Year-End Tax Planning is Different This Year

Year-end tax planning will be unique and tricky this year. The usual year-end strategies are complicated by the potential for significant tax increases over the next couple of years and the lack of details we have today. In addition, the incentive to convert traditional IRAs into Roth IRAs in 2010 provides a fresh wrinkle, which is discussed in previous posts. Yet, the right moves in the next few months could save you a lot of money. It is worth the time to begin year-end planning now.

The key to year-end tax planning is to try to examine at least two years together. This allows you to reduce total taxes. Otherwise, if you look at one year at a time you are likely to simply shift the tax bill from one year to another, or even to inadvertently raise the bill one year by reducing it in another year. So, consider this year and next year together. That won't be easy, because of the lack of detail about those likely future tax increases. Yet, we can make reasonable assumptions.

Year-end tax planning involves four broad, basic strategies. Income can be accelerated into the current year or deferred into next year. Likewise, deductions can be accelerated into this year or deferred into next year. These are the basic rules:

* If you think your tax rate is likely to rise next year, you want to accelerate income into this year and defer deductions into next year.

* If you think tax rates might decline, defer income to next year and accelerate deductions into this year.

* If you think deductions might be restricted next year, accelerate some deductible expenses into this year.

* If you think deductions might be increased next year, defer until next year some expenses that might be deductible.

There are other situations when you might want to shift income or deductions. A minority of taxpayers itemize deductions these days. The rest use the standard deduction, because their total itemized deductions are less than the standard. Careful shifting of deductions can allow you to itemize deductions every other year and reduce overall taxes. The standard deduction for 2009 is $11,400 for married filing jointly and $5,700 for single taxpayers. It is increased each year for inflation, with the next year's amounts usually announced in December. You can use the 2009 number for planning.

Here are some ways to move deductions to qualify for itemizing.

State and local taxes, whether income taxes or property taxes, generally are itemized deductions. You might be able to mail a Jan. 2010 payment in late Dec. 2009, or hold a Dec. 2009 payment until Jan. 2010. If you have a mortgage, doing the same with monthly payments can shift a month's interest payments from one year to another, giving you 13 months of interest deductions in one year. Charitable gifts generally are flexible payments. You can bunch more of them in one year to increase itemized deductions.

Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income, and only if deductions are itemized. Few people have enough medical expenses to deduct them. You might be able to make them deductible by incurring elective medical expenses in one year instead of spreading them over two.

Remember, the provision for making charitable contributions from an IRA was extended through the end of 2009. Normally when a charitable contribution is made from an IRA it is treated as a distribution and included in gross income. You receive a charitable contribution deduction if you itemize expenses. But in 2009 those age 70½ or older can have charitable contributions made directly by their IRA custodians to a charity. There is no deduction for the contribution, but it also is not treated as a distribution and not included in gross income. This contribution is limited to $100,000 annually.

In addition to the regular income tax, you need to pay attention to the alternative minimum tax (AMT). More and more middle income Americans, especially retirees, are falling under this second tax system originally intended for the wealthy. You compute taxes under both the regular system and the AMT, and pay the higher tax. High itemized deductions (other than charitable contributions) and personal exemptions can trigger the AMT. Large capital gains also trigger the AMT. New retirees frequently fall under the AMT because their incomes decline while their itemized deductions remain the same.

When estimating your regular income tax for the year, also estimate the AMT. Then, before making any changes in income or deductions to reduce the regular income tax see how they would change the AMT.

Home improvements are a special consideration this year, because Congress enacted additional tax credits for many energy-efficient improvements for 2009 and 2010. The credits can be substantial, but the qualifying improvements also can be expensive. You have to decide if the credits plus potential energy savings are worth the additional cost of the qualifying improvements. Check the IRS web site at for updates and details about the available credits and how to qualify for them.

Don't forget to check your tax prepayments. They are likely to be off this year for more taxpayers because of the new withholding tables under the Making Work Pay tax credit from the stimulus law. If your estimated tax payments and withholding are not high enough, increase payments. Even better, if you receive wages, IRA distributions, annuity payments, or other payments from which you can ask for withholding, have the additional taxes withheld. You are more likely to avoid penalties by increasing withholding than by increasing your last estimated tax payment or two.

Income can be deferred or accelerated by changing distributions from IRAs and annuities and timing sales of investment assets. Of course, if you still are working you might be able to work with your employer on the timing of bonuses and raises.

Taxpayers age 70½ and over do not have to worry about taking required minimum distributions from IRAs and other qualified retirement plans for 2009. But unless Congress changes the law this fall, RMDs will be restored in 2010. You might consider taking some distribution from the IRA this year to reduce next year's RMD, especially if this year will have a lower tax rate or higher deductions than next year. Taking a distribution in 2009 will reduce 2010’s RMD, because RMDs are based on the IRA’s value of Dec. 31 of the previous year. So reducing the Dec. 31, 2009 IRA balance reduces the 2010 RMD.

Take a look at your investment portfolio. If you were fortunate enough to buy stocks or other risky investments near their lows in March through a taxable account, you have sizeable gains now. Be careful about when to cash in those gains. If you sell them before owning them more than one year, the gains are short-term and taxed as ordinary income, with a top rate of 35%. You can save a lot of money by waiting for the one year period to pass and take them as long-term capital gains, if the gains hold up long enough.

If you still have losses from the bear market, continue pruning them to save taxes. Capital losses offset gains dollar for dollar. Up to $3,000 of any additional losses can be deducted against other income. Unused losses can be carried forward indefinitely to future years until used.

You can sell an investment to take a deductible loss, and then later buy back the investment. With stocks, bonds, mutual funds, and other securities you need to wait more than 30 days before re-buying the same or a substantially identical investment. If you don't wait long enough, the loss can’t be deducted for this year but is added to the basis of the new investment.

Consider making charitable contributions with your securities instead of cash, but do it the right way. You deduct the fair market value of long-term capital gains property that is contributed to charity. Give such long-term capital gains property. You won't any owe any taxes on the gain and can deduct the full market value. If your securities are showing a loss, sell them, deduct the loss, and give the cash proceeds.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 10-09-2009 11:24 AM by Bob Carlson