All Things Financial Planning Blog

As we went into the weekend of the Fourth of July holiday of 2010, the Congress failed to pass an extension of unemployment benefits that would eventually impact over 2 million Americans who were receiving benefits. At the same time, there is legislation that is stalled to deal with various aspects of the income tax law that will impact many more of us in 2010 and 2011.

While there may be many reasons for why the legislation is not getting passed, a significant reason gets tied to the “cost” of such legislation to our national debt if there are not offsetting reductions in spending to pay for these issues.

This blog will deal with the major issues of income tax rules that will impact all of us as we prepare our tax returns over the next several years. With only six months left to plan in 2010 on how much our tax bill will eventually be, it is important to understand what is scheduled to happen in 2010 and 2011 if Congress does not act to deal with the issues.

A major issue in 2010, that has also been an issue in the past several years, is the Alternative Minimum Tax (AMT). In 2009 there were about 2.9 million taxpayers who paid more taxes due to the AMT rules. If Congress were to take no action to change the AMT allowance in 2010, there would be 26 million taxpayers impacted. The price tag alone for this item is $66 Billion of revenue that the Treasury would not get if Congress were to make the AMT allowance the same in 2010 as it was in 2009.

Other issues that have expired that Congress would need to extend include the $1,000 additional standard deduction for taxpayers who have property taxes but do not itemize (tax cost to you between $150 and $250, depending on your tax bracket and filing status), the $250 educator expense adjustment to income, and the $4,000 college education deduction. Each of these have a tax “cost” to the Treasury in lost revenue if these are extended so we can claim them if they apply to us.

If any of these apply to you, you need to consider what the impact will be on your return if Congress does not extend these for your 2010 tax return. These could cause your tax liability to increase leading to a tax being due versus getting a refund when you file your return. This could also cause you to incur a penalty for underpaying your taxes, so you should be sure to have your tax withholdings for 2010 as least equal to 100% of what your tax liability was for 2009. If your adjusted gross income in 2009 was more than $150,000, the 2010 withholding needs to be 110% of the 2009 tax liability.

Failure to have the proper withholding in 2010 will result in an underpayment penalty that would require you to use Form 2210 to figure the amount of the penalty.

Beyond the changes in tax laws for 2010 is the bigger issue of tax law changes between 2010 and 2011. Tax rates for 2010 are the last year of the rates under the so-called “Bush Tax Cuts” from the early years of the 2000s. If Congress takes no action then the tax rates for 2011 will be higher for all taxpayers.

In simple form, the 10% tax bracket will disappear and income will be taxed at 15%. For taxpayers with income above the 15% tax bracket, this will mean a higher tax liability of $837 for those filing as Married Filing Jointly (MFJ) and $419 for those filing in Single status.

For taxpayers who were in the 25% tax bracket in 2009, the rate goes up to 28%. If you were in the top of this bracket, the additional tax cost will be $2,070 for MFJ and $1,440 for Single. These amounts are in addition to the amounts in the previous paragraph.

For those with incomes in the 28%, 33%, and 35% tax brackets, they will see all that income taxed at 3 to 4.6 percentage points higher in 2011 than what the 2010 income was taxed at if Congress makes no changes to the current tax laws.

Two other tax categories are set to change in 2011. Dividend income in 2010 is taxed at 15% as will be capital gain income. In 2011, the capital gains rate is 20% and dividend income is taxed at the ordinary income tax rate that you are in, as noted in the previous paragraphs.

This requires that you look at your investment portfolio to see what capital gains you may have in your investments that you might want to harvest in 2010 so you can pay a lower tax. You may also want to shift your portfolio from a dividend paying portfolio to one more oriented towards capital appreciation, assuming that capital gains tax rates will be lower than ordinary income rates in the future.

The final issue to address in this blog is the question of taking the opportunity to convert IRA amounts into Roth IRAs in 2010. While you can do the conversion in 2010, you have the option when you file your 2010 tax return next year to either pay the tax entirely in 2010 or to spread the tax payment over the 2011 and 2012 tax years by reporting half of the converted amount on each of those two years’ tax returns. As noted above, the tax rates could be as much as 3% higher in 2011 and 2012 versus the rates for 2010.

The only good news in all this is that you have time left to see what Congress will do between now and the end of this year to see how they deal with these issues. On the IRA conversion to the Roth IRA, you could have until October 2011 when you file your 2010 tax return that you put on an extension in April 2010 before you need to make that election on reporting the income from the conversion that you did between now and December 2010.

Yes it has been very difficult trying to explain this coherently to clients while we wait for Congress to act on these important issues. I remain hopeful that we will be able to make rational decisions on these important matters to all of us. I would suggest that you keep in close touch with your tax professional to be sure that these complex issues are properly interpretated so you pay the least tax under the various scenarios.

Francis St. Onge, CFP®
President
Total Financial Planning, LLC
Brighton, MI