My F&M

Tax Increases on the way – separating reality from exaggeration

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Everyone who watches TV, surfs the net or listens to the radio knows that taxes are going up.  But how do you separate the fact from fiction?  What is political exaggeration and what is reality?  My goal here is to provide an unbiased and apolitical summary to get you the facts to help you make sound decisions. 

First, let’s look at 2010:

  • BIG change - anyone can do a Roth conversion – the income limit of $100,000 has been eliminated.
  • Long term capital gains and qualified dividends (LTCG/QD) continue to receive special tax treatment – maximum 15% rate.  There is still a 0% special rate for taxpayers in the 15% bracket.
  • The phaseout of itemized deductions for high income taxpayers is gone in 2010.

In summary, 2010 should be a fairly low tax year by historical standards.  The highest federal marginal tax rate is 35% and starts at around $373,000 of taxable income for married filing joint (MFJ).

2011 and beyond?

Now the fun starts.  We do know a few things for sure.  There are some “Bush Tax Cuts” that are set to expire at the end of this year.  The most critical is the special 15% rate on LTCG/QD.  If Congress does nothing, these provisions will expire and cap gains and dividends will receive the same treatment as before 2001 (dividends would be taxed just like other income while cap gains would be subject to either an 18% rate or 20% rate depending on holding period).  For dividend income, this would result in a significant rate increase – from perhaps 15% to 33%, resulting in a doubling of the tax on dividend income for many of our clients.

However, the President has some important tax provisions in his recent budget proposal.

Key provisions:

  • Make the special 15% rate on LTCG/QD permanent, but raise the rate to 20% for high income taxpayers (over $250,000 in taxable income MFJ).
  • Raise the top marginal rates, adding a 36% bracket for taxable income over $232,000 (MFJ) and a 39.6% bracket for taxable income over $375,000 (again, MFJ).  Note there is an expanded 28% bracket that may actually help reduce taxes for a small group of taxpayers.
  • Reinstate the phaseout of both exemptions and itemized deductions for high income taxpayers (this would generally impact folks with taxable income over $250,000 MFJ).

This, of course, is not law yet, but it is a clear indication of what the President is thinking in terms of near term tax policies.  But who knows how this might ultimately impact the tax laws.  If Congress does nothing, we will revert back to rates from 2000, which will result in increased marginal rates, quite similar to those proposed in the President’s budget.

Recent Health Care Reform Bill:

Perhaps the most critical tax provision in the recently passed legislation, at least for individual investors, is the new 3.8% surtax on “investment income,” which is defined as interest, dividends, capital gains, royalties, rents and other passive income.  It does NOT include income from an active trade or business, IRA distributions or other distributions from retirement plans.  This surtax applies if your modified adjusted gross income exceeds $250,000 (MFJ).  The surtax starts January 1, 2013.

Obviously, from a planning perspective this surtax increases taxes on investment earnings.  It will make tax exempt municipal interest relatively more attractive (muni interest is not subject to the surtax).  Also distributions from tax deferred annuities are not treated as investment income (kudos to the powerful insurance company lobby).  It makes tax deferred retirement accounts, relatively more attractive, especially Roth IRA’s, which are not only tax deferred but TAX FREE.

There is a new Medicare surtax of .9% on wages above a $250,000 (MFJ) and $200,000 for single filers.  It doesn’t sound like much, but it takes another 1% (approximately) from a wage earner’s paycheck.

Planning Implications:

First, I think it is important to point out, that if your future taxable income is likely to be under $200,000 for the next few years then you might not experience much additional tax pain.  Almost all of the tax provisions the President is proposing are for those “high income” taxpayers above $250,000 (lower amounts for single folks). 

2010 looks like a low tax year by just about any measure.  We may not see a top marginal rate of 35% (federal) again for a long time.  So, for those of you who can move income forward, and who really do believe that higher future tax rates are in the cards, then you just might be better off prepaying tax in 2010.  You may want to look at exercising stock options sooner rather than later.  For those of you still working, you may want to think twice before deferring compensation to future years.  That flies in the face of conventional tax wisdom of deferring as long as possible, but we just might be at a point where that strategy does not make sense for some of you.  Another possibility is to look at a Roth conversion.  I know we have written about this before, but this latest Medicare surtax makes a Roth appear even more attractive. 

All these changes create opportunities for meaningful tax planning.  However, you still need to look at the non-tax impact of some of these strategies – don’t let the “tax tail wag the dog”.