Tax Season 2010
Each year, savvy individuals review their tax pictures and determine the steps they should take before the end of the year to minimize their tax bills. This year is especially challenging for year-end tax planning because of several factors: the economy, the number of tax breaks that are expiring and the potential for adverse tax changes in the future. The sooner that year-end planning begins, the more opportunities for tax savings.
Conventional wisdom suggests that wherever possible, income should be deferred to next year and deductions that might otherwise be taken next year should be accelerated into the current year. This wisdom is based on the belief that a taxpayer's tax rates could be lower next year due to indexing of tax brackets, lower income or a reduction in tax rates. At this time, these assumptions might not apply for the following reasons:
- Tax brackets might not be adjusted for inflation. For example, Social Security benefits will not increase for 2010 because of historically low inflation.
- Taxpayers might already be in low brackets in 2009 because the economy has impacted their incomes; 2010 might see incomes rise, along with taxpayers' tax brackets.
- Tax rates surely will not be reduced; in fact, they could increase in 2010 to pay for government programs and the mushrooming deficit. The current low tax rates on individuals are scheduled to sunset after 2010.
The bottom line is that it is difficult to determine whether this year or next year will be the lower tax rate year. For those who can confidently make this determination, maximizing deductions and minimizing income in the higher tax rate year is advisable. The following checklist details tax-savings strategies for accomplishing this:
Accelerate Medical Expenses
Have elective medical procedures done before the end of 2009 (assuming that total medical expenses exceed 7.5% of adjusted gross income).
Prepay Income and Property Taxes
Prepay state and local income taxes and property taxes. For example, pay taxes otherwise due in January 2010 before the end of 2009. However, do not prepay these taxes if subject to the alternative minimum tax (AMT). The taxes are not deductible for AMT purposes.
Increase Charitable Contributions
Donations charged to a credit card before the end of the year are deductible this year even though the credit card bill is paid in 2010. Obtain required substantiation for all donations.
Delay Year-End Billing
Self-employed individuals using the cash basis for accounting purposes should delay year-end billing so funds will be received next year (assuming the customers' ability to pay is not a concern).
Take Advantage of Expiring Tax Laws
More than two dozen tax provisions are set to expire in 2009. Some might be extended; others won't be. As of now, there have been no indications from Congress that breaks will be extended. Here are some important ones to use before it is too late.
- Buy a principal residence by Nov. 30, 2009, to take advantage of the first-time homebuyer credit. This credit of up to $8,000 applies only if the purchaser (and spouse) has not owned a home in the past three years and has income below set limits.
- Buy a new car before the end of the year to deduct the state and local sales and excise taxes on the purchase as an itemized deduction, or as an additional standard deduction if not itemizing.
- Transfer tax free up to $100,000 from an IRA to a public charity if at least age 70½ by the end of 2009. This transfer opportunity can reduce future taxes while benefiting a favorite charity now.
Harvest Capital Losses
Despite some recovery in the stock market, investors might be holding securities that could generate tax losses. Capital losses on the sale of securities can offset capital gains, dollar for dollar. Capital losses in excess of capital gains can offset up to $3,000 of ordinary income ($1,500 for married persons filing separately).
Capital losses in excess of these limits can be carried forward indefinitely to offset gains (and limited ordinary income) in future years. "Banking" capital losses might yield sizable tax savings in the future if capital gains rates increase. The current low rates are set to sunset after 2010, but could be increased before then.
Abandon Worthless Securities
Worthless securities are treated as having been sold on the last day of the year in which they became worthless. Usually worthlessness requires more than the issuer merely filing for bankruptcy. However, investors can treat securities as worthless if they abandon them by giving up any rights in them.
Alternatively, investors might be able to sell nearly worthless securities for pennies through their brokerage firms in "accommodation sales" and take the capital loss.
However, beware of the wash sale rule, which prevents recognition of a capital loss if substantially identical securities are purchased 30 days before or after the sale. The wash sale rule applies even to securities that are sold or acquired in tax-deferred accounts, such as IRAs. For example, if an investor sells stock at a loss in a taxable account and then has his or her IRA purchase the same stock within the wash sale period, no loss on the stock sale can be recognized now.
Take Capital Gains
This might be the last year to enjoy favorable capital gains rates. The 15% and the zero rates for taxpayers in the 10% or 15% tax bracket are set to expire at the end of 2010; the rates could be changed even earlier.
Shift Income to Family Members
Because of the zero tax rate on long-term capital gains and qualified dividends for 2009, consider shifting income to members in the 10% or 15% tax brackets so they can receive this type of income tax-free. For example, an adult child providing support for a parent could gift appreciated securities rather than cash, saving the capital gains tax on the securities and possibly increasing the funds available for the parent's support.
Caution: When gifting to a child subject to the kiddie tax (up to age 23 if a full-time student not providing more than half his or her own support), keep in mind investment income limits applicable to the child. For 2009, investment income over $1,900 is taxed to the child at the parent's highest marginal rate. A child could, for example, have $38,000 in investments yielding a 5% return without exceeding the kiddie tax limit ($47,500 at a 4% return).
Gift Income to Family Members
Income-shifting is aided in 2009 by an increased annual gift tax exclusion of $13,000 per beneficiary ($26,000 if a spouse consents to split the gift). For wealthier individuals, greater gift opportunities include:
- Transferring funds to a child or grandchild's 529 college savings plan: The gift-tax-free limit per child for 2009 is $65,000 (five times $13,000), or $130,000 if the spouse splits the gift.
- Paying for tuition or medical expenses of a family member directly to the service provider: No dollar limit here.
- Making interest-free loans: Because of the current low interest rate climate, the cost of these loans, if any, is low. The first $10,000 of such loans is exempt as a gift loan; loans of up to $100,000 — to enable a child to purchase a home, for example — also are exempt if the child's investment income does not exceed $1,000.
Add Funds to 529 Plans
See aforementioned "Gift Income to Family Members" for the rules for contributions. Withdrawals from 529 plans in 2009 and 2010 can be qualified (i.e., tax-free) for computer technology. This includes the cost of a laptop, Internet access and software (gaming and entertainment software must be primarily for education purposes).
Cash in Savings Bonds for College
Cashing in U.S. savings bonds can help pay for higher education without current income tax cost. The MAGI limits on the exclusion of savings interest redeemed to pay qualified higher education expenses are up in 2009.
Use New Education Credit
The American Opportunity credit, which can be used for the first four years of higher education, applies in 2009 and 2010. There are MAGI limits on eligibility; 40% of the credit is refundable (it can be received even though it exceeds tax liability).
Consider Timing of Tuition Payments
Determine when to pay spring 2010 tuition and fees. Depending on the timing of the payment, it could engender a tax break for 2009 or 2010. Note: The above-the-line deduction for tuition and fees is set to expire at the end of 2009.
Minimize IRA Withdrawals
There are no required minimum distributions from traditional IRAs, 401(k) and similar plans in 2009. This rule applies to account owners and beneficiaries. Individuals are permitted to take some or all of their savings, but usual taxation rules apply (i.e., ordinary income treatment and a 10% early distribution penalty for those younger than 59½ unless an exception to the penalty applies).
Maximize IRA Contributions
Active participants in qualified retirement plans might be able to add to deductible IRAs in 2009 because the income limits have increased. For 2009, fully deductible IRA contributions are allowed as long as modified adjusted gross income (MAGI) does not exceed $55,000 for singles, $89,000 for joint filers and $166,000 for a nonactive participant with an active-participant spouse. Partial deductible contributions are permitted for those with MAGI within a phase-out range.
The MAGI limits for contributing nondeductible amounts to a Roth IRA have increased to $105,000 for singles and $166,000 for joint filers (partial contributions are permitted for those with MAGI within a phase-out range).
Make IRA Contributions Early
IRA contributions for 2009 can be made up to April 15, 2010; however, the sooner contributions are made, the more tax-deferred income in a traditional IRA or tax-free income in a Roth IRA can accrue.
Convert to Roth
For 2009, conversions from traditional IRAs or qualified retirement plans to Roth IRAs are allowed only if MAGI does not exceed $100,000 (married persons must file jointly to convert). Starting in 2010, the conversion restrictions are repealed; anyone can make a conversion of some or all taxable accounts. The cost of the conversion is the tax that results, though there is no early distribution penalty. Individuals who want to make conversions next year should be sure to have sufficient cash (separate from the converted account) to pay the resulting taxes. Note that the tax on conversions in 2010 automatically is payable one-half in 2011 and one-half in 2012. However, taxpayers can elect to report all conversion income in 2010, which might be advisable if income tax rates increase after 2010.
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