What’s Going on with Your Taxes

Posted on: September 13th, 2010 by

Tax Breaks - CPA - Rockville, MDUncertainty on Capitol Hill is making everyone’s life miserable. Congress’ inability to to make a decision on what to do about the expiring Bush tax cuts means that we probably won’t know what will happen to next year’s tax rates until after the November elections.  Sigh.

President Obama wants to keep current tax breaks in effect for lower and middle income taxpayers, but favors reinstituting higher rates for the wealthiest 3% of Americans.  Ironically, while the Obama plan would raise taxes on the highest income earners, some pretty well off taxpayers would enjoy a 5% rate cut on some of their income.  That’s because the 28% bracket would have to be expanded to accommodate the president’s definition of middle class.  So some income now hit with the 33% rate would drop into the 28% bracket.

Congressional Republicans argue that current tax rates should be extended for everyone, noting that many of the taxpayers targeted for tax hikes are small-business owners and that higher taxes on them could derail the economic recovery.  Extending the current tax rates for all taxpayers, however, would cost $3.3 trillion over the next 10 years, compared with $2.2 trillion if they were extended for all but the rich, according to the Pew Economic Policy Group.

The more time Congress spends arguing over what to do about the Bush tax cuts, the more likely it is that lawmakers will ultimately extend current rates for everyone for a year or two to buy more time to work on more permanent tax reform.  But anything could happen during a likely post-election session. If political gridlock sets in, the Bush tax cuts could actually expire on schedule on Dec. 31, and everyone’s taxes would go up in 2011.

Normally, it makes sense to reduce your income and increase deductions as a way to hold down your tax bill for the current year.  And that’s what you should continue to do if Congress extends current tax rates for your income level.  But if your tax rates will increase in 2011, it may make more sense to reverse those strategies.  If that is the case, consider accelerating any discretionary income, such as a year end bonus or income from exercising nonqualified stock options, into the current year, when tax rates are lower.  And to the extent that you have control over itemized deductions, such as when you make charitable contributions, you might want to push a donation into January, when it will deliver a bigger tax savings.

Usually, investors focus on harvesting losses before the end of the year to offset profits and the tax bill that goes along with them.  That is a viable strategy if maximum long-term capital gains rates remain at the current 15% level.  But if Obama gets his way, the top capital gains rate would rise to 20% for upper income taxpayers. The same goes if the tax cuts expire.

Regardless of whether your tax bracket remains the same or increases next year, adding to your tax-deferred retirement savings before the end of this year is a good way to reduce your 2010 tax bill and boost your future nest egg.  You can contribute up to $16,500 to your 401(k) or similar employer-based plan in 2010, and if you are 50 or older, you can kick in an extra $5,500.  You have until April 15, 2011, to contribute to an IRA for 2010.  On the flip side, some taxpayers may want to bite the bullet now and convert some or all of their traditional IRAs to a Roth IRA, paying taxes at current rates on the converted amount and locking in tax-free withdrawals for the future, when rates may be even higher.  Note that if you convert to a Roth in 2010, you can also choose to split the taxable income between your 2011 and 2012 returns and pay whatever tax rates are in effect at that time.

Even if Congress extends the current tax rules for another year or two, most financial experts believe that higher taxes to tame rising budget deficits are inevitable.  And that could change the way Americans save and invest their money in the long run.  You don’t need to make these decisions by year-end, but it’s never too early to begin thinking about strategies for coping in a higher tax world.

Without congressional action this year, everyone will feel the pain of higher income taxes in 2011.  The lowest 10% tax bracket would disappear, meaning everyone would pay higher rates on more of their income.  The marriage penalty that forced some dual-income couples to pay more tax on their combined income than they would have owed if they had remained single would be reinstated.  The end of the Bush tax cuts would also cut the child tax credit in half, from $1,000 to $500 per child.

Higher-income taxpayers would face bigger tax bills as rates increase and as limits on itemized deductions and personal exemptions, which disappeared in 2010, come back into play.  In addition to increased capital gains rates, qualified dividends would revert to being taxed at ordinary income rates as high as 39.6%.  A more immediate problem is what will happen to the alternative minimum tax and a host of other expired tax breaks, such as a choice between deducting either state sales taxes or state income taxes, which will affect the 2010 tax returns that Americans file next spring.  The AMT disallows personal exemptions and many of the deductions that taxpayers count on to reduce their tax bill.  Without an annual fix to raise the AMT exemption level, an estimated 25 million Americans will be hit by the alternative minimum tax in 2010, compared with five million last year. But it is expected that Congress will muster the votes to patch the AMT for 2010, as it has each of the past several years, and revive the expired tax breaks, too.



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