Last Updated Dec 16, 2009 2:16 PM EST
This is part of a three-part series on what to do with your money in 2010. For what to do with your banking and credit cards, click here; and for new investing strategies, click here.
Hold onto your wallet. Prospects are strong that Washington will shrink the budget deficit and pay for health care reform by raising your taxes somehow over the next few years. “There’s probably no doubt that income taxes will go up on high income earners in 2011,” says Gerald Prante, an economist with the Tax Foundation. “Given the deficits, the unlikelihood that Congress will significantly cut spending, and that we might see a healthcare bill that increases spending, low- and middle-income people could see additional taxes too.”
On top of that, the planned estate-tax repeal for 2010 isn’t likely to happen. And the Bush tax cuts are due to expire at the end of 2010. If Congress doesn’t change the law, the top income tax rate will rise from 36 to 39.6 percent and the top 15 percent long-term capital gains rate will hit 20 percent. After 2010, dividends will be taxed as — gulp — ordinary income.
Although middle-class taxpayers may get a reprieve from these planned tax hikes, it’s “highly likely” that the top income tax rates (paid by couples making more than $250,000, and singles with incomes over $200,000) will be restored to Clinton-era levels, says Clint Stretch, managing principal of tax policy for Deloitte Tax.
So you’ll want to work especially hard in 2010 finding ways to keep your future taxes down. Two tax goodies may help: Starting in January, anyone can convert a traditional IRA to a Roth IRA, whose eventual withdrawals will be tax-free. And some homeowners who trade up (or down) may get a $6,500 federal tax credit.
Tax experts suggest these six strategies to run for shelter in 2010:
1. Consider converting your IRA to a Roth IRA
In the past, you could contribute to a Roth IRA only if your income was under $100,000. But starting in 2010, that bar is gone. So if you have a traditional IRA, whose withdrawals will be taxed, you may want to roll it into a Roth IRA and escape future taxes. This could be especially smart if you plan to transfer money to heirs someday, since they’ll get the Roth proceeds tax-free. But as MoneyWatch blogger Charlie Farrell has written, the conversion isn’t right for everyone. For starters, when you convert, you’ll need to have enough in savings to pay the taxes on the principal plus what your IRA has earned. “If you don’t have the money to pay those taxes, there’s no value in a conversion,” says Scott Leonard, a financial planner in Redondo Beach, Calif. You’ll be able to pay those taxes over two tax years — 2010 and 2011, however. The younger you are, the bigger the benefit of converting, since your retirement account will have more time to grow tax-free.
2. Fund your tax-deferred retirement accounts to the max
Exactly how taxes might go up in 2010 and who’ll owe them may be a mystery, but one thing is certain: taxes aren’t going down. So you’ll want to stuff as much as possible into your 401(k), IRA, or Keogh next year. In 2010, the maximum contribution amounts will be $16,500 for 401(k)s and $5,000 for IRAs. Eligible self-employed people will be allowed to invest up to $49,000 in Keogh. If you’re your own boss, spend a little time comparing the alternative tax-sheltered savings plans.
3. Heap cash into HSAs and FSAs
If your employer offers a pre-tax health savings account — and you’re signed up for it — you’ll be able to contribute up to $3,050 for yourself in 2010, $6,150 for your family. Flexible spending accounts (both medical and dependent versions) will be capped at $5,000. It’s too late to designate FSA money for 2010, but make your open enrollment selections accordingly for 2011.
4. Consider selling appreciated stocks and funds
Odds are good that the long-term capital gains tax rate will rise in 2011, as planned, for anyone above the 15 percent tax bracket. So if you’re single with an income over $34,000 or you and your spouse make more than $68,000, you can pretty much count on a capital gains tax rate boost after this year. While you should never sell an investment wholly for tax purposes, if you own winning stocks or equity funds and were planning to sell them, do it before the end of 2010 and avoid owing higher taxes on their gains. You might also push back your annual portfolio rebalancing from January 2011 to December 2010 to take advantage of the current tax rate on gains. You do rebalance every year, right?
5. Act fast to grab the home-buyer tax credit
Although the $6,500 tax credit for home purchases ($8,000 for first-time buyers) is on the books through June 30, binding contracts must be signed by April 30. So if you want to get the credit, make an offer pretty soon. Familiarize yourself with the details of the tax break to be sure you’ll qualify for it.
6. Keep an eye on Washington
Unless Congress acts, the estate tax will disappear in 2010 and then come roaring back in 2011 with a 55 percent top rate and a meager exclusion of $1 million. But experts believe there’s very little chance Washington will let the estate tax vanish, even for a year. The House just passed a bill permanently extending 2009’s 45 percent inheritance tax on estates over $3.5 million and the Senate is working on something similar. “It looks like there’s definitely going to be estate tax next year,” says William Massey, senior tax analyst at tax and accounting firm Thomson Reuters. “The exact shape is unknown, but probably a $3.5 million exemption per person and a continuation of the 45 percent top rate.” What happens after 2010 is anybody’s guess, though. Some pundits think the 2009 tax rules will be made permanent; others think the exclusion might get hitched to inflation or increased to $4 million or more.
Wait until the rules get set before making any estate-planning moves. But if Congress reinstates the $3.5 million exclusion, as expected, and you and your spouse have an estate worth more than that amount, you’ll then want to meet with an estate attorney. Ask about creating a tax-planned will with a bypass trust. With those documents, “when the first spouse dies, his assets go into a trust for the surviving spouse’s benefit,” says Houston financial planner Tom Posey. The surviving spouse can use the trust, but it doesn’t count as her property, so upon her death both her estate and the trust qualify for estate tax exclusions — and she can pass on the estate tax-free if the estate and trust are under the cap.
If you want to start shrinking your estate in 2010, both you and your spouse can give your children up to $13,000 each tax-free. Make sure they thank you.
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