2010 – A Taxing Year to Remember

Posted on January 19th, 2010 in Newsletter Articles, Taxes by wayne

Typically, financial advisors and tax consultants advise their clients to defer all income possible into future years to avoid paying taxes on earnings for as long as possible.  However, 2010 should be looked at as a “tax waterfall” year, in which this advice may get turned on its head.  Let’s examine why you might consider having as much income as possible taxed in 2010.

The press has been full of the fact that the “Bush tax cuts” will expire at the end of 2010.  We have been led to believe that this event will only effect the wealthy, currently being defined as couples earning over $250,000 per year.  While I could make the case that working couples with total income of $250K per year are not always “wealthy”, let’s explore how the expiration of these tax cuts will affect all tax payers, rich and poor alike.

In 2011, when the tax cuts passed in 2001 expire, everyone’s taxes will increase.  What is not commonly known is that, on a percentage basis, the largest increases will be on taxpayers who earn the least.  Here’s why:

In 2010 a couple with taxable earnings of only $25,000 per year pays 10% taxes on the first $16,750 and then 15% on each additional dollar that they earn, up to $68,000.  The total 2010 federal tax bill on $25,000 of taxable income is approximately $2,900.

Since 2011 tax brackets have yet to be published, we will assume no inflation, leaving the 2011 tax brackets the same as in 2010.  In 2011, the 10% tax bracket disappears.  The couple earning $25,000 now pays 15% taxes on every taxable dollar that they earn.  When their tax bill comes due, instead of owing $2,900 to the federal government, they will owe $3,750.  This represents a 30% increase in federal taxes owed.

Now let’s look at a “wealthy” couple, with taxable earnings of $250,000 per year.  In 2010, they are in the 33% marginal tax bracket with a federal tax bill of approximately $60,300.  In 2011, if this couple again has $250K in taxable income, they are now in the 36% marginal tax bracket, with a federal tax bill of approximately $66,600.   The additional $6,300 represents a 10% increase in federal taxes owed..

When the 2001 tax cuts expire, every tax payer will be negatively impacted.   Tax payers with the least income will be hit with the greatest percentage federal tax increase.   Regardless of what the politicians say, the expiration of the 2001 tax cuts will hurt every tax payer, not just the wealthy.

The 2011 tax impact will be even more onerous for Americans who have saved and invested their income. Currently, if you are lucky enough to have long term investments that have increased in value, the government receives a maximum of 15% of your (capital) gain when you sell the investment.   In 2011, the taxes on investment gains will increase by at least 33%, as the long term capital tax rate rises to (at least) 20%.

If you are receiving stock dividends, you currently pay a maximum of 15% federal tax on all of your qualified dividends.  In 2011, these same dividends will be taxed at your ordinary income tax rate, which could be as high as 39.6%.  Thus your dividends will receive tax increases that could be a great as 164% of their current rate.

These tax increases require no action by congress.  Our politicians are also considering numerous new tax increases.  One increase being considered is a European style Value Added Tax (VAT), similar to a sales tax but on a national scale.  However, without any legislative action, the expiration of the 2001 tax cuts will result in a significant tax increase on every tax-paying American.

2010 will be a very important year to pay close attention to your taxes.  If you are planning on retiring, selling a vacation home or any other activity that might have significant tax consequences, visit with you financial and/or tax advisor early in 2010.  Together, you can determine the lowest cost approach, on an after tax basis, to the important decisions that you face in 2010.

Roth IRA Conversion Insurance

Posted on January 19th, 2010 in Newsletter Articles, Retirement Planning, Taxes by wayne

In recent newsletters, I have explained why it is often wise to convert traditional IRA account assets to a Roth IRA.  However, for many people this was not allowed.  In 2010, the $100,000 income ceiling has been removed, allowing everyone to convert IRA funds to a Roth IRA.  2010 also provides the added benefit of being able to spread the income taxes owed on the conversion over two tax years.

What many people are unaware of is that the IRS also offers an “insurance policy” on your Roth conversions.  This insurance can be especially important if you pay taxes on a large amount of converted funds that then proceed to fall dramatically in value, as did the stock market in 2008  This IRS “insurance policy”  is called “Recharacterization.”

Recharacterization allows you undo an IRA to Roth IRA conversion.  If you make the IRA to Roth IRA conversion in January of 2010, you will typically have until October 15, 2011 to undo this conversion through a recharacterization.   Over this 21 month period, if your converted funds fall substantially in value, you would have been better off leaving these funds in the IRA and converting them at their lower value  Recharacterization is the IRS “insurance policy” that allows this.

Here is how recharacterization works:

Let’s assume that you convert $100,000 from your traditional IRA to a Roth IRA in January 2010.  If your marginal tax bracket is 25%, you will be required to pay $25,000 in additional taxes for this conversion.  If the market goes up, the $100,000 grows tax free and you (or your heirs) are never required to pay taxes on this growth.

But what if the market declines, leaving the converted $100,000 with a value of only $50,000 in September, 2011.  You have now paid $25,000 in taxes on an investment that is now worth $50,000.  At this point, your effective tax rate is 50%.  If this happens, you should use the IRS provided “insurance policy” called recharacterization.

Before October 15, 2011, you may put the $50,000 remaining in your Roth IRA back into your traditional IRA account.  You must also file an amended tax return showing this recharacterization.  If done properly, your amended tax return will provide for a refund of the $25,000, in 2010 taxes that was accessed for the Roth conversion.

31 days after you have completed a recharacterization you can once again convert the remaining $50,000 in IRA funds to a Roth IRA.  If you are still in the 25% tax bracket, your tax bill is $12,500 for this new conversion.  If the market skyrockets and the $50,000 grows to $100,000, you will have paid only a 12.5% tax rate on the conversion, based on the new market value.

IRA to Roth IRA conversions have many benefits, as long as you have the financial resources to pay the taxes owed, without having to use IRA funds.  However, the conversion and recharacterization rules are somewhat complex.  If you are exploring a Roth conversion in 2010, be sure to talk to your financial adviser or CPA about the benefits and drawbacks of an IRA to Roth conversion.  After considering all of the facts, if you decide on an IRA to Roth IRA conversion, be sure to re-analyze this decision in September 2011, to see if you should take advantage of the recharacterization insurance policy.