Financial Abundance

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.