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Top 5 Tax Changes in Your Future

The countdown is on for the expiration of the 2001 and 2003 tax cuts enacted by President Bush: If Congress does nothing before the end of the year, tax rates will climb back to 2000 levels. While a complete overhaul of the tax code is unlikely this year, lawmakers are likely to make incremental shifts toward higher taxes for high earners. If your income is below $200,000 ($250,000 for married couples), you are unlikely to feel any pain in your wallet.

For top earners, though, the just-passed health reform legislation is a telling preview of your tax future. If your income is above the $200,000/$250,000 threshold, in 2013 you’ll pay an additional 0.9 percent on your federal payroll taxes, and your investment income and gains will be hit with an added 3.8 percent levy.

Here’s your cheat sheet on what’s on the table, what’s likely to happen, and the tactical shifts you might want to make this year if you’ll face a less friendly tax code in 2011.

1. Higher Income Taxes for High Earners

  • The change: Reinstate top rates of 36 and 39.6 percent
  • Who gets hit: High earners
  • Likelihood of passing: Extremely high

Today’s top income-tax rates of 33 percent and 35 percent will most likely return to 2000 levels: 36 percent and 39.6 percent. Single filers with taxable income above $192,000 and married couples filing jointly with income above $232,950 will fall into the reinstated 36 percent bracket, according to an analysis by the Tax Policy Center; the 39.6 rate will kick in above $375,700 (single or joint). For everyone else, the Bush tax cuts should become permanent. “It’s as close to a done deal as things get in Washington,” says Clint Stretch, managing principal of the Washington office of Deloitte Tax.

What to do now: If you’d face a higher tax rate in 2011, look for ways to take advantage of 2010’s lower rates. “You might want to reverse the usual tactic of deferring income into the next year,” says Mark Luscombe, senior tax analyst at CCH publications. Plus, high earners who convert a traditional IRA to a Roth this year should consider turning down the option to spread the tax bill out to 2012. Instead, pay all the conversion taxes at today’s rates. (Since a Roth conversion is a rat’s nest of complexity, a chat with a tax advisor is recommended.)

2. Steeper Taxes on Investment Gains

  • The change: 20 percent rate for capital gains and dividends
  • Who gets hit: High-income investors
  • Likelihood of passing: Another likely done deal

For the past several years investors have been enjoying a 15 percent maximum rate on long-term capital gains and qualified dividends. If Congress does nothing, capital gains would be taxed at 20 percent, and dividends would be treated as ordinary income, with rates as high as 39.6 percent. The most likely fix is a hike to 20 percent, but only for investors in the top two brackets (see above for estimated income cut-offs). Come 2013, that 20 percent tax will effectively rise to 23.8 percent for high earners, as the new excise tax that’s part of health care kicks in.

While Republicans won’t be thrilled by a 20 percent cap gains rate, the GOP is expected to go along in exchange for locking in that same rate on dividends. For tax payers in the top brackets, that’s a lot better than a return to taxing dividends as income.

What to do now: Don’t sell winning stocks simply to qualify for a lower tax rate. But high earners who’ve been meaning to rebalance a taxable portfolio should do so in 2010, when taxes on both long-term and short-term capital gains (taxed as ordinary income) should be lower. The same goes for high-income homeowners sitting on a boatload of home equity: Downsizing will result in a lower tax bill in 2010 than you’ll pay in 2011. Home-sale gains above $500,000 ($250,000 for individuals) are taxed at 15 percent today. If that rate rises to 20 percent in 2011 as expected, a married couple will owe an extra $10,000 ($40,000 vs. $30,000) on a profit of $700,000.

3. Return of the Estate Tax

  • The change: Reinstatement of the federal estate tax
  • Who gets hit: Estates over $3.5 million ($7 million for married couples)
  • Likelihood of passing: High

Thanks to the 2001 tax bill — and the failure of lawmakers to act in 2009 — the federal estate tax is now zero. But come 2011 it roars back to 2000 levels, with a top tax rate of 55 percent on estates worth $1 million to $10 million and 60 percent on estates worth more than that. Congressional leaders have vowed to fix the mess early in 2010 by reinstating the 2009 rules — no tax on estates worth up to $3.5 million, then a maximum rate of 45 percent on assets above that level — retroactive to January 1, 2010. (That provision may lead to court fights from wealthy families with a death in the family during this estate-tax limbo.) What’s not entirely clear, though, is what happens after 2010. The Obama administration wants to make 2009 levels permanent, but Republicans are pushing for a higher exemption. Expect back-room horse-trading on this one.

What to do now: Hope Congress gets it act together pronto — and talk to your attorney while you wait. The current up-in-the-air status of the estate tax doesn’t necessarily leave you in the clear. For example, with certain kinds of trusts you could inadvertently disinherit yourself if your spouse dies before the tax comes back. Plus, a little-known provision of the estate-tax repeal caps how much inherited property qualifies for what’s known as a “stepped-up tax basis.” So on inherited property and assets (excluding retirement accounts) worth more than $1.3 million, you would owe taxes on gains based on your parents’ original cost basis — what they paid for the assets — and not their market value at the time of their death. In addition to the financial pain, imagine trying to figure out the price dad paid for every stock in his portfolio.

4. Fewer Write-Offs for High-Income Earners

  • The change: A return to pre-2001 limits on personal exemptions and itemized deductions, and a cap on the rate for deductions at 28 percent
  • Who gets hit: Taxpayers in the two highest tax brackets
  • Likelihood of passing: Toss-up

The Obama 2011 budget calls for reinstating the phase-out of personal exemptions and itemized deductions for taxpayers in the two highest tax brackets. Another proposal would cap the deduction rate for these two brackets at 28 percent. The phase-out provision could see the light of day, but charities will lobby hard against reducing the maximum deduction rate to 28 percent.

What to do now: The itemized deduction phase-out has disappeared for 2010, making it a good year to make big gifts to your favorite charities.

5. Another AMT Band-Aid

  • The change: A one-year “patch,” then exemptions indexed to inflation
  • Who’s hit: Plenty of middle-class taxpayers
  • Likelihood of passing: High (hey, they pass a patch every year)

Every year the Alternative Minimum Tax, a tax designed to ensure that rich taxpayers didn’t skirt taxes, hits middle-class taxpayers because the tax was never indexed for inflation. Every year Congress passes a one-year “patch” to spare some of those taxpayers (essentially, they raise the AMT exemption). Count on a one-year patch for 2010 and then possibly a permanent fix for 2011 — an automatic annual inflation adjustment to the exemption. Though the AMT is the poster child for the absurdity of the tax code, it’s also a big-time revenue source (an estimated $875 billion from 2009 to 2019, assuming inflation indexing). It’s not going away.

What to do now: Singles with an adjusted gross income above $46,700 (in 2009) and married couples with AGIs above $70,950 have to run the numbers using the regular tax rules and the AMT — and pay the bigger tab. The AMT hammer comes down especially hard on parents in states with hefty income and property taxes (both the standard deduction for family members and local taxes are limited under the AMT). Short of moving out of New York, New Jersey, or California, your next best move is to hope for more substantial tax reform after the mid-term elections. “I find it hard to believe that in the next few years we won’t see significant tax changes beyond dealing with the sunset provisions,” says leading tax wonk Gene Steuerle, of the Urban Institute. Stay tuned.

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