There’s still plenty of time to put last-minute planning techniques into play, but remember to consider your individual circumstances and consult a tax adviser. There is an extra wrinkle of complexity this year as the 2001 and 2003 Bush tax cuts are set to expire at the end of the year. Many members of Congress have expressed support for extending these tax cuts to some, if not all, taxpayers either temporarily or permanently. Without Congressional action, tax rates will rise to as high as 39.6% on ordinary income and 20% on capital gains.
This uncertainty can make year-end tax planning tricky for even the most tax-savvy taxpayer—acting before knowing what Congress will do renders some planning a crapshoot. It may be prudent to prepare your strategies now, but wait to see what lawmakers do. With that in mind, here are 10 last-minute tax-planning tips (keeping in mind that Congressional action can affect which strategies make sense):
1. Adjust timing of income and deductions.
In years in which tax rates remain the same, it is generally recommended that income be deferred and deductions be accelerated – why pay tax today when you can put it off until tomorrow? However, if tax rates increase next year, it may be wise to reverse this strategy. Paying tax now at a lower rate may save you taxes in the long run. Generally this means you want to accelerate income into the current year and defer deductions into next year. There are plenty of income items and expenses you may be able to control. Consider accelerating bonuses, consulting income or self-employment income. On the deduction side, you may be able to defer state and local income taxes, interest payments and real estate taxes. But beware of the alternative minimum tax (AMT), which can affect timing strategies.
2. Bunch itemized deductions.
Many expenses can be deducted only if they exceed a certain%age of your adjusted gross income (AGI). Bunching itemized deductible expenses into one year can help you get over these AGI floors. Consider scheduling your non-urgent medical procedures all in one year to get over the 7.5% AGI floor for medical expenses. To get over the 2% AGI floor for miscellaneous expenses, bunch professional fees such as legal advice and tax planning, and unreimbursed business expenses such as travel and vehicle costs. If you can defer bunching these itemized deductions until next year, you may get a bigger bang for your buck!
3. Maximize “above-the-line” deductions.
Above-the-line deductions are especially valuable because they reduce your AGI. Many valuable tax benefits are limited based on your AGI. Common above-the-line deductions include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed health insurance costs, alimony payments and any bank penalties you may have had to pay for early account withdrawals.
4. Consider charitable contributions carefully.
Think about giving appreciated property to charity so you can deduct the full value without paying capital gains taxes. But don’t donate depreciated property. Sell it first and give the proceeds to charity so you can take the capital loss and a charitable deduction. As always, double-check the limits and substantiation rules before making any contributions. And don’t forget to consider whether an increase in taxes next year would make your contributions and deductions more valuable then.
5. Make up a tax shortfall with increased withholding.
Don’t forget that taxes are due throughout the year. Check your withholding and estimated tax payments now while you have time to fix a problem. If you’re in danger of an underpayment penalty, try to make up the shortfall through increased withholding on your salary or bonuses. A bigger estimated tax payment can still leave you exposed to penalties for previous quarters, while withholding is considered to have been paid ratably throughout the year. Also, now would be a good time to consider how the expiration of the Bush tax cuts might affect your tax liability and, thus, your tax estimated payment for 2011. To avoid any penalties, the best action plan would be to make sure you pay estimated taxes equal to 110% of your estimated tax liability.
6. Leverage retirement account tax savings.
It’s not too late to maximize contributions to a retirement account. Traditional retirement accounts like 401(k)s and IRAs still offer some of the best tax savings in the Internal Revenue Code. Contributions reduce taxable income at the time you make them, and you don’t pay taxes until you take the money out at retirement. The 2010 contribution limits are $16,500 for a 401(k) and $5,000 for an IRA (not including catch-up contributions for those 50 and older). Remember that contributions to your IRA can be made as late as April 15, 2011. Regardless of whether tax rates go up, it almost always makes sense to put as much money into tax-favored retirement vehicles as you can.
7. Roll over into a Roth account.
“Roth” versions of traditional retirement accounts, such as 401(k)s and IRAs, also provide a great savings opportunity. You don’t get a tax break when you put money into a Roth account, but the money grows tax-free and is never taxed again if distributions are made properly. Rolling over into a Roth account now may make sense. Tax rates are low, and the value of many accounts has been artificially depressed by the downturn. Paying tax on the rollover now could save you if tax rates go up and your account recovers. Starting this year, the $100,000 AGI limit on these rollovers is lifted; thus, even high-income taxpayers can convert their retirement accounts this year. Understand that you will be required to pay tax on the converted amount and will need to plan accordingly. For 2010 only, you will pay half of the tax associated with the rollover in 2011 and the other half in 2010 unless you make an election to pay the tax in 2010, but make sure you have considered tax rates in those years.
8. Consider selling assets.
If your capital gains rate will increase in 2011, you can consider selling assets now to take advantage of today’s low rates. Stock and other securities can be sold and bought back immediately allowing the payment of tax without changing position. This gives you an increased basis in the asset for future sale but it may make more sense to take advantage of today’s low rates to diversify a concentrated position. If much of your portfolio is tied up in one stock or asset because you’re deferring the tax bill on a large gain, keep in mind that rates only have one way to go from here. But be careful because the time value of money still often makes deferral a better strategy and there are many other factors to consider – including whether your tax rate actually increases.
9. Don’t forget to use annual gift tax exclusion.
If you may have to pay estate taxes eventually, consider establishing a gifting program for your children and grandchildren to take advantage of the annual gift tax exclusion. Gifts of up to $13,000 per donee ($26,000 for married couples) are generally excluded from gift tax in 2010 and will be removed from your estate, with no limit on the number of donees. In addition, payments of tuition to an educational institution for the benefit of your children or grandchildren are excluded from gift tax.
10. Watch out for the “kiddie tax.”
The “kiddie tax,” which requires a portion of a child’s unearned income to be taxed at the parents’ marginal rate, has been expanded to apply to full-time students under the age of 24 whose earned income does not represent at least one-half of their support. Be careful transferring income-producing assets to your kids.
Justin Ransome is a partner in Grant Thornton’s Washington National Tax Office. For more information, visit GrantThornton.com.