Planning for Individuals Amid Uncertainty

Traditionally, tax planning is done before the end of the year to minimize taxes for the current year and optimize savings opportunities for the future. This year, however, income tax planning is a challenge because of the many unknowns about federal income tax rules. Still, it is helpful to understand these unknowns and planning strategies that can be used amid this uncertainty.

Uncertainty Persists

There are a number of areas of uncertainty because of prior laws, the state of the economy, the federal deficit, and Congress' inaction on a number of fronts.

Expired provisions. More than two dozen favorable tax rules expired at the end of 2009, many of which applied to individuals. Congress is working on a variety of measures that could extend, at least for 2010, some of these provisions (retroactive extensions of favorable tax rules have been done before). The House passed an "extender bill" (American Jobs and Closing Tax Loopholes Act, H.R. 4213) before the Memorial Day recess; the Senate failed three times to pass a similar measure before the July 4th recess but could take up the matter again — before or after the November election (the extenders themselves are not controversial but the way in which to pay for them is still uncertain). Key provisions in the extender bill for individuals include:

• The option to itemize state and local sales taxes in lieu of state and local income taxes.
• Additional standard deduction for real estate taxes up to $500 ($1,000 for joint filers).
• Above-the-line deductions for tuition and fees, and educator expenses up to $250.
• Transfers of IRA funds up to $100,000 by those age 70½ and older to public charities.

Expiring provisions. A number of provisions created by the American Recovery and Reinvestment Act of 2009 were set to run only for 2009 and 2010. With concerns about the deficit, there is little action underway in Congress to extend them. Provisions that will not run beyond this year unless Congress extends them include:

• Making work pay credit of up to $400 ($800 for joint filers (Code Sec. 36A).
• American Opportunity credit, which expands and replaces the Hope credit (Code Sec. 25A(i)).
• Tax credit of up to $1,500 over 2009 and 2010 for certain home-energy improvements (e.g., insulation, storm windows) (Code Sec. 25C).
• Using 529 funds tax-free for technology (e.g., computer equipment, Internet access) (Code Sec. 529(e)(3)(A)(iii)).

Most of the provisions under the so-called "Bush tax cuts" created by the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) and the Jobs Growth and Tax Relief Reconciliation Act of 2003 (P.L. 108-27) are scheduled to sunset at the end of 2010. Again, deficit concerns make some extensions unlikely, even though the Administration had promised to retain the breaks for all but higher-income taxpayers. Tax breaks scheduled to sunset include:

• Lower income tax rates. Currently, the top tax rate for individuals is 35%; starting in 2011 they are scheduled to revert to 36% and 39.6%.
• Reduced capital gains rates. Currently, the top rate is 15%; starting in 2011 the top rate will revert to 20%.
• Special treatment for qualified dividends. Now they are taxed the same as capital gains (i.e., at no more than 15%); starting in 2011, they will be taxed as ordinary income up to 39.6%.
• Phaseout of personal exemptions and itemized deductions for high-income taxpayers.

Alternative minimum tax (AMT). For the past nine years, Congress has provided a "patch" (an increase in the exemption amount) to keep millions of taxpayers from owing AMT. The exemption amounts for 2009 were $70,950 for 2009 joint filers; $46,700 for unmarried persons; and $35,475 for those married filing separately. There has been no such patch created for 2010, which means that the exemption amounts are set to decline to pre-2001 levels ($45,000 for joint filers; $33,750 for unmarried persons; and $22,500 for those married filing separately). Congress likely will again create a temporary fix to AMT, but this could be delayed until late in 2010 or even early in 2011 and made retroactive.

Planning in the Current Tax Environment

While uncertainty about many tax rules prevails, there are some actions that can be taken now to benefit from what is certain.

Making Roth IRA conversions. Starting in 2010, there are no income limits barring individuals from converting traditional IRAs to Roth IRAs. While tax is due on the income that results from the conversion (i.e., if the IRA was funded entirely by tax-deductible contributions, then all of the conversion amount is taxable), there is an opportunity to build up tax-free income in the Roth IRA. If higher tax rates persist after 2010, then the value of the tax-free income will be even greater than it is now. There is a safety value for converters: If the value of the account drops significantly after the conversion, the account can be recharacterized to avoid taxation on the higher value; another conversion can be made at a later time.

Note: Income from conversions made in 2010 only are reported 50% in 2011 and 50% in 2012, providing helpful tax deferral (Code Sec. 408A(d)(3)(E)). Alternatively, an individual can opt to include all of the income in 2010. The election will depend upon what the tax rates will be after 2010.

Taking advantage now of expiring provisions. With extensions uncertain, act now to utilize existing tax breaks. Examples:

• Homeowners may want to make certain energy improvements so they can claim a 30% tax credit of up to $1,500 (Code Sec. 25C).
• Students with 529 plans may want to purchase new computers with funds from their plans so the withdrawals will be tax-free (Code Sec. 529(e)(3)(A)(iii)).
• Buy a new hybrid vehicle. The tax credit for such a purchase is set to expire at the end of 2010 (Code Sec. 30B(a)(3)). Caution: Only certain vehicles continue to qualify for the credit, so check www.fueleconomy.gov.

Reviewing investments. Given the favorable tax rate on capital gains, now may be a good time to take gains. If an investor wants to maintain the investment position, the security can be purchased; the wash sale rule that bars recognition of losses if substantially identical securities are acquired within 30 days of the sale only applies to losses and not to gains (Code Sec. 1091).

Investors may also want to consider the advisability of holding dividend-paying stock. Advisors have been touting these investments because of their yield. However, the after-tax yield starting in 2011 will likely be lower than today because of the end to favorable treatment for qualified dividends.

Accelerating or deferring deductions. Some tax deductions, such as charitable contributions and certain elective medical procedures, are within the control of an individual. The decision on whether to take actions this year or wait until next year can result in tax savings. High-income taxpayers may benefit from accelerating certain itemized deductions because they are not subject to any phase-out of those deductions in 2010; the phase-out is set to return in 2011.

Thus, for example, charitable-minded individuals might contribute appreciated securities (to get a deduction at fair market value and avoid capital gains tax) but sell securities that have declined in value (to create a capital loss) and then donate the cash.

The same strategy — accelerating deductions — also applies to accelerating state and local tax payments (e.g., paying real estate taxes and state and/or local income taxes that would otherwise be due in 2011 before the end of 2010). However, the decision for preparing state taxes is impacted by the alternative minimum tax (AMT); deductions for these taxes are not allowable for AMT purposes (Code Secs. 55-59).

Accelerating or deferring income. Conventional wisdom has suggested that deferral is generally the best strategy for income wherever possible because there is at least an additional year in which the taxes must be paid. However, given the possible rise in tax rates in 2011, deferral may mean higher taxes on income that is deferred. For example, someone in the top tax bracket who earns $10,000 as a year-end bonus for 2010 would pay $3,500 in taxes on this amount if the bonus is received this year. If the bonus is deferred to 2011, the income tax bite would likely rise to $3,960, or $460 more.

Adjusting withholding and estimated taxes. While tax refunds are nice (and some taxpayers use them as forced savings to pay for vacations, etc.), they amount to interest-free loans to the government. Those who overpaid 2009 taxes should review withholding and estimated taxes to ensure they don't needlessly overpay in advance. Similarly, those who underpaid taxes (perhaps because of the making work pay credit) should also revise tax payments to avoid underpayment penalties. Situations likely to require adjustments in withholding and estimated taxes include:

• Changes in family situations, such as marriages, divorces, births of a child.
• Substantial investment gains, such as gains from the sale of a business interest.
• Roth IRA conversions that will be reported in 2010.

Final Word

Individuals should consult with their tax advisors to help determine which strategies would be beneficial to them. Also watch for actions in Congress that can impact mid-year planning strategies.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.