Taxing Matters

by: J. Patrick Collins, CFP® , EA

In their second day in office the new Democratic controlled House of Representatives approved new rules on balancing the budget, labeled “pay as you go”.  This means that moving forward any new proposal brought in front of Congress to either cut taxes or increase spending must be balanced with cutting federal spending or raising taxes, respectively.

There are several implications to these new rules that individuals must be aware of:  first, if these “pay as you go” rules remain in place, it may be difficult for President Bush’s tax cuts to be extended when they expire in 2011, since these cuts make it complicated to balance spending and tax revenue (the United States is currently running a $3.5 trillion dollar deficit).  Second, reform on the Alternative Minimum Tax will be complex since it will require a major cut in federal spending.  Seeing as many experts believe that repealing the alternative minimum tax would cost over $1 trillion over the next decade, it is hard to see where the government is going to cut federal spending in an equal amount.

So now you are probably asking, how does this affect me?  Depending on your circumstances, there are several strategies that should be considered in light of potential tax rate increases:

• Receive income in years when you are in a lower income tax bracket:  for example, if you are planning on selling an investment property or stock that you will realized a gain from in the next five years, you may want to consider doing so before 2011, when capital gains are scheduled to increase.  For tax payers able to stay at or below the 15 percent tax bracket from 2008 to 2010, the tax rates on capital gains will be 0 percent.  Waiting into the future could cost you thousands of dollars in additional taxes.  To put it in perspective, currently the United States has the lowest long-term capital gains tax rates since 1933.  With the new “pay as you go” rules in place, one should be cautious that these rates may not stay in place long-term. 

• Consider Roth IRA conversions in 2010:  this is an item we have spoken to many of our clients about in the past year.  In order to boost revenues in 2010, Congress has created a provision that will allow all taxpayers to convert their IRA accounts to Roth IRA accounts in 2010 (in all other years, taxpayers must have less than $100,000 in adjusted gross income to make this conversion).  A conversion means that you pay tax on the IRA money today in order to allow the money to grow tax-free in the future.  If you expect your tax rate to be the same or increase in the future, this strategy should be considered.  Even in a situation where the tax ramifications would be neutral, the benefits of a Roth IRA should be considered (no required minimum distributions at age 70 1/2, estate planning benefits, etc).

• Delay deductions until you are in a higher tax bracket:  let’s assume that in a few years you decide to make a sizable gift to your alma mater.  If you believe that tax rates will most likely increase after 2010, it may make sense to make your gift in 2011 getting a bigger “bang for your buck”.  If you are in the highest tax bracket, you currently would receive $0.35 for every dollar you gave to charity (1).  If the highest tax rate rose to 50%, you would receive $0.50 for every dollar you gave.  In this example, you would receive 42% more savings from your gift to charity by waiting until income tax rates rose.        

Over the next several years we should begin to see more clarity with respect to changes in the tax code.  Many of these strategies involve looking at your entire tax picture before making any changes.  It is imperative that you discuss your situation with your tax and/or financial advisor to determine the best course of action. 

(1) Does not account for phase-out of itemized deductions.  No state income tax benefits are considered.

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.