filing status? The conversion creates taxable income this year, which you can pay in full prior to any tax rate increase.
The benefit to doing this is that later withdrawals will be tax-free. Converting to a Roth also eliminates the need to withdraw required amounts from the account, so you could reduce your income, and the related taxes, in future years.
Another income planning consideration is the effect of minimum distributions from your traditional IRA if you’ll reach age 70½ this year. The rule requiring mandatory withdrawals is reinstated in 2010. However, for the first year in which you’re required to take distributions, you have the option of deferring your initial withdrawal from December 31 until the following April.
Doing so means you’ll have to take two distributions in 2011. Depending on your expected income next year, waiting may not be advantageous.
Planning for future events is an ongoing process, made more important by the big changes coming. For suggestions and advice that will help you save tax dollars, please call for a tax planning review.