Year-End Tax Planning

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The midterm elections have changed the Congressional landscape, with Republicans winning control of the House of Representatives and picking up seats in the Senate. Even so, it’s too early to know exactly how this will affect open tax issues for 2010 and 2011.

Specifically, when the “lame-duck” Congress returns this month, it must decide whether to “patch” the alternative minimum tax (AMT) for 2010 (increase exemption amounts, and allow personal credits to offset the AMT), as it has done in past years. It also must decide whether to retroactively extend a number of tax provisions that expired at the end of 2009.

In addition, Congress must decide whether to extend the Bush tax cuts for some or all taxpayers. They and other Bush-era tax rules expire at the end of this year. Without Congressional action, individuals will face higher tax rates on their income, including capital gains. Also, unless Congress changes the rules, the estate tax, which isn’t in effect this year, will return next year with a 55% top rate.

In short, year-end planning—which always involves some educated guesswork—is a bigger challenge this year than in past years.

That said, here is a checklist of actions that may help you save tax dollars if you act before year-end. These moves may benefit you regardless of what the lame-duck Congress does on the major tax questions of the day. Not all actions will apply in your particular situation, but you may benefit from some of them.  Please review the following list and contact me with questions or to schedule a short review.

  • Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA) if you set aside too little for this year. Don’t forget that you cannot set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids (2010 is the last year that FSAs can be used for nonprescription drugs).
  • Realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later. It may be advisable for us to meet to discuss year-end trades you should consider making.
  • Increase your withholding if you are facing a penalty for underpayment of federal estimated tax. Doing so may reduce or eliminate the penalty.
  • Take an eligible rollover distribution from a qualified retirement plan before the end of 2010 if your are facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2010. You can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2010, but the withheld tax will be applied pro rata over the full 2010 tax year to reduce previous underpayments of estimated tax.
  • Make energy saving improvements to your main home, such as putting in extra insulation or installing energy saving windows or buying and installing an energy efficient furnace, and qualify for a 30% tax credit. The total (aggregate) credit for energy efficient improvements to the home in 2009 and 2010 is $1,500. Unless Congress acts, this tax break won’t be around after this year. Additionally, substantial tax credits are available for installing energy generating equipment (such as solar electric panels or solar hot water heaters) to your home (this break stays on the books through 2016).
  • Convert your traditional IRA into a Roth IRA if doing so is expected to produce better long-term tax results for you and your beneficiaries. Distributions from a Roth IRA can be tax-free but the conversion will increase your adjusted gross income for 2010. However, you will have the choice of when to pay the tax on the conversion. You can either (1) pay the tax on the conversion when you file your 2010 return in 2011, or (2) pay half the tax on the conversion when you file your 2011 return in 2012, and the other half when you file your 2012 return in 2013.
  • Take required minimum distributions (RMD) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70 1/2. Failure to take a required withdrawal can result in a penalty of 50% of the amount not withdrawn. A temporary tax law change waived the RMD requirement for 2009 only, but the usual withdrawal rules apply full force for 2010. So individuals age 70 1/2 or older generally must take the required distribution amount out of their retirement account before the end of 2010 to avoid the penalty. If you turned age 70 1/2 in 2010, you can delay the required distribution to 2011, but if you do, you will have to take a double distribution in 2011—the amount required for 2010 plus the amount required for 2011. Think twice before delaying 2010 distributions to 2011—bunching income into 2011 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels.
  • Make annual exclusion gifts before year end to save gift tax (and estate tax if it is reinstated). You can give $13,000 in 2010 or 2011 to an unlimited number of individuals free of gift tax. However, you can’t carry over unused exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.