The midterm elections have changed the chemistry of the US Legislature, but taxpayers will have to wait to see what that change will generate in the area of income taxation. Traditional year-end tax strategy centered around accelerating deductible expenses and deferring taxable income. In December 2010, taxpayers may be wise to take the opposite approach.
Without Congressional action, the “Bush tax cuts” are scheduled to expire on January 1, 2011. Both Democrat and Republican legislative leaders have stated that these tax cuts should be extended for the “middle class.” However, some more conservative factions in Washington, DC are proposing to hold hostage the extensions of tax cuts to middle class taxpayers as a means to force the extension of those cuts to all taxpayers. The only thing that is certain is that the tax rates will not be reduced in 2011. In addition, interest rates are now low. As a result, the opportunity cost to taxpayers of paying taxes early is minimized. These facts considered, increasing taxable income in 2010 may be better than deferring income and paying taxes on that deferred income in 2011.
Below is a comparison of the 2011 tax rates and limitations for medium and higher income taxpayers filing joint returns under various scenarios:
|Tax Rate||Bush Cuts Extended||Bush Cuts Not Extended||Obama’s Proposal|
|25%||$69,000 – $139,350||–||$69,000 – $139.350|
|28%||$139,350 – $212,300||$57,650 – $139,350||$139,350 – $237,300|
|31%||–||$139,350 – $212,300||–|
|33%||$212,300 – $379,150||–||–|
|36%||–||$212,300 – $379,150||$237,300 – $379,150|
|39.6%||–||$379,150 +||$379,150 +|
|Qualified Dividend||15%||at normal rates||at normal rates|
|Personal Exemption||Not limited||2% phase-out @ $255,000||2% phase-out @ $250,200|
|Itemized Deductions||Not limited||3% phase-out @ $170,000||capped at 28% for 36% and 39.6% taxpayers|
It is clear that tax rates will not decrease. The conventional plan of accelerating deductions and deferring income into the next year may not be appropriate for 2010.
There are other provisions to consider beyond the general tax rate. Following is a brief summary of some of the tax related items to evaluate as 2010 comes to a close.
Alternative Minimum Tax
A separate tax regime exists which computes an “alternative minimum tax” (“AMT”) at 26% or 28% of alternative minimum taxable income. The taxpayer pays the higher of the AMT or the regular income tax. Alternative minimum taxable income is regular taxable income increased by tax preference items such as tax-exempt interest, accelerated depreciation, and other items. The exemption from AMT is $45,000 for 2010. In 2009, the exemption was $71,000. The $26,000 decrease in the exemption will catch an estimated additional 27 million taxpayers in the AMT trap in 2010. If AMT could be a problem, income in various categories should be estimated and controlled to minimize the AMT impact. Also, the AMT must be considered when estimating taxes for 2010.
- Contribution. Those taxpayers who do not participate in an employee pension plan, have modified adjusted income of less than $89,000 (joint filers) or $56,000 (individual), and who are less then 71 years of age may make a tax deductible contribution to a traditional IRA of $5,000 plus another $1,000 for those over age 50. Contributions for 2010 must be made by April 15, 2011.
- Spousal. Contributions for an unemployed spouse can be made even if other spouse is a participant in an employee pension plan.
- Roth. After-tax contributions to a Roth IRA can be made instead of contribution to a traditional tax deferred IRA. A Roth IRA grows tax-free and is distributed tax-free if distributions are made as the Roth IRA permits. There is no age limit. The maximum contribution is phased out for joint filers with income of $167,000 and $105,000 for individual filers.
- Roth Conversion. Beginning in 2010, the previous income limitation of $100,000 was lifted for converting traditional IRAs to Roth IRAs. The amount converted will be subject to income tax but the tax will be spread between 2011 and 2012. The values of some IRA accounts have decreased from their previous highs and are expected to regain value in the future. This might be an advantageous time to convert. To be truly effective, the income taxes incurred as a result of conversion should be paid from other sources.
- RMDs. Unlike 2009, some taxpayers are required to make the “required minimum distributions” (“RMDs”) for 2010 from traditional IRAs, 401(k) accounts, and other plans. Taxpayers subject to the RMD provisions are generally beneficiaries of the plans, principally those aged 70 ½ and older, and others who may have received the plan benefits from a person who is now deceased.
Other Tax Favored Plans
The limits for contributions to pension, profit sharing and 401(k) plans are the same for 2011 as for 2010. The amount contributed to all tax favored plans including flexible spending accounts, 401K plans, and cafeteria plan elections should be reviewed each year-end to take maximum advantage of the tax deferral opportunities available.
- Net capital losses may be used to offset capital gains and $3,000 of other income, with unused losses carried over to future years. A review of capital transactions for 2010 should be made to take current advantage of any loss. Take note that a current sale of a stock made for the purpose of recognizing gain or loss will be deemed a “wash sale” if the stock is reacquired within 31 days of the sale.
- Net short-term capital gains are taxed at ordinary income tax rates. To get the favorable long-term rates, the asset must have been held for at least 12 months.
- It is almost assured that capital gains rates will increase in 2011. From a tax standpoint, a sale in 2010 would be more advantageous than a sale in 2011.
- In 2011, It is likely that qualified dividends will lose the favorable 2010 tax rate of 15%.
Other Income Items
- Passive losses and portfolio deductions are only deductible against passive income and portfolio income, respectively. Cash basis taxpayers may have an opportunity to adjust income or deductions to prevent the loss or deferral of full current benefits.
- For low income taxpayers receiving Social Security payments, the amount of income (including tax-exempt income) received could determine how much of their benefit is taxed. If income can accelerated to 2010 or deferred to 2011, the amount of Social Security benefit taxed in the reduced income year could be decreased below the 85% maximum.
- Medical expenses are deductible to the extent they exceed 7.5% of “adjusted gross income” (“AGI”). Taxpayers should consider deferring or accelerating payment of medical expenses and health insurance premiums so the bulk of such expenditures occur in one year. Other itemized deductions that are limited are “miscellaneous deductions” (deductible only in excess of 2% of AGI), casualty losses (excess of 10% of AGI), and student loan interest.
- State and local taxes including property taxes, are deductible in year paid. Most local income and property taxes can be paid in 2010 or 2011. Taxpayers who itemize should determine when the payment would be most advantageous.
- Payment of deductible expenses in 2010 by credit card or check (if paid prior to January 1, 2011), could give the taxpayer a 2010 deduction.
- Charitable contributions are subject to income limitations but are deductible in the year made.
- It is almost assured that itemized deductions will be limited in 2011 for high income taxpayers (see chart above).
Considerations for 2013
The health care reform package recently enacted by Congress includes a provision imposing a 3.8% Medicaid surtax on “net investment income” effective in 2013. This tax is an important factor in making current investment decisions. The tax would apply to joint taxpayers with “modified adjusted gross income” (“MAGI”) in excess of $250,000, and for individual taxpayers with MAGI in excess of $200,000. For trusts and estates, the MAGI limitation is about $13,000.
“Net investment income” includes all investment income such as dividends, royalties, passive income, and gains from non-transaction business assets. Most are distributions from IRAs and qualified plans and earned income.
In addition, the health care reform package included a .9% (9/10ths of 1%) Medicare surtax on earned income above $250,000 for joint filers and $200,000 for individual filers.
Obviously, the foregoing will impact each taxpayer differently. Tax planning in December 2010 is more of an exercise in prognostication than in planning. However, plan we must because the exercise may result in significant tax savings. We at Berry Moorman and our Michigan tax attorneys are always available to provide some guidance and direction through this maze of opposing concerns and shifting tax laws.