2010 Q4 | Year-End Tax Planning for Mutual Funds

If you invest in mutual funds, proceed cautiously at year-end. At this time of year, funds may distribute any net capital gains for 2010 to their shareholders. These distributions are taxable to investors (unless the fund is held in a tax-favored retirement account), and the share price typically drops to reflect the distribution.

Example 1: Caitlin Carter invests $10,000 in Mutual Fund ABC in early December 2010. She acquires 500 shares at $20 apiece. One week later, ABC makes a $2-pershare capital gain distribution, and the share price drops to $18. Caitlin owes tax on a $1,000 capital gain distribution ($2 per share x 500 shares)-even though the distribution is essentially a return of her own money. Therefore, if you are going to invest in a mutual fund between now and December 31,2010, you may be better off waiting until after any distribution. You might be able to avoid this tax trap and buy at the post distribution reduced trading price. Check the fund’s website for information about capital gain distributions; if the fund won’t distribute capital gains because of bear market losses, you can buy at a time of your choosing.

If you are thinking of selling mutual fund shares, on the other hand, you may decide to advance your plans if you learn that your fund will make a capital gain distribution.

Example 2: Steve Davis invested $10,000 in Mutual Fund XYZ many years ago. He now owns 700 shares of the fund, trading at $25, for a total of $17,500. Steve wishes to take his gains in 2010 while the maximum tax rate on long-term gains is 15%. On the XYZ website, Steve sees that a $3 per share distribution is planned for December 15,2010. The fund estimates that $2.50 per share of that distribution will be in the form of short-term capital gains from last winter’s rally. Thus, if Steve holds onto his shares, he will receive a distribution of $2,100 ($3 x 700 shares), most of which will be taxed in his 28% ordinary income tax bracket as short-term capital gains.

Instead, Steve sells before XYZ’s distribution. With a $10,000 cost basis and a $17,500 selling price, Steve will have a $7,500 long-term gain, all of which will be taxed at only 15%.

2010 Q4 | Year-End Tax Planning for IRAs

Through 2009, you could convert a traditional IRA to a Roth IRA only if your modified adjusted gross income (for the year was no greater than $100,000 on a single or joint tax return. The $100,000 cap came off in January 2010. Under current law, this change is permanent. Therefore, high-income taxpayers can convert traditional IRAs to Roth IRAs in 2010, 2011, 2012, and so on. For taxpayers who would like to convert their traditional IRA to a Roth IRA, year-end 2010 presents multiple opportunities.

Example 1: Wendy Ames has $200,000 in her traditional IRA that contains only pretax dollars. Wendy would like to invest in a Roth IRA because these accounts may permit tax-free withdrawals in the future, and Roth IRA owners don’t have to take required distributions. Also, if she wishes, Wendy can leave her Roth IRA intact for her beneficiaries, who will have to take scheduled distributions but will owe no tax as long as the account is at least five years old.

Crafting a conversion

If Wendy is debating whether to convert her traditional IRA to a Roth IRA in 2010 or wait until 2011 or later, a 2010 conversion offers several advantages:

  1. Lower taxes. Although Wendy will owe tax on the amount she converts, in this example, her traditional IRA has a much lower value now than it did in 2007 because of stock market declines. Therefore, a Roth IRA conversion now would generate a lower tax obligation than it would have created three years ago.
  2. Lower tax rates. A 2010 conversion also will lock in this year’s income tax rates, which might be higher in the future.
  3. Faster tax-free withdrawals. Roth IRA withdrawals are tax-free after five years and after age 59 1/2. By converting in late 2010, Wendy will start the five year clock for tax-free withdrawals at January 1, 2010.
  4. Future flexibility. Taxpayers who convert to a Roth IRA in 2010 have a unique choice. In this example, Wendy can report the taxable income from her 2010 Roth IRA conversion on her 2010 tax return. Or she can take advantage of a special rule for 2010 conversions and report half of the income on her 2011 tax return and the remaining half on her 2012 return, thus obtaining a period of tax deferral.
  5. Surtax relief. Starting in 2013, some high-income taxpayers will owe a 3.8% surtax on investment income. (See the third quarter 2010 issue of the CPA Client Tax Letter for further details.) If Wendy converts her traditional IRA to a Roth IRA, she will not have to make required minimum distributions in the future, and she may reduce her taxable portfolio to pay the income tax on her Roth IRA conversion. Consequently, Wendy might have lower gross income and lower taxable investment income in future years, which could reduce her exposure to the 3.8% surtax. Wendy can gain thi: advantage with a Roth IRA conversion in 2011 or 2012 as well, but a 2010 conversion also will provide the other advantages on this list.

Taking action

Some taxpayers may choose to convert by year-end 2010 because they will have a chance to reverse their conversion. All Roth IRA conversions can be recharacterized by October 15 of the following year (October 17 in 2011); the account would revert to a traditional IRA, and the taxpayer would receive a refund of any tax paid on the conversion.

Example 2: Tim Bradley decides to convert his $100,000 traditional IRA to a Roth IRA in late 2010 to take advantage of a low IRA balance and today’s relatively low tax rates. He pays the tax on $100,000 of income with his 2011 tax return. In October 2011, Tim sees that his Roth IRA is worth $125,000. He decides to leave his Roth IRA in place, with $25,000 of tax-free growth in the account.

Example 3: Assume the same facts as in example 2, except that Tim’s Roth IRA has declined to $80,000 by October 2011. He recharacterizes the account to a traditional IRA and files an amended tax return for a refund. After waiting at least 31 days, Tim can reconvert this traditional IRA to a Roth IRA. If the account value has not changed materially in the interim, Tim will owe less tax on this Roth IRA conversion than he owed on his 2010 conversion.

Taxpayers who are considering a Roth IRA conversion in the last quarter of 2010 should take the following steps:

  • First, evaluate the benefits of converting your traditional IRA to a Roth IRA. If you are concerned that upper income individuals and couples will a much higher taxes in the future, you may want to convert your tax-deferred traditional IRA to a tax-free Roth IRA.
  • Second, if you would like to have a Roth IRA, decide how much you are willing to convert. If you do a partial conversion, you will reduce your tax obligation.
  • Finally, if you decide to convert your traditional IRA to a Roth IRA and you have determined how much you’d like to convert, notify the custodian of your traditional IRA in advance. There may be a rush to convert to Roth IRAs at the end of2010 as many taxpayers seek to take advantage of the benefits mentioned previously.

By notifying your IRA custodian in advance about your plans, you may be able to get your paperwork ready for a Roth IRA conversion in late 2010. If you or a loved one face a similar decision, our office can help you make an IRA plan that’s appropriate for your specific circumstances.

2010 Q4 | Year-End Tax Planning for Itemized Deductions

When you fill out your tax return for 2010, you’ll have to choose whether to itemize deductions or claim a standard deduction. If you itemize, you’ll deduct certain amounts you spent this year on charitable donations, mortgage interest, and so on. You may, instead, claim a standard deduction. For 2010, the standard deduction is $11,400 for married couples filing a joint return; 5,700 for singles and married individuals filing separately; and $8,400 for heads of household. Taxpayers who are over age 65 receive an additional standard deduction: $1,400 for single taxpayers and $1,100 apiece for married taxpayers in 2010. Similar deductions are available to the blind. If you qualify on both counts, you’ll get two deductions.

Possible tax break

For 2010, you may need to consider another possibility when you decide whether to itemize or take the standard deduction. In previous years, homeowners could deduct up to $500 of property tax paid, in addition to their standard deduction (married couples could deduct up to $1,000). This tax break expired afrer 2009, but Congress is considering a bill to extend it into 2010, as of this writing. Regardless of how Congress acts on this issue, if you itemize deductions instead of taking the standard deduction, you generally can deduct all the property tax you pay.

Making the choice

As year-end nears, you can determine whether you will be better off itemizing or taking the standard deduction this year. If you think you’ll take the standard deduction, you may want to defer itemized deductions until 2011, when you might get a tax benefit. Example 1:Wallace and Diane Franklin are both 66 years old. They own their home without a mortgage and pay $2,000 per year in property tax. The Franklins expect to pay around $4,000 in state income tax this year. They have not had significant unreimbursed medical expenses. So far this year, they have not made substantial charitable contributions. If the Franklins decide to take the standard deduction, their total will be either $13,600 or $14,600, depending on whether the real estate property tax break has been extended.

Standard deduction for all couples filing jointly $11,400

Additional deduction for married people 65 and older $2,200

Special property tax deduction (if available) $1,000

Total $14,600

      If the Franklins decide to itemize, their deductions would include only $4,000 in state income tax and $2,000 in property tax‑$6,000 total. Thus, in this example, they would be much better off taking the standard deduction. Therefore, the Franklins probably should delay their usual year-end charitable contributions until January 2011 because they might save tax in 2011 by itemizing deductions. In contrast, taxpayers whose itemized deductions clearly will top the standard deduction amount generally should incur itemized deductions, such as charitable contributions, in 2010. Some taxpayers who owe the alternative minimum tax (AMT) will save tax by itemizing, even if their standard deduction exceeds their itemized deductions. Our office can help you decide.

Healthier deductions

You can take steps to increase your deductions for 2010, if you decide to itemize rather than take the standard deduction. For instance, you can figure out whether you are likely to deduct medical costs this year. You can deduct such costs only to the extent they exceed 7.5% of your adjusted gross income (AGI). Example 2:Melody Neale expects her AGI this year to be around $100,000. Thus, she’ll be able to deduct health care expenses over $7,500: 7.5% of$100,000. When Melody tallies her medical outlays for the year, she finds she already has spent $10,000, so she is over the threshold. She can go to the dentist, get doctors’ checkups, buy prescription eyeglasses, and so on before December 31 and pay those bills with tax-deductible dollars. On the other hand, suppose Melody’s health care expenses are only $4,000 for the year, through November. She can decide to postpone all elective medical procedures until 2011, when they might lead to tax deductions.

Make the most of miscellany

You should approach miscellaneous itemized deductions in the same manner. Such deductions include outlays for tax preparation, unreimbursed employee business expenses, investment expenses, Roth IRA losses, and 529 college savings plan losses. You add up all of those items and take deductions to the extent they exceed 2% of your AGI. Example 3: Gary Roberts expects his AGI this year to be around $150,000. Therefore, he’ll be able to deduct miscellaneous itemized deductions over $3,000: 2% of $150,000. As of early December, Gary finds that his miscellaneous deductions for 2010 are already at $4,000; thus, further expenses will be deductible. Before year-end, he can pay for investment publications and software with tax-deductible dollars. If Gary closes out his sole Roth IRA and sole 529 account for losses this year, those losses also will be deductible on his 2010 tax return. On the other hand, if Gary has only a few hundred dollars in miscellaneous costs in 2010, he may decide to incur additional miscellaneous costs in 2011, when they might be more valuable. Your strategies for itemized deductions will be different if you are subject to the AMT. Increasingly, moderate and upper income taxpayers owe the AMT in addition to regular tax; our office can tell you if you will pay the AMT this year. Taxpayers who are subject to the AMT can deduct medical costs only to the extent those costs exceed 10% of AGI, rather than 7.5% of AGI. Therefore, your decision on whether to incur elective medical bills by year-end will be based on whether they’ll be greater than 10% of your AGI, not 7.5%. If you are subject to the AMT, you won’t be able to take miscellaneous itemized deductions, no matter how much you spend. Therefore, if you will owe the AMT this year, you shouldn’t close out Roth IRAs or 529 college savings plans at a loss because you won’t get any tax benefit. Instead, wait until next year to see if those tax-favored accounts recover-or if you’ll escape the AMT in 2011 and perhaps be able to deduct miscellaneous expenses. Just as you can’t take miscellaneous itemized deductions for AMT purposes, you-also can’t -deduct state and local tax payments. Taxpayers who itemize deductions may decide to prepay in 2010 any property tax or state and local income tax due in early 2011 to get a current deduction. However, if you will owe the AMT in 2010, you might as well wait until those tax payments are due in early 2011 because you might be able to deduct them on your 2011 return.

2010 Year-End

As we approach the close of 2010, there is still time to take steps that can reduce your 2010 tax bill. Year-end tax planning is more complicated this year due to: ongoing uncertainties regarding tax rates for 2011; questions as to when and if many popular tax breaks that expired last year will be extended; and short windows of opportunity to take advantage of recently-enacted tax breaks that are scheduled to expire after 2010. As we complete this letter, there is no assurance that Congress will resolve these issues by the end of this year. However, regardless of how and when these uncertainties are addressed, there are many “tried and true” year-end tax savings steps that you should consider for 2010, no matter what action Congress ultimately takes. Moreover, Congress has passed several tax bills this year that offer new tax breaks to individuals, many of which are temporary, and some that are available in 2010 only!

We are sending you this letter to remind you of the traditional year-end tax planning strategies that 1) help ensure your income is taxed at lower rates, and 2) will, in some cases, postpone taxes by deferring your taxable income and accelerating your deductions (so long as deferring income does not expose you to a significantly higher tax bracket in later years). This letter will also help you navigate through the many new tax planning opportunities available to individuals under recent law changes. Caution! Since many recently enacted tax breaks expire after 2010 (and others after 2011), it is extremely important that you be proactive and act timely to obtain maximum benefits! Tax Tip. Even though the recent recession has caused many individuals to experience a significant drop in income for 2010, this drop in income may actually produce additional tax benefits. If your income is down for 2010 as compared to recent years, you may be eligible for deductions and credits that you did not get in previous years because your income exceeded the phase-out thresholds. So, pay close attention to the income thresholds for the various deductions and credits discussed in this letter, which we highlight prominently in each section.

Planning Alert! Tax planning strategies suggested in this letter may subject you to an unexpected alternative minimum tax (AMT). For example, many deductions are not allowed for AMT purposes, such as: personal exemptions, certain standard deductions, state and local income taxes, and real estate taxes. Also, AMT can be triggered by taking large capital gains or exercising incentive stock options. Therefore, we suggest that you call our firm before implementing any tax planning technique discussed in this letter. You cannot properly evaluate a particular planning strategy without calculating your overall tax with and without that strategy. Please Note! This letter contains ideas for Federal income tax planning only. State income tax issues are not addressed.

Sincerely,

Matthew B. Hitt, CPA

2009 Year-End for the Business Owner

Dear Client:

As the end of 2009 approaches, it’s time to evaluate year-end tax planning for corporations and other businesses. Over the past year, Congress, the IRS, and the courts have flooded us with significant tax developments. These changes make year-end tax planning for 2009 exceedingly important! Most recently, Congress passed the American Recovery and Reinvestment Tax Act of 2009, which includes corporate and business tax benefits that: provide a longer carryback period for 2008 Net Operating Losses; expand the Work Opportunity Tax Credit for hiring certain disadvantaged employees; extend through 2009 accelerated business asset write-offs including the higher $250,000 §179 deduction, the 50% bonus depreciation, and a 15-year (instead of 39-year) write-off of certain leasehold improvements, restaurant properties, and retail properties; offer a new income deferral election for businesses that experience cancellation of debt income; and temporarily shorten the time (from 10 years to 7 years) that an “S” corporation which used to be a regular C corporation is exposed to the corporate built-in gains tax.

We are sending you this letter to bring you up-to-date on these and other new tax planning opportunities for corporate and non-corporate businesses. Caution! Several of the most significant new tax breaks expire in 2009 (and others in 2010). Therefore, it is extremely important that you be proactive and act timely to obtain maximum benefits! This letter also contains traditional year-end tax planning strategies 1) to help ensure that your business income is taxed at the lowest possible rate, and 2) to postpone taxes by deferring taxable income and accelerating deductions.

Planning Alert! Although this letter contains many planning ideas, you cannot properly evaluate a particular planning strategy without calculating the overall tax liability (including the alternative minimum tax) with and without the strategy. In addition, this letter contains ideas for Federal income tax planning only. You should also consider any state income tax consequences of a particular planning strategy. We recommend that you call our firm before implementing any tax planning technique discussed in this letter, or if you need more information.

Sincerely,

Matthew B. Hitt, CPA

2009 Year-End for the Individual

Dear Client:

Once again, it’s time for year-end tax planning. Over the past year, Congress, the IRS, and the courts have flooded us with significant tax developments. The White House has also warned of imminent tax increases, particularly for higher income taxpayers. Collectively, these changes make year-end tax planning for 2009 more important than for any year in recent history! Most recently, Congress passed the American Recovery and Reinvestment Tax Act of 2009, which includes the following individual tax benefits: an increased refundable first-time home buyer’s credit of up to $8,000 (which expires after November 30, 2009, unless extended by Congress); estimated tax payment relief for certain individuals owning small businesses; a deduction for sales tax on the purchase of new vehicles; an increased and partially refundable tuition tax credit (up to $2,500); a refundable income tax credit to offset payroll taxes of low and middle income individuals; a significant expansion of various credits for energy-efficient home improvements; and alternative minimum tax (AMT) relief. As expected, many taxpayers have been scrambling to keep up with all of these important, and often temporary, tax changes.

We are sending you this letter to help you navigate through the many new tax planning opportunities available to individuals under these new provisions. We also want to remind you of the traditional year-end tax planning strategies that 1) help ensure your income is taxed at the lowest possible rate, and 2) will postpone taxes by deferring your taxable income and accelerating your deductions. Caution! Several of the most significant new tax breaks expire in 2009 (and others in 2010). So, it is extremely important that you be proactive and act timely to obtain maximum benefits! Tax Tip. Even though the recent recession has caused many individuals to experience a significant drop in income for 2009, this drop in income may actually produce additional tax benefits. If your income is down for 2009, you may be eligible for deductions and credits that you did not get in previous years because your income exceeded the phase-out thresholds. So, you should pay close attention to the income thresholds for the various deductions and credits discussed in this letter. With informed year-end planning, you may now qualify for tax breaks that were not available in the past because of your higher income.

Planning Alert! Tax planning strategies suggested in this letter may subject you to an unexpected alternative minimum tax (AMT). For example, many deductions are not allowed for AMT purposes, such as: personal exemptions, certain standard deductions, state and local income taxes, and real estate taxes. Also, AMT can be triggered by taking large capital gains or exercising incentive stock options. Therefore, we suggest that you call our firm before implementing any tax planning technique discussed in this letter. You cannot properly evaluate a particular planning strategy without calculating your overall tax with and without that strategy. Please Note! This letter contains ideas for Federal income tax planning only. State income tax issues are not addressed.

Sincerely,

Matthew B. Hitt, CPA