Higher Taxes Are Likely, But Perhaps Not for Everyone

Many of the tax cuts passed during the George W. Bush administration are due to expire after 2010. Although some of them may be extended to future years, high income taxpayers may face higher rates starting in 2011. If you will be affected by higher tax rates, some planning can help you trim your tax bill.

Now and then
Under current law, there are six rates for federal income tax: 10%, 15%, 25%, 28%, 33%, and 35%. As your income increases, higher rates apply to your taxable income.
Special rates apply to long-term capital gains (profits on assets held for more than one year) and qualified dividends (most dividends received by investors). The maximum tax on both types of income is now 15%, although some long-term gains on collectibles such as works of art and rare coins are taxed at 28%. A 25% rate may also apply to any previously-taken depreciations on the sale of long-term assets. Taxpayers in the 10% and 15% tax brackets owe 0% tax on most long-term gains and qualified dividends. If Congress does not pass legislation this year, many people will face higher tax rates on ordinary income, qualified dividends, and long-term capital gains received in 2011. President Obama’s budget proposal calls for increasing the 33% tax rate to 36% and the top federal income tax rate from 35% to 39.6%.

Under the President’s proposal, these higher rates would affect single taxpayers with taxable income of more than $200,000 “less the standard deduction and one personal exemption, indexed for inflation.” The exact number under this formula probably would be around $190,000. Similarly, the higher tax rates would affect married couples filing joint returns if their taxable income were higher than approximately $230,000.

These numbers are for taxable income. Therefore, it’s possible that even if your gross income were $200,000 or more ($250,000 or more on a joint return), you’d still only be in the third highest federal tax bracket—28%—under this proposal.

The Obama administration suggests a similar approach to qualified dividends and long-term capital gains. Most taxpayers would continue to pay tax at 15% or 0%; however, those taxpayers with incomes in the proposed 36% or 39.6% tax brackets would owe 20% on qualified dividends and long-term capital gains.

Forecasting the future
Congress might not pass any tax law at all this year. And if it does pass a law, the new rules may not follow the administration’s proposal. However, many observers believe that Congress will pass a tax increase to reduce the projected federal budget deficit. Such a tax increase probably will fall largely on high income families and individuals.

If you are likely to be affected, some broad principles can assist you in your tax planning. For example, beginning next year, you probably will owe more tax on all types of income. Therefore, you may want to increase your use of tax-advantaged vehicles, including employer sponsored retirement plans, tax-exempt municipal bonds, and 529 college savings plans. Our office can help you weigh the tax consequences of various choices for savings and investments.

You also may want to consider converting some or all of your traditional IRAs to Roth IRAs. You can pay tax on the conversion at 2010 rates. Five years after opening the account or at age 59½, which ever comes later, all withdrawals from your Roth IRA will be tax free, even if tax rates are much higher by then. For more information on the benefits of converting your traditional IRA to a Roth IRA, see the article “Good Reasons for Roth IRA Conversions” in the February 2010 issue of CPA Client Bulletin.

Assuming some variation of President Obama’s plan becomes law, the gap between high income taxpayers and other taxpayers will increase in future years. This will make income shifting strategies more valuable.

If you plan to sell appreciated assets, for example, you might first transfer them to your parents if they are in a lower tax bracket. They may be able to sell those assets and owe less tax than you would owe on a sale. If passage is likely, our office can go over the details with you and develop suitable strategies.