What if tax cuts expire?
In 2001 and 2003, Congress enacted temporary tax cuts that pushed tax rates to historic lows and provided other tax incentives.
But the key word is “temporary,” and the end of the tax breaks is now in sight. Unless Congress acts, the tax code will return to pre-2001 statutes Jan. 1, 2011.
The original cuts were approved in large part because the U.S. Treasury was running a surplus back then. However, today’s budget deficit, combined with the politicized atmosphere of a midterm election year, mean that any changes before the existing tax laws sunset are not sure things.
So, what exactly will you encounter if next year arrives without any alterations to the current tax law? You’ll face higher income tax rates, more taxes on investment income, fewer tax breaks for families, the return of so-called stealth taxes and a tougher estate tax.
What can you do to prepare for the worst-case tax increase scenario? In some instances, quite a bit if you start your tax planning now. In other tax situations, not so much. But you might be able to make adjustments elsewhere to offset the changes if tax cuts expire.
Adjust for increased income tax rates
Taxpayers now find their income might fall into one of six tax rate brackets, starting at 10 percent and topping out at 35 percent.
On the first day of next year, however, there will be only five income tax rates: 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent.
Today’s lowest tax rate of 10 percent will be gone, meaning taxes at 15 percent will be assessed on up to at least $34,000 in income for single filers.
The top tax rate of 35 percent, which now is applied to $373,651 or more in earnings, will be replaced by two higher tax rates of 36 percent and 39.6 percent.
The upshot of this income tax bracket realignment is that everyone will see some increase in their tax bills.
And this means that the usual advice of deferring income is turned on its head. Now tax advisers say it might be worthwhile to accelerate income in 2010 to take advantage of today’s lower tax rates.
That’s easier said than done, especially if you’re an employee. But if you have control over your payments, send invoices in plenty of time to ensure you get the income in 2010.
Plan for investment tax hikes
Investment income also will be taxed at higher rates. Most taxpayers now pay maximum long-term capital gain and qualified dividend rates of 15 percent; some lower-income taxpayers don’t owe any taxes on investment earnings.
But in 2011, capital gains tax rates are scheduled to return to 20 percent and 10 percent.
As with income tax advice, the standard investment recommendations are reversed: 2010 might be the year to sell that stock that has appreciated nicely so you can take advantage of the lower capital gains rate.
Similarly, hold on to to possible capital losses. These will be more valuable in future years when the capital gains and ordinary income tax rates are higher, says Bard Malovany, Certified Financial Planner with Sagemark Consulting in Vienna, Va. You can use those losses to offset gains, and when you have more losses than gains, you can use up to $3,000 in excess losses to reduce your regular taxable income.
In examining your portfolio for possible sales, also review your income streams. “Since the lower tax rates on dividends are expiring, consider tax-exempt investments if you are in the soon-to-be 28 percent or higher bracket,” says Bryan Knuff, CPA and principal at Bryan Knuff & Associates in Boise, Idaho.
Reconsider a Roth
Retirement accounts are a large part of most portfolios. Consider making one of those retirement plans a Roth IRA in light of a 2010 tax law change and possible higher tax rates.
While traditional IRA distributions will be taxed at ordinary income tax rates, money taken out of a qualified Roth IRA is tax-free. Such a switch could be a good move if you expect to be in a higher tax bracket when you retire.
Traditional IRA to Roth conversions also are now available to anyone, regardless of income. And for the 2010 tax year only, you have the chance to defer any tax you might owe on the conversion and pay it in equal installments with your 2011 and 2012 tax filings.
“At first blush, it is an incredible opportunity,” says Certified Financial Planner Cass Chappell of the conversion tax deferral option. However, individuals who are now in or expect to be in a higher tax bracket in coming years might want to pay all the tax due at the 2010 rates instead of possibly facing a 35 percent or higher tax rate, says Chappell of Chappell, Mayfield & Associates in Atlanta.
Prepare for the marriage penalty
The marriage penalty, a quirk of the tax code under which a couple filing a joint return pays more tax than if they each filed individual 1040s, will return next year.
This so-called marriage tax was largely alleviated by the soon-to-expire tax laws. They gave joint filers a standard deduction twice that of a single taxpayer. Also, the 15 percent tax bracket for couples was made twice that of a single filer.
Essentially, much of a husband and wife’s income is now treated as if they were filing as single taxpayers. That equity will be erased if the law is allowed to sunset. However, in an election year, most candidates don’t want to seem unfriendly to families, so this tax fix has a decent shot at being continued.
But just in case, you might want to speed up your wedding ceremony. Your filing status is determined by your marital status at the end of a tax year. If you were single for 364 days, but wed Dec. 31, the IRS considers you married for the full year.
If you marry in 2010, you’ll get at least get one year without paying a marriage tax penalty.
Child credit cut in half
Most moms and dads just claim a dependent youngster who is aged 16 or younger on their tax return and then deduct the $1,000 per child tax credit. Because this tax break is a credit, you get to subtract it, dollar-for-dollar, from the amount of tax owed. It could potentially zero out your tax bill.
That tax credit glow, however, will dim a bit on Jan. 1, 2011. On that day, it will drop from $1,000 to $500.
Unfortunately, there’s not much you can do here. Your kids are your kids and the expiring tax law is law… for now.
But as with the marriage tax, Congress has long supported tax breaks for families. It even made the child tax credit refundable in some situations, meaning you could get some money back from the IRS even if you don’t owe.
So look for the child tax credit to be on the shortlist of legislative to-do’s this fall.
Phaseouts on the way back
The U.S. tax code is progressive, meaning that the more you make, the higher your tax rate. However, for more than 20 years, the tax code also included provisions that cost higher-income individuals a bit more when they filed their returns.
The personal exemption phaseout, or PEP, reduced the amount a taxpayer could claim personally, as well as the allowable exemptions for a spouse and dependents.
When that higher-income taxpayer also itemized deductions, a portion of those tax breaks also were disallowed under the Pease rule, named for U.S. Rep. Edward Pease, who championed the reduction. Under this phaseout, some taxpayers lost as much as 80 percent of their itemized deductions.
However, between 2006 and 2009, the Bush-era tax cuts gradually phased out these phaseouts. In 2010, there are no limits on personal exemption or itemized deduction claims regardless of a taxpayer’s income.
In 2011, though, the phaseouts for wealthier taxpayers return.
If you expect to be in a high tax bracket next year, take full advantage of this tax year’s lack of limits on itemized deductions. A charitable donation made in 2010 could be significantly more valuable to folks now than it might be if made in 2011 or later.
Watch out for the resurrected estate tax
The U.S. Treasury took a big hit this year because of the expiration of the estate tax. A Texas tycoon and New York Yankees owner George Steinbrenner were just two of the billionaires whose heirs didn’t have to worry about paying federal taxes on the value of the property their relatives left behind.
In 2011, however, the estate tax comes back to life, at a higher 55 percent tax rate and targeting smaller estates, those worth more than $1 million.
If you fear that Congress won’t increase the estate tax exemption amount — it was $3.5 million in 2009 when the tax was last in place — you can take some steps now to reduce your estate’s taxable value.
Start by giving away some of your wealth. You and your spouse can each give up to $13,000 in cash or other assets to as many individuals as you want, without any tax consequences.
If you want to give substantially more, you can, but once you’ve given away $1 million, you’ll have to pay the gift tax, which is 35 percent. Still, that’s 20 percent lower than the tax rate at which the estate tax is set to resume in 2011.