Preparing for a World of Higher Taxes
Beginning January 1, 2011, it is highly likely your taxes will increase. For some of you, the increase will be minor. For others, it will be substantial.
As you probably know, the reason for the tax increase is that many provisions related to the ordinary income tax rates and long-term capital gains tax are scheduled to “sunset” at the end of 2010. These are commonly referred to, in the news, as “the Bush tax cuts.”
When Congress left in September to campaign for the November election, it also left us in limbo as to the fate of the Bush tax cuts. If, when Congress reconvenes in November, they cannot reach an agreement and, as a result, let the current tax provisions expire on January 1, as they are scheduled to do, you and I will face a higher federal tax bill regardless of income.
Given that uncertainty, I believe you should take steps now to get prepared for a world of higher taxes.
What steps should you take?
Here are eight action items you may want to consider:
1. Sell appreciated assets in 2010. Let’s say you own a business or have an investment in real estate. Taking profits now may allow you to take advantage of this year’s lower 15% capital gains rate.
2. Receive income in 2010. In addition to taking profits, it may also be smart to drag income into 2010. One example might be the exercise of non-qualified stock options. Or, if you turned 70 1/2 in 2010, you may want to take your required minimum distribution from your IRA before December 31st, rather than waiting until April 1st. Any income reported in 2010 would be subject to the lower federal tax rates as compared to 2011.
3. Defer deductions to 2011. Unlike previous years, you may not want to double up deductible items such as mortgage payments, property taxes and charitable donations at year end since these may be more valuable in 2011 due to higher ordinary income tax rates.
That said, this is an area where you definitely want to consult a tax professional, which we are not. While this strategy may make sense for many of you given the higher tax rates, there is also the reinstatement of the AGI phase out on itemized deductions that you must weigh it against.
Moreover, the Alternative Minimum Tax may further cloud the issue. If deductions like state and local taxes are disallowed, it may not make any sense to pay them early.
Knowing exactly how to play the deductions game in 2010 versus 2011 will require some of you to look at several different what-if scenarios and determine which gives the least amount to Uncle Sam. Unless you are a tax geek, that is probably best done by someone who is.
4. Take full advantage of employer-sponsored retirement plans. We hope you are doing this anyway, unrelated to taxes. But if you needed another reason, income that is tax deferred could potentially help to lower your tax bracket.
The current annual contribution limits are $16,500 for 401(k), Roth 401(k) and 403(b) plans. There is an additional $5,500 catch-up contribution allowed if you are over 50. The annual limit for SIMPLE IRAs is $11,500 with a $2,500 catch-up if you are over 50. If you are a business owner or self-employed, you may be able to establish a qualified plan that will allow you to defer even more.
5. Review your future goals and savings strategies. What are you saving for? College? A new house? Retirement? Medical expenses? You may be able to find more tax advantaged strategies for saving that money.
For example, putting money in a Flexible Spending Account (FSA) allows you to pay out-of-pocket medical expenses with pre-tax dollars. Along the same lines, if you participate in a high-deductible health insurance plan, you can fund a Health Savings Account (HSA). HSAs give you both an upfront tax deduction and tax-free distributions for qualifying expenses.
You might also consider an after-tax contribution to your IRA. Many people don’t even know you can make an after-tax contribution!
Why would you want to do that? Even though the money is non-deductible, it will still grow tax-deferred allowing you to potentially save more for your retirement than you would in a plain old taxable brokerage account. Plus, it is protected from creditors and more painful to rob if you aren’t 59 1/2, acting as a bit of a deterrent to sacking your retirement savings.
Just remember though, don’t ever let the tax tail wag the investment dog. Never make a bad investment just to save on taxes.
6. Buy long-term care insurance. This is related to number five but reaches beyond just taxes in 2011. Statistics say there is a very high probability you will need some long-term care in your lifetime. If you pay for it out of your pocket, you are paying with mostly after-tax dollars. If you purchase a long-term care policy, you pay a smaller amount in premiums with after tax dollars now but the benefit, which stands to be much larger, is not taxed. Not to mention all the other risk management benefits of a long-term care policy.
7. Review current portfolio and asset allocation. All things being equal, you want to minimize future after tax returns. But again, I would caution you, all things are seldom equal. There is also required rate of return, expected rate of return, risk adjusted rate of return and fees to consider. Again, don’t let the tax tail wag the investment dog!
That said, don’t leave money on the table either. For example, where possible, consider using tax-deferred accounts for active investments and short term holdings. Use your taxable accounts, as much as possible, for tax-advantaged and long-term holdings.
8. Consider a Roth IRA conversion. Now here is a strategy I can give my almost unconditional support to. When you convert an IRA to a Roth IRA, which you can now do without limit, you pay the taxes this year and future distributions are completely tax-free.
If you don’t think you will need the money in your traditional IRA to fund your retirement, the Roth IRA can also be a very powerful wealth transfer tool because there are no required minimum distributions and beneficiaries can generally take distributions from the inherited account tax-free, just like you would have.
So now what?
I would urge you to review each these action items with your financial advisor. Everyone’s situation is different and what may be the highest priority for you will not necessarily be the highest priority for me. Once you determine which strategies will have the biggest impact, create an action plan with the specific steps needed to implement into your financial plan.
Many people will make the mistake of waiting until December to look at year-end tax strategies. Don’t make that mistake. Tax planning is best done throughout the year. And this year in particular, with the threat of increased taxes looming for 2011, it pays more than ever to prepare now for a world of higher taxes.
The intent of this article is to help expand your financial education. Although the information included may be relevant to your particular situation, it is not meant to be personalized advice. When it comes to investing, insurance and financial planning, it is important to speak to a professional and get advice that is tailored to your unique, individual situation. All investments involve risk including possible loss of principal. Investment objectives, risks and other information are contained in the Snider Investment Method Owner’s Manual; read and consider them carefully before investing. More information can be found on our website or by calling 1-888-6SNIDER. Past performance is not indicative of future results.