Tax Planning: Navigating Uncertainty this Year End

Posted by   admin on    November 17, 2010

Tax Planning: Navigating Uncertainty this Year End

Typically, year end tax planning strategies involve recommendations for delaying income and accelerating expenses. However, this year is not typical.

Since 2001, we have been complying with tax laws that were crafted by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. Together, these Acts are commonly referred to as the Bush tax cuts. Now, at the end of 2010, the provisions of the Bush tax cuts are set to expire.

Perhaps the most well known provision of the tax cuts was the reduction in tax bracket rates. The lowest tax bracket rate was reduced by 5%, the middle brackets were reduced by 3%, and the top bracket was reduced by 4.9%. However, the Bush tax cuts did much, much more:

  • It reduced by 5% the capital gains tax on investments held longer than one year;
  • It capped the rate on qualified dividend income at 15%;
  • It eased rollover rules for retirement plans, created the Roth IRA and allowed people over the age of 50 to contribute more to their plans;
  • It increased the child tax credit to $1,000 and made it partially refundable;
  • It increased the exemption amounts for the Alternative Minimum Tax;
  • It increased expensing limits for investments in business property;
  • It eased the marriage tax penalty for two earner households, increased the deductibility of student loan interest; and,
  • It reduced the tax bite from death and gift taxes.

And these were just the major provisions

Now, unless Washington comes together to extend the Bush tax cuts, we will experience the impact of higher tax rates in the New Year. The good news is that our elected officials in Washington have been talking about extending the expiration date; the bad news is that it remains uncertain whether they will be able agree to extend them for all or a portion of the population - if at all. The rules are not close to being set and there remains a divide in the debate. If grid-lock prevails, well all be paying higher taxes in 2011.

Because of this uncertainty, it makes year end tax planning rather difficult to do.

Yet there are things you can still consider while we wait for the drama to play out. 

Income Taxes

Whether the Bush tax cuts are extended, or not, homeowners contemplating making energy saving improvements before the end of this year can cut their 2010 tax bill as well as their winter heating bills. By spending as little as $5,000 before the end of the year on eligible energy-saving improvements, you may be able to save up to $1,500 (30% of the expenditure) on your 2010 tax return. But, if you've used up some of this credit on your 2009 return, your potential savings is limited to the amount left over. After 2010, the credit goes away and is unlikely to be extended.

When it comes to itemized deductions, a handful of them can be tended to at the last minute. If it looks like no agreement is going to be reached, you'll want to delay these deductions until next year. Otherwise, if they do agree to extend the tax cuts, be ready to make your payments before years end. Here are some common items:

  • Home Mortgage Interest: If the grace period on your mortgage allows you the ability to make your December payment in January penalty-free, then this will defer the interest deduction into 2011. Alternatively, if the tax cuts expire, then you'll want to consider making both December and January payments before years end.
  • Estimated State Income Tax Payments: The 4th quarter estimated payments for 2010 are generally due on January 15, 2011. If the cuts are not extended, pay in January; if the tax cuts are extended, send in your estimated tax payment before December 31st.
  • Charitable Contributions: The busiest time of the year for charities receiving donations often occurs during the last half of December. However, this year could be different. If the tax cuts aren't extended, many charitable donations might just be held back until January.

If you are considering making charitable contributions and have gains in your investment portfolio, you may want to consider donating appreciated stock instead of cash. By doing so, you can deduct the current market value of the investment without being taxed on the gain. But don't consider gifting an investment that is worth less than its cost, because you won't be able to deduct the loss if you gift it. Instead, sell the investment, capture the loss and send the cash.

Also, if you have household members in college, you may want to time when you make those tuition payments. If the tax cuts are extended, you should consider prepaying the tuition. Otherwise, pay next year when tax rates would be higher. 

Capital Gains and Dividends

When it comes to your investments, and Ive written about this before  never, ever, make your investment decisions based solely upon income tax considerations. As volatile as the markets have been the past several years, changes in investment values can exceed any related tax savings to be gained. However, if you're already inclined to make changes to your portfolio, then here are some things to consider.

First, know that long-term capital gains are taxed at a lower rate than short-term gains  even if the Bush tax cuts aren't extended. Gains are considered long-term only if you've owned (held) the investment for more than a year.

Stock market pundits are predicting that the market will go lower by years end due to last minute tax selling. Yet I think that any decline may be temporary if tax selling is the only reason for it. However, Im not so sure that significant year-end tax selling will occur. While its true that tax rates increasing anywhere from 3% to 5% would provide an incentive to sell, many investors have losses carrying over from prior years. And, the deductibility of a net capital loss is limited $3,000 per year with any remaining loss carried forward to future years. Before this year and last, didn't we just experience the worst market declines in our lifetimes? As a result, anyone with ample capital losses carrying forward wont gain much, if any, advantage by implementing such a tax saving strategy and, for them, there is no urgency to sell before years end. Yet, if you are inclined to accelerate your losses into this year to achieve a lower tax bill, be careful not to trigger the wash sale rules.

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

  • Buy substantially identical stock or securities,
  • Acquire substantially identical stock or securities in a fully taxable trade,
  • Acquire a contract or option to buy substantially identical stock or securities, or
  • Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
  • Also, if you sell stock and your spouse or a corporation you control buys substantially identical stock, you have a wash sale too.

While the wash sale rules were enacted to impact persons selling investments for the purpose of timing when to take a capital loss, I wouldn't be surprised to see the IRS take a more aggressive position about the timing of gains should we see higher rates on the horizon. Yet, any IRS challenge should easily be overcome as IRS Code 1091 is fairly specific that wash sales apply to the taking of losses.

When it comes to dividend income, the best to be hoped for is that the tax cuts are extended. For 2010, the maximum tax rate on qualified dividend income is 15%. If the tax cuts are left to expire, dividend income will be taxed at your highest marginal rate. Then, dividend income will become less attractive for those in the higher tax brackets. Yet, for those in the lower brackets, taxes on dividend income shouldn't lose much luster. In fact, these people might be able to find higher yielding opportunities if the higher tax bracket people stage a revolt.

Miscellaneous Tax Burdens

Perhaps the most concerning and least understood tax is the Alternative Minimum Tax (or AMT for short). The AMTs purpose is to ensure that anyone who benefits from too many allowable deductions, pays at least a minimum amount of tax. The AMT is a separately figured tax that eliminates most deductions plus many credits and recalculates your tax liability using a different set of rules. Basically, if your AMT income exceeds the exemption amount for your particular filing status, you will owe the greater of the amount calculated by the AMT or your regular tax.

Most people aren't aware of the AMT because, in the past, the exemption amount has been large enough to keep the average taxpayer from having to pay it. The Bush tax cuts had raised the exemption amount through the end of last year (2009). As a result, if Washington doesn't address the expired AMT exemption amount, it is estimated that roughly 32 million taxpayers will owe AMT this year versus 5 million last year. The good news is that it is widely thought that there will be an AMT fix before years end  even if everything else goes unsettled.

Planning to minimize the potential for getting hit by the AMT is fairly complex. Yet, its safe to say that this years recommendations share a common theme: accelerate income and delay deductible expenses if Washington can't agree on extending the tax cuts; otherwise, be prepared to do the opposite if they are extended for you. However, be aware, that if you follow a strategy to lock in significant capital gains to take advantage of this years lower rates, you could trigger the AMT and negate the tax savings altogether. Talking with you tax advisor before acting is the best advice.

Another topic that seems to have small business owners in an uproar relates to a change that was tucked away in the recent Health Care Reform Act. This stealth change alters the requirements for taxpayers having to issue 1099 forms. The new rules will require that businesses will have to issue millions of new tax documents each year.

Under the old rules, a business only had to issue 1099s to independent contractors who they paid $600 or more during the tax year. The new rules will require sending a 1099 to any person or business that was paid more than $600 each year. Can you imagine the added burden of tracking every vendor you purchased from and then having to send them a 1099? The good news is that this new rule doesn't go into effect until the beginning of 2012 and Washington may very well repeal it before taking effect.

The most challenging aspect of tax planning this year is not knowing what the 2011 tax landscape will look like until mid-December or later. Be prepared to act fast and be aware that bottlenecks are going to be part of the experience as everyone will be trying to get things done in the last few days of the year also.

ELFs Outlook and Performance

Markets continued rallying through October at a much more modest pace than in September, yet, they still registered impressive gains. The Fed's money printing scheme has fueled the markets and the markets are adding fuel to the economy  once again. By most measures, U.S. economic growth is regaining positive momentum and employment data has begun to surprise analysts to the upside also. Job creation remains lackluster but Non-Farm payrolls expanded in October by more than 150,000 net new jobs versus the 60,000 consensus expectation.

More recent, however, worries about a debt crisis in Ireland and Chinas efforts to slow their growth has scared the markets into giving up all of Novembers gains and began to take back some of Octobers rise as well. I hope we do not revisit what was experienced last May, June and August. We started the first four months of this year with great momentum in the economy. Then, worries of a Greek debt default and over spending practices in Government crashed the markets and substantially slowed the pace of our Great Recession recovery.

European debt challenges look to be an ongoing saga that may continually threaten to derail a global recovery. Yet, a tragic outcome is not certain. The situation should abate with an improving global recovery. As for Chinas actions, I have to agree with an argument provided me by Liam Molloy over at Galway Investment Strategy. His view is that when commodity prices have grown too fast, the Chinese signal that that they are taking steps to reduce demand in their economy. Once prices drop to a satisfactory level, they resume buying again. Liam commented that the Chinese Government published this strategy for sourcing raw materials in 1954 and have been following it ever since.

During the rally from late August through mid October, we slowly sold into it and raised our cash levels near 70% of portfolio assets. Now as the markets are taking a breather, and have fallen back some, were slowly putting cash to work with an updated buying list. Over the next twelve months, we are pretty bullish. Yet, uncertainty over some form of European debt crisis could make it a choppy experience along the way.

As mentioned last month, our cash raising activities would have us underperform against the markets to the upside and it did. Our portfolio clients ended the month of October up 1.02%. Here are some comparative numbers for you to review:


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