OCEAN CITY – Tax considerations are about to play a much more central role in many people’s thinking as they’re making critical financial decisions. At the end of 2010, several cornerstones of the federal tax legislation of 2001 and 2003 —specifically, those reducing tax rates on income, capital gains and dividends — are set to expire. Meanwhile, with U.S. government debt soaring as the result of stimulus spending to rescue the economy, many economists believe there’s a good chance that tax rates could rise, perhaps even before your 2009 filing.
"We might see changes in the tax rates before the end of this year," says Vinay Navani, a CPA with Wilkin & Guttenplan, an accounting firm in New Jersey. Under current rules, taxpayers must pay a top rate of 35% on income greater than $372,950. Navani thinks that rate could rise and would not be surprised if a new, higher bracket for annual incomes — perhaps exceeding $500,000 or so — were implemented.
You might want to give some thought to these four ways of potentially maximizing tax efficiency, for next April and beyond.
1. Accelerate income; postpone deductions. Traditionally, the sensible move for most taxpayers has been to take deductions as soon as possible while seeking to delay some taxable income till the following year. However, you may want to consider reversing that formula, accelerating income into 2009 so that it may be taxed at lower rates.
2. Take capital gains now. This may also be a good time to rethink your strategy regarding capital gains. The current maximum rate on long-term gains is 15%, but it could soon rise. You might therefore decide to sell an appreciated asset this year in order to secure the current low rate.
3. Maximize retirement-plan contributions. You should also consider your retirement accounts in any assessment of your tax strategy. When rates rise, tax-deductible contributions and tax-deferred investment growth can become more valuable. But although it’s true that tax deductions will be worth even more if tax rates move higher, there’s no need to postpone them; it still makes sense to continue making the maximum retirement-plan contribution each year.
4. Consider a Roth IRA conversion. Starting in 2010, the IRS is lifting the income restriction on conversions from traditional IRAs and eligible employer-sponsored retirement plan assets to Roths. You’ll owe income tax on the value of the assets in the conversion, less any nondeductible contributions you made to the plan. But the taxes will be lower now if your traditional IRA has been hit by market losses, as most have. And taxpayers who convert to a Roth in 2010 will be able to spread their tax liability for the conversion over the following two years.
What makes these year-end retirement account strategies even more potentially attractive is that they may provide benefits even if tax rates don’t rise anytime soon. And a well-funded retirement plan — along with the possible conversion to a Roth IRA — is likely to prove to be a sound investment for decades to come, whichever way the tax winds blow.
With your consent, your financial advisor can work closely with your tax professional to determine whether these strategies can be helpful to you. Their relationship is bound to become more critical than ever in a tax climate that may well increase in complexity over the next several years.
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)