Spring Means Taxes and Spring 2010 Means Taxplanning

It is spring and that means spring cleaning, spring planting, and ... taxes.  While preparing one's taxes is one of the spring tasks we love to hate, tax planning this year is significantly more difficult and potentially important than ever. The legislators in Washington and Lansing are all busy trying to find ways to raise more money.  One simple way to do that, especially given the apparent difficulty of passing legislation, is to let prior tax laws with sunset provisions expire.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Pub.L. 107-16, 115 Stat. 38, June 7, 2001), made significant changes in more than a few areas of the U.S. Internal Revenue Code, including income tax rates, estate and gift tax exclusions, and qualified and retirement plan rules.

In general, the act lowered tax rates and simplified retirement and qualified plan rules such as for IRAs, 401(k) plans, 403(b), and pension plans.

All the 2001 tax cuts are set to expire at the end of 2010 unless Congress acts to extend them. Back then, it seemed perfectly reasonable to assume that by the time 2010 or 2011 came around, lawmakers would have made definitive arrangements either to extend those provisions or eliminate them. Unfortunately, those arrangements really have not happened and there does not seem to be a legislative will to address them. The resulting vacuum makes doing nothing more likely.

Take a look at some of the tax laws that either have already changed or will be changing in the next year or so without further action:

• Estate tax. Right now, there's no estate tax. But that's not a perfect situation -- because those who inherit assets may have to pay greater capital gains taxes when they sell, thanks to a complicated set of rules that determines the tax basis of assets you inherit.
• Capital gains. A maximum rate of 15% applies to long-term capital gains, but individuals in the two lowest tax brackets receive a 0% rate. Next year, the maximum is scheduled to climb to 20% for those above the two lowest brackets.
• Dividends. Similarly, dividends on many stocks now qualify for a 15% maximum tax rate. In 2011, that provision could disappear entirely, returning dividend taxation back to ordinary income tax rates as high as 39.6%. It is possible rates could even go higher.

In addition, there are proposals for new sorts of taxes, including the following:

• A proposed "fee" on financial institutions like that received government funds during the financial crisis would raise nearly $10 billion per year in revenue.
• Closing a loophole that applies to multinationals might have generated billions in additional corporate taxes, but companies like Microsoft counter that it would threaten US multinationals' competitiveness.
• Various health-care reform provisions could result in increased payroll taxes, and a Medicare tax on the investment income of higher-income taxpayers could be in the offing.

What to do?

With so many things up in the air, how can you make sure that you are tax-smart with your money? Increased taxes seem all but certain.  Even if Congress succeeds in making exceptions to tax increases on low-bracket taxpayers, many investors could get caught by the restored old rules.

Financial planners with credentials this author does not have are suggesting that taxpayers take advantage of tax-favored accounts like IRAs and 401(k) plans.  These were always a good idea but with higher tax rates looming, they become even more valuable. You could even own high-yielding dividend stocks in your IRA to keep the income from hitting your annual tax return. If you tend to own long term investments that do not pay dividends, there's no tax bill to pay along the way so you will want to keep an eye on capital gain tax rates.

How to plan for your taxes is problematic. While you may recognize that there is not much you can do to affect what legislators will do to taxes, if you use tax-advantaged savings, you will be in a better position both to pay appropriate taxes and retire with reasonable income support.