2010 Year-End Tax Planning Memo

President's Advisory Panel for Federal Tax Reform
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As the end of the year approaches, time is of the essence since many changes may take place if Congress acts, or even more changes if it takes no action, before the end of December.  Here are some of the planning issues you may want to consider.

CHARITABLE CONTRIBUTIONS

In the usual situation, you may deduct the full amount of cash donations made to qualified charitable organizations.  If you donate appreciated property held for more than one year, you can generally deduct the property’s current fair-market value.

Year-end strategy: To increase your charitable deduction for 2010, be sure to complete your gifts before January 1, 2011.  If you use a credit card to pay for year-end donations, you can deduct the contribution on your 2010 return – then pay off the credit card charge in 2011.

Be aware of the strict substantiation rules for monetary gifts.  You must maintain a record of the contribution, such as a bank statement, receipt or written communication supplied by the charity.  The written communication should show the charity’s name, the contribution date and the amount.

Note: If you expect to be in a higher tax bracket in 2011 than 2010, you might postpone charitable gifts to offset higher-taxed income next year.

Alternative Minimum Tax

The alternative minimum tax (AMT) is a special tax return calculation involving certain “tax preference” items, technical adjustments and an exemption amount based on your filing status.  If the resulting AMT liability exceeds your regular income tax liability, you must pay the AMT.  The AMT rate is 26% for the first $175,000 of AMT income, 28% on amounts above $175,000.

Year-end strategy: Review your AMT liability for 2010.  If warranted, it may be advisable to shift tax preference items to 2011 to avoid or reduce expected AMT liability for this year.

The AMT exemption amounts have been “patched” several times during the past decade.  The chart here shows exemption amounts dating back to 2006:

Filing Status20062007200820092010 *
Joint filers$62,550$66,250$69,950$70,950$45,000
Single filers$42,500$44,350$46,200$46,700$33,750
*Proposed legislation could increase these amounts.

Be aware, however, that the exemption amounts are lower for high-income taxpayers.  The reduction of the exemption is equal to 25 cents for each dollar of AMT income above $150,000 ($112,500 for single filers).

Note: If you are facing AMT liability this year and expect to be in a high regular income tax bracket next year, you might accelerate additional income into 2010.  The extra income will be taxed at either the 26% or 28% AMT rate.

Higher Education Expenses

The tax law provides some relief to parents who pay higher education expenses for their children.  However, be aware that the tax benefits are phased out for taxpayers with income above certain levels.

Year-end strategy: Generally, you can claim a deduction or credit (but not both) in 2010 for amounts paid or incurred this year.  For instance, if you pay the tuition bill for the spring 2011 semester in December, you may qualify for a deduction in 2010.  Here is a brief summary of the two key tax breaks.

  • Tax credits: You may claim either one of two credits.  Under the revamped American Opportunity credit (formerly the Hope credit); the maximum credit for 2010 is $2,500.  The credit begins to phase out for joint filers with a modified adjusted gross income (MAGI) of $160,000 ($80,000 for single filers).  The maximum Lifetime Learning credit of $2,000 begins to phase out for joint filers with an MAGI of $100,000 ($50,000 for single filers).
  • Tuition deduction: The maximum deduction for 2010 is $4,000 of qualified tuition and related fees for joint filers with an MAGI of $130,000 or less ($65,000 for single filers).  The maximum deduction is $2,000 for joint filers with an MAGI up to $160,000 ($80,000 for single filers).  Taxpayers with an MAGI above these limits do not qualify.

Note: Technically, the American Opportunity credit is scheduled to expire after 2010, but it may be extended by new legislation.

Estimated Tax Penalty

The IRS may impose an underpayment penalty if you do not pay sufficient “estimated tax” during the year through quarterly installments or income tax withholding, or a combination of the two.

Year-end strategy: Seek tax shelter under one of the safe harbor rules.  Typically, you may qualify by adjusting payroll withholding at year-end.  The safe harbor exceptions are as follows:

  1. Your annual payments equal at least 90% of your current liability.
  2. Your annual payments equal at least 100% of the prior year’s tax liability (110% if your AGI for the prior year exceeded $150,000).
  3. You make installments currently under an “annualized income” method.  This method is only if you receive or accrue most of your annual income in a short span (e.g., from holiday sales).

Note: If you increase withholding after clearing the Social Security wage base ($106,800 for 2010), you may notice little or no reduction in take-home pay.

Residential Energy Credit

Due to a recent tax-law change, you may be able to claim an enhanced “residential energy credit” for qualified energy-saving improvements.

Year-end strategy: Complete the improvements before January 1, 2011.  As the law stands now, the credit equals 30% of the cost of expenditures in 2009 and 2010, for a maximum credit of $1,500 covering the two years.

The list of qualified expenses may be more expansive than you think.  It covers such items as insulation materials; exterior windows (including skylights); exterior doors; central air conditioners; natural gas, propane and oil water heaters or furnaces; hot water boilers; electric heat pump water heaters; certain metal roofs; stoves; and advanced main air-circulating fans.

Note: Prior to 2009, the credit was equal to only 10% of qualified expenses, with a $500 lifetime dollar cap.  Proposed legislation may extend and/or modify the current credit.

Miscellaneous Tax Benefits

  • When state law permits, you can consolidate outstanding personal debts into a home equity debt.  Interest on personal debts is not tax deductible, but you may deduct mortgage interest paid on the first $100,000 of home-equity debt, no matter how the proceeds are used.  Caution: The debt must be secured by your home, so use this technique judiciously.
  • The tax law allows you to deduct your annual unreimbursed medical expenses exceeding 7.5% of your AGI for 2010 (scheduled to increase to 10% in 2013).  If you are near the 7.5% mark or already over it, schedule nonemergency medical and dental visits before the end of the year.
  • As a general rule, you may claim a dependency exemption of $3,650 in 2010 for a child under age 19 (or a full-time student under age 24) if you provide more than half of his or her annual support.  It does not matter how much taxable income the child receives.  To secure an exemption for an older child, make sure you clear the half-support mark this year.
  • Miscellaneous expenses are deductible to the extent that the annual total exceeds 2% of your AGI.  When it is warranted, pay qualified expenses (e.g., tax assistance fees) before the end of the year to maximize your deduction for 2010.
  • Under the “kiddie tax,” investment income received by your child under age 19 or full-time student under age 24 is generally taxed at your top tax rate to the extent it exceeds $1,900 in 2010.  Try to minimize any kiddie tax impact through astute investment planning.
  • If you are in the market to buy a new hybrid vehicle, make the purchase before 2011.  The tax law provides a special credit for hybrid vehicles placed in service this year based on the vehicle’s fuel economy.  Caveat: The credit has been phased out for some of the more popular models.  Consult a tax professional.

Capital Gains and Losses

For tax purposes, capital gains and losses effectively cancel out each other.  However, any excess capital loss can also offset up to $3,000 of high-taxed ordinary income in 2010.  The remainder is carried over to next year.  If a gain from a sale qualifies as long-term capital gain (i.e., you have owned the asset for more than a year), the maximum tax rate in 2010 is normally 15%.

Year-end strategy: If it otherwise makes economic sense, you might time capital gains and losses to your tax advantage.  For example, if you have already realized capital gains in 2010, you might “harvest” capital losses at year-end to absorb those gains.  Similarly, if you have realized capital losses in 2010, you can realize gains at year-end to offset those losses.

For taxpayers in the regular 10% or 15% tax brackets, the maximum tax rate for long-term capital gains in 2010 is 0%.  If warranted, you might have low-bracket children sell securities to realize long-term capital gain in 2010.  But you must also consider any potential kiddie tax impact.

Note: The 15% and 0% maximum tax rates for capital gains are scheduled to increase to 20% and 10%, respectively, in 2011.  However, Congress is weighing proposals to extend lower rates.

IRA Contributions

There are two main types of Individual Retirement Accounts (IRAs) designed to benefit retirement-savers: traditional IRAs and Roth IRAs.

  1. Traditional IRAs: Contributions are tax deductible unless you are an “active participant” in an employer-sponsored retirement plan and your AGI exceeds a certain level.  For 2010, deductions are phased out for an AGI between $89,000 and $109,000 for joint filers ($56,000 and $66,000 for single filers).  If your spouse is an active participant and you are not, the deduction is phased out for an AGI between $167,000 and $177,000.

The maximum IRA contribution for 2010 is $5,000.  Furthermore, if you are 50 years of age or older, you can make an extra “catch-up” contribution of $1,000.

  1. Roth IRAs: Contributions are not tax deductible, but withdrawals from a Roth in existence five years may be tax-free.  To qualify, distributions must be received after age 59½, upon death or disability, or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000).  The ability to contribute to a Roth IRA for 2010 is phased out for joint filers with an AGI between $167,000 and $177,000 ($105,000 and $120,000 for single filers).

The contribution limits for Roth IRAs are the same as for traditional IRAs.  If you choose, you may allocate contributions to both types of IRAs, up to the total annual limit.

Note: The deadline to make IRA contributions for the 2010 tax year is your tax return due date.  Nevertheless, you can boost retirement savings by contributing sooner rather than later.  This provides more time for contributions to grow on a tax-deferred basis.

Roth IRA Conversions

For the first time ever, many high-income taxpayers may convert a traditional IRA to a Roth IRA.  Previously, this was not permitted in a year in which your MAGI exceeded $100,000.  Due to a recent tax-law change, this limit has been removed, beginning in 2010.

Year-end strategy: Weigh the pros and cons of a Roth conversion.  Remember that a conversion results in tax liability based on the amount transferred to the Roth IRA.  But future Roth distributions may be tax free and, unlike a traditional IRA, annual lifetime distributions are not required after age 70½.

As an added incentive, you can choose to have the taxable income from a Roth conversion occurring in 2010 split evenly between the following two years—2011 and 2012.  Alternatively, if it suits your needs, you can choose to pay the full amount owed on your 2010 tax return.

Furthermore, be aware that you do not have to convert all of your traditional IRA funds.  A partial conversion is allowed.

Note: The decision to convert or not is a complex one.  You should take into account various factors, such as whether IRA funds are needed to pay the tax, your age and health status, your expected tax rates in future years and potential state income-tax liability.  Consult a professional adviser to determine the best course of action.

401(k) Plans

A 401(k) plan allows you to allocate a portion of your salary to an account where the funds can grow on a tax-deferred basis.  In addition, your company may provide matching contributions based on a percentage of your compensation (e.g., 3% of your salary).

Year-end strategy: Increase 401(k) plan contributions at year-end to boost retirement savings.  For instance, you might decide to defer more dollars to your 401(k) account after you clear the 2010 Social Security wage base of $106,800.  This will not reduce your take-home pay if the payroll tax savings are allocated to the 401(k) deferrals.

As with other tax-qualified retirement plans, a 401(k) plan must meet strict nondiscrimination requirements to maintain its tax-favored status.  Furthermore, there is an annual dollar cap on elective deferrals.  For 2010, you can defer a maximum of $16,500 to your account.

Note: If you are age 50 or older, you can add a “catch-up contribution” of $5,500.  Thus, the total maximum deferral allowed in 2010 for 401(k) participants age 50 or older is $22,000.

Estate and Gift Taxes

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 gradually reduced the top estate-tax rate to 45% while increasing the estate-tax exemption to $3.5 million for 2009.  Furthermore, the law completely repealed the estate tax in 2010.  However, the top tax rate and exemption are scheduled to return to pre-EGTRRA levels, beginning in 2011.

YEARTOP ESTATE-TAX RATEEXEMPTION AMOUNT
200250%$1.0 million
200349%$1.0 million
200448%$1.5 million
200547%$1.5 million
200646%$2.0 million
2007–200845%$2.0 million
200945%$3.5 million
2010RepealedNot applicable
201155%$1.0 million

Year-end strategy: Review your estate plan.  Upon review, you might decide to reduce your taxable estate via lifetime gifts to family members.  Under the annual gift-tax exclusion, you can give each recipient up to $13,000 in 2010 without any gift tax ($26,000 for joint gifts by a married couple).

EGTRRA includes other key estate-tax provisions.  For example, the basis of inherited assets must be carried over, instead of receiving a step-up, although up to $4.3 million may be exempt.  EGTRRA also imposes “generation-skipping tax” changes comparable to the estate-tax changes.

Note: Congress may yet modify the law or reinstate pre-2010 rules.  Plan accordingly with your professional advisers.

Miscellaneous Tax Benefits

  • Defer tax on investment income from certificates of deposit (CDs) and Treasury securities by acquiring investments that mature after 2010.  Generally, the income from these investments is taxable in the year it is received.  Caveat: Consider your expected tax rate for 2011.
  • Under the “wash sale rule,” you cannot deduct a loss on securities sales if you acquire substantially identical securities within 30 days.  The easiest way to avoid this result is to wait at least 31 days before you repurchase the same or similar securities.
  • It is generally beneficial tax-wise to sell mutual fund shares before the fund declares dividends (the “ex-dividend date”) and to buy shares after the date the fund declares dividends.
  • Consider investments in dividend-paying stocks.  As with net long-term capital gain, the maximum tax rate on qualified dividends received in 2010 is 15% (0% for low-income taxpayers).

CONCLUSION

This year-end tax-planning memo is intended only to serve as a general guideline.  Of course, your personal circumstances may require in-depth examination.  We would be glad to schedule a meeting with you to provide assistance with your tax-planning needs.

This year-end planning memo is published for our clients, friends and professional associates.  It is designed to provide accurate and authoritative information with respect to the subject matter covered.

IRS Circular 230 requires us to inform you that the information contained in this memo is not intended or written to be used for the purpose of avoiding any penalties that may be imposed under federal tax law and cannot be used by you or any other taxpayer for the purpose of avoiding such penalties.  Before any action is taken based on this information, it is essential that competent, individual, professional advice be obtained.

Sources:

www.irs.gov

The Economic Growth and Tax Relief Reconciliation Act of 2001

American Recovery and Reinvestment Act of 2009

Small Business Jobs Act of 2010

Patient Protection and Affordable Care Act of 2010

Hiring Incentives to Restore Employment Act of 2010

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