Year-End Income Tax Planning Considerations
Doug Rothermich, V.P. Estate and Tax Planning
John O’Shea, Wealth Planning Specialist
Certain tax cuts are set to expire at the end of this year. Uncertainty around what action Congress will take makes it important to stay informed and to be prepared.
Expiration of tax cuts from 2001 through 2003 are looming and Congress is working on how to address the legislation going forward. One proposal allows the tax cuts to sunset, meaning rates would revert to 2001 levels. A second proposal, advanced by the current Administration, involves the concept of “wealthy” and “nonwealthy” taxpayers.
The current Administration has defined wealthy taxpayers as married filing jointly with annual income of about $250,000, or as a single taxpayer with annual income of about $200,000. The Administration’s proposal increases ordinary income tax rates for wealthy taxpayers only, with the belief that increasing the income tax liability of higher-income taxpayers reduces the deficit, makes the income tax system more progressive and distributes the cost of government more fairly among taxpayers of various income levels. The table below illustrates the 2010 tax rates and possible rates for 2011 and beyond.
In 2010, you can receive a dollar-for-dollar deduction for allowable itemized deductions. Both proposals for 2011 reinstate a phase-out of itemized deductions, so that more income is subject to the higher ordinary income tax rates. If 2001 tax cuts are allowed to sunset, itemized deductions are phased out by an amount equal to the lesser of (a) 3% of the excess over the threshold amount or (b) 80% of allowable deductions. The threshold amount for 2011 is about $167,000 ($83,550 if married filing separately). This threshold amount might be increased slightly to account for inflation. If the Administration’s proposal is enacted, the phase-out rules would be reinstated only for wealthy taxpayers. The Administration also favors capping the value of allowable deductions at 28% rather than allowing a deduction equal to a taxpayer’s highest marginal income tax rate.
The Administration’s proposal does not phase out deductions for medical expenses, investment interest, theft and casualty losses, or gambling losses. But effective in 2013, the healthcare legislation will increase the threshold for claiming unreimbursed medical expenses from expenses that exceed 7.5% of Adjusted Gross Income (AGI) to expenses that exceed 10% of AGI.
For 2010, a full personal exemption of $3,650 if single and $7,300, if married filing jointly, is available. The Administration wants to phase out personal exemptions for wealthy taxpayers by 2% of the exemption amount for each $2,500, or fraction thereof, by which AGI exceeds the $200,000 / $250,000 income threshold.
For 2010, if you fall in the 10% or 15% tax bracket, you’re taxed at a 0% tax rate. Dividends are taxed at a rate of 15% for those in a bracket of 25% or higher. If the qualified dividend tax rates are allowed to sunset, taxpayers would pay tax on qualified dividends at their ordinary income tax rates. Many Democrats in Congress prefer to have the dividend rates sunset. The Administration, however, prefers to allow dividend rates to remain at 2010 levels for nonwealthy taxpayers and to increase the dividend rate to 20% for wealthy taxpayers. In 2013, wealthy taxpayers may also incur an additional 3.8% tax on qualified dividends because of the Medicare tax on unearned income.
Long-Term Capital Gains
For 2010, the tax bracket analysis is the same as outlined above for qualified dividends. If the capital gains tax rate sunsets, many taxpayers will pay capital gains tax at about 20%. The Administration agrees with increasing the tax rate to 20%, but only for wealthy taxpayers.
Political leaders may not tip their hand on income tax reform until after the November elections. Therefore, we encourage you to take action in late November or December to minimize your income tax. For this reason, keeping cash available to pay additional taxes for 2010 is likely a prudent strategy. End-of-year tax planning ideas to consider include the following:
Accelerate Income and Withdrawal
If you expect your ordinary income tax rate to increase in 2011, you may wish to accelerate a year-end bonus into 2010, or to take the distribution from a nonqualified deferred compensation plan (e.g., withdrawal from a 457 Plan that has an option to take a current payment or to defer), or to accelerate accrued interest on U.S. savings bonds, and/or to withdraw assets from an after-tax annuity. In 2013, wealthy taxpayers may also incur an additional 3.8% tax on withdrawals from after-tax annuity products because of the Medicare tax on unearned income.
Accelerate or Defer Deductions
You may also want to consider accelerating certain itemized deductions into 2010 or deferring them until 2011. Traditionally, when income tax rates are expected to rise in the following year, it has made sense to defer deductions because they were worth more when used to offset income in the higher-tax year. However, this year may be different because of the proposal to cap deductions at 28% beginning in 2011.
- Example: Arthur is in the highest tax bracket. He gifts $10,000 of his earnings to charity. For 2010, Arthur owes $3,500 in tax on the earnings and receives a $3,500 charitable deduction. For 2011, if Arthur wishes to do the same thing, he may owe $3,960 in tax on the earnings and may have a charitable deduction that is capped at $2,800.
If you have unrealized long-term capital gains, you may want to consider realizing a portion or all of the unrealized gain in 2010. This strategy could make sense if you’re planning to liquidate an appreciated asset within about the next six years. If you plan to own the asset for longer, this strategy makes less sense because of the potential loss of cash paid for taxes. You may even want to liquidate an appreciated asset to lock in the current lower capital gains rate and repurchase it immediately after it is sold. This is possible because the wash sale rules do not apply to capital gains.1 This strategy may not be beneficial for smaller unrealized gains due to transactional costs. Similarly, you may benefit from a deferral of capital losses into 2011, using them to offset gains realized in the higher tax-rate environment. The losses could also be used to offset up to $3,000 in ordinary income annually.
IRA and Plan Withdrawals
If you’ve turned age 70 ½ and are required to withdraw funds from your retirement accounts this year, you might consider withdrawing more from qualified plans and/or IRAs in 2010.2 Alternatively, consider converting a portion of these assets into a Roth IRA in 2010 while income tax rates remain lower. Tax changes are coming, although the timing and scope of the changes are still unclear. Talk with your TIAA-CREF advisor and your tax advisor to develop contingency plans. Doing so will better position you to make tax-wise decisions in late November or December.
Here are some examples of issues to consider over the longer term.
For those who own rental properties, you might want to consider the increased tax impact of operating the properties long term. Beginning in January 2011, rental income will be subject to higher marginal income tax rates; and beginning in January 2013, rental income will also be classified as net investment income and could be subject to 3.8% Medicare tax for taxpayers who meet the $200,000/$250,000 threshold.
Keep in mind that tax rates rise and fall over time. If you think your retirement income may put you in a lower tax bracket than today’s bracket (or next year’s bracket), deferring as much income as possible into qualified plans and IRAs is still prudent. Non-qualified tax deferred annuities and/or life insurance contracts that provide a death benefit as well as tax-deferred growth inside the policy might also be appropriate for when you have a longer investment horizon.
Also consider adjusting your investment portfolios (e.g., more growth stocks, less dividend-yielding stocks, more tax-free municipal bonds, more U.S. Series E savings bonds, or inflation indexed U.S. series I bonds, as needed.)
Consider establishing an entity, such as a limited liability company, for rental or royalty income to facilitate gifting of ownership interests over time to lower bracketed taxes to loved ones, such as parents or adult children. In this way, future rental income or royalty payments can be distributed to and among the taxpayer and loved ones to shift income to lower bracketed taxpayers.
* 2011 tax brackets will likely be indexed for inflation. An inflation increase is not reflected in this table.
1 The Wash Sale Rule states that a taxpayer may not earn a tax benefit from selling a security at a loss if he reacquires that security, or one substantially identical to it, within a 30-day period prior to and after the sale.
2 A taxpayer can keep assets inside a retirement plan until the taxpayer reaches the required beginning date, usually April 1 following the calendar year when the taxpayer is age 70½. Or, if the taxpayer has a retirement plan (other than an IRA and plans in which the taxpayer has a 5% or greater interest in the plan sponsor) and is employed beyond age 70½, the required beginning date is April 1 following the calendar year when the taxpayer retires. IRS Publication 590 is designed to assist you in determining the required minimum distribution amounts.
The tax information contained herein is not intended to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. It was written to support the promotion of TIAA-CREF Wealth Management services. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor. Examples included herein are hypothetical and for illustrative purposes only.
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