The stock market implosion fried your retirement nest egg, your house is now worth less than the mortgage securing it, you're holding on to your job by a slowly unraveling string, and now you're facing the biggest tax increases in the history of the U.S. Tax Code. No wonder more retirees are filing for bankruptcy.
Unless Congress acts soon, the Bush tax cuts created by the Economic Growth and Tax Reconciliation Act of 2001 will expire at the end of 2010. Here's what's at stake, what I expect to happen and how I suggest you plan for the changes:
Estate taxA properly drafted will would have sheltered $7 million for a married couple from the Internal Revenue Service in 2009. We had an estate tax with a $3.5 million exclusion.
This year, there is no estate tax -- we have an unlimited exclusion. George Steinbrenner, the principal owner of the New York Yankees, picked the right time to die. His family saved a federal estate tax of more than $500 million.
Nobody wants an estate tax with only a $1 million exclusion. The Democrats are fighting for a $3.5 million exclusion with a top 45% rate; the Republicans demand a $5 million exclusion with a top 35% rate. They've been arguing this issue for more than two years now with no resolution.
Sen. Olympia Snowe, R-Maine, hit the nail on the head when she said: "It's all political theater. It's not about legislating anymore. It's all for the election coming very shortly."
After the November election, there should be a compromise. I expect the maximum rate to phase downward from 45% to 35%. I also predict an exclusion of $3.5 million for 2010 and 2011, phasing up to $5 million with a return to full step-up in basis. I suspect the law to be retroactive for 2010, but the estates of those dying before passage could follow the current zero-estate-tax rules.
Investment and income taxesHere's where the issues become really dicey. Hefty increases in income taxes and marginal rates would turn normal tax planning on its head. Unless Congress acts, this is what will happen to tax brackets and capital gains:
- The 10% bracket for low earners will disappear, and those dollars will be taxed at 15%. That's a 50% increase in tax on those dollars for everyone, including those least able to afford it.
- The top marginal bracket will go from 35% to 39.6%. That's an increase of more than 13%.
- The maximum marginal rate on long-term capital gains will go from 15% to 20%. That's an increase of 33%. The zero tax rate for those in the 15% bracket or lower will disappear.
- The maximum rate on qualified dividends will jump from 15% to 39.6%. That's an increase of 164%.
Do you expect these increases to go into effect? Rather than accelerate deductions and defer income, you'd defer deductions until next year, when they will be worth more, and accelerate income into this year, so that it will be taxed at a lower rate.
Recognize capital gains now at a lower rate, even if you turn around and repurchase the same securities immediately. The wash-sale rules apply only to losses, not gains. From a tax perspective only, dump your dividend stock in exchange for appreciating securities. Trading dividend-yielding investments taxed at as much as 39.6% for investments producing capital gains with a top tax rate of 20% would be more than prudent, again purely on a tax basis.
Phaseouts by incomeCongress is not known for its transparency. Rather than raising your taxes directly, it chooses to hide the increase by decreasing your deductions. As your income increases above certain floor levels, both your deduction for personal exemptions and the total of your itemized deductions are reduced. The expiring Bush tax cuts phased out these exemption/deduction slicers. They're scheduled to return Jan. 1.
This is nothing more than a 3% to 5% increase in your marginal tax. Again, if rates are going up and deductions going down, the new planning paradigm would be to accelerate income into 2010 rather than 2011.
Child creditThe child tax credit is now $1,000 for each dependent child under age 17.
That's a $1,000 reduction in your tax. Without congressional action, it may fall 50% to $500 for 2011.
Education savings accountsContributions to Coverdell Education Accounts (what used to be called Educational IRAs) are capped at $2,000 a year. If spent for appropriate educational purposes, the earnings on these accounts are tax-free. If the Bush cuts expire, the limit falls back to $500 per year.
If you invested $2,000 a year at 7% into a Coverdell Education Account for 18 years, you would have $38,758 in tax-free income and a total account valued at $74,758. At $500 a year, the tax-free income would drop to $9,690, with a total account value of $18,690.
Deductions that will be renewed -- againThis is where Congress really plays politics. That's from the Greek, "poly" meaning many and "ticks" meaning bloodsuckers.
We have a whole lot of tax provisions that are scheduled to expire but that are typically renewed each December. They include:
- The $250 deduction for teachers' supplies.
- The itemized deduction for sales taxes.
- The tuition deduction.
- The fix to the alternative minimum tax.
- Extension of research and development credits.
By waiting until the end of the year, Congress shamefully makes planning a "will they or won't they" game. It also causes costly IRS confusion and frustration. That's because it's hard to design and print tax forms for January distribution if the laws keep changing at the end of December.
Congress will renew the extenders. But, as many have pointed out, it's difficult to plan when you don't know the rules until the last month in the game, especially when those rules change each year. How can an employer make a decision to hire additional employees when the employer doesn't know what the cost will be (health reform, anybody?) or even what the tax implications will be?
If "con" is the opposite of "pro," is Congress the opposite of progress? Think about that when you go into the voting booth next week.
Published Oct. 28, 2010