The Great Tax Debate

Uncertainty on Capitol Hill is making everyone's life miserable. Congress's, inability to decide what to do about the expiring Bush-era tax cuts means you can procrastinate on your year-end tax planning guilt-free. And there's a good chance Congress won't act until after the November elections. Until then, the only thing you can do is review your options so that you'll be ready to take action once it becomes clear what tax rates will be next year. Congressional action -- or inaction -- regarding the expiring tax cuts won't affect the 2010 tax return that you file next spring. But it could affect your year-end tax planning.

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 -- singles whose taxable income exceeds $200,000 and married couples with taxable income above $250,000. Although the Obama plan would raise taxes on the highest-income earners, some well-off taxpayers would enjoy a five-percentage-point rate cut on some of their income. That's because the 28% bracket (which now ends at about $170,000 for singles and $210,000 for couples) would have to be expanded to accommodate the President's definition of middle class. So some income now smacked by 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 everyone would cost $3.3 trillion over the next ten years, compared with $2.2 trillion if they were extended for all but the rich, according to the Pew Economic Policy Group.

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The more time Congress spends arguing over what to do about the Bush tax cuts, the more likely it is that lawmakers will ultimately kick the can down the road by extending current rates for everyone for a year or two to buy time to work on more-permanent tax reform. But anything could happen during a likely post-election lame-duck session. If political gridlock sets in, the Bush tax cuts could actually expire on schedule on December 31, and everyone's taxes would go up in 2011. Remember, almost no one believed Congress would actually let the estate tax expire at the end of last year -- but it did.

Meanwhile, states are facing their own budget challenges, and unlike the federal government, they cannot run deficits. Their only choice is to cut spending or increase taxes. See the facing page for some of the creative ways states propose to raise revenues.

Year-end strategies

Normally, it makes sense to reduce your income and increase deductions as a way to hold down your tax bill. And that's what you should continue to do if Congress extends current tax rates for your income level. But if your tax rates increase in 2011, it may make more sense to reverse those strategies, says Gregory Rosica, a tax partner with Ernst & Young in Tampa.

In that 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, says Rosica. 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-saving bang for each buck you deduct. (However, postponing the donation delays the tax benefit you'll enjoy by a year.)

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's 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. Ditto if current tax rates expire; the maximum capital-gains rate reverts to 20%. So if you expect your capital-gains rate to rise next year, you may want to cash in your profits before year-end and pay the current 15% tax, advises Steve Kunkel, a CPA in Los Angeles.

If you love your investment and hate to part with it, don't worry. You can turn around and buy it back the next day, establishing a new, higher basis for future gains. (Unlike the "wash-sale rule," which prohibits you from buying an asset within 30 days before or 30 days after selling a similar asset at a loss, there are no time restrictions on repurchasing an investment that you sell at a profit.)

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 (up to $5,000, or $6,000 if you're 50 or older).

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 (see 7 Myths About Roth IRA Conversions).

Longer-term solutions

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.

Higher rates would heighten the attraction of tax-deferred annuities for upper-income Americans who have maxed out their retirement savings and are looking for additional tax shelters, says Tom Karsten, managing partner of Karsten Tax & Financial Management, in Fort Worth. Tax-free municipal bonds will become even more appealing in a higher-tax environment, but investors need to be vigilant about investigating the creditworthiness of bond issuers. And remember, both bond interest and the taxable portion of annuity income is subject to ordinary income-tax rates.

Higher tax rates also increase the appeal of cash-value life insurance, says Adam Sherman, a financial planner with Firstrust Financial Resources, in Philadelphia. Individuals can use insurance to pass on wealth to heirs tax-free, and policyholders can tap the cash value -- which accumulates inside the policy on a tax-deferred basis -- through tax-free withdrawals and low-interest loans.

Other methods of tax-deferred savings, such as 529 college-savings plans and health savings accounts (HSAs), will be more attractive in a higher-tax environment, too.

The price of gridlock

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, which 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 reduce the child tax credit by 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 higher capital-gains rates, the tax rate on qualified dividends would revert to 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 expired tax breaks -- including a choice between deducting state sales taxes or state income taxes -- that will affect the 2010 tax returns you file next spring. The AMT, a parallel tax system originally designed to ensure that wealthy Americans don't escape taxes, 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 we expect Congress to 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. Will they get around to it before the IRS prints the 2010 tax forms? Stay tuned.