Last week, tax legislation was passed that will extend our current income tax structure for two more years. This includes the annual patch to the Alternative Minimum Tax. In addition, it provides temporarily modification of our federal estate, gift and generation-skipping transfer tax code through 2012. Employee Social Security taxes will be lowered by 2% so employees will pay 4.2% on wages and self employed people will pay 10.4% on self employment income up to $106,800. Finally it allows for an extension of unemployment insurance for an additional year.
From a macro perspective I believe that the tax legislation is good for the overall economy as things remain weak and unemployment is still high. If nothing was done I feel that the higher tax environment that we were going to face would put us at higher risk of a double dip recession. At the same time we kicked the can down the road as far as our federal deficit issues. So eventually when the economy begins to heat up, higher taxes will become a necessity.
As far as the estate tax, this was more of a relief as exemptions and tax rates were to revert back to 2001 rules where the estate exemption would have been $1 million per individual with a maximum rate of 55%. The new rules allow for a $5 million dollar exemption per person and any unused portion can pass off to the surviving spouse and the maximum rate is 35%. That’s the good news. The bad news is that this is only in effect through 2012. So we are going to run into the same uncertainty come two years from now.
What can you do right now in light of the income tax changes? The fortunate thing is now you don’t have to rush based on any changes for next year because they will be either is the same or more advantageous next year. So essentially if your taxable income will remain similar or is expected to be lower next year, the best thing you can do is accelerate any items that may create a deduction or credit into this year while delaying and taxable income into next year if you have the capability to do so. If taxable income is expected to be significantly higher next year, then you want to do the opposite.
However this is only a temporary reprieve. We are historically in a low tax environment. Given our budget deficits, entitlement systems and health care legislation passed earlier this year, I suspect that we are in the beginning of a secular long term trend towards higher taxation. This two year extension provides an excellent opportunity to plan for this.
For those who generate a lot of taxable investment income, this may be a good time to recalibrate your portfolios. Qualified dividend tax rates now at taxed at 15%. If no further tax extensions are passed, this rate will increase 43.4% if you are in the highest tax bracket and are subject to the health care surcharge. Add in Maine taxes and then we have a tax rate that exceeds 50%. Long term capital gain rates will increase from the current 15% to 23.5%. And finally keep in mind that the 3.8% health care surcharge beginning clicks in on all investment income (capital gains, interest and rental income) if taxable income exceeds $200K for an individual or $250K for a married couple filing jointly. You can be over this threshold by $1 and the surcharge applies to ALL of this income.
So at this point you may want to be thinking about diverting interest and dividend income to tax deferred accounts rather than keeping it in taxable accounts. You may also want to consider recognizing taxable gains now in stock investments that you don’t expect to hold for the long-term and replace this with stock index funds more due to their tax efficiency. This would hold especially true if you hold a concentrated position in one or a few stocks. Municipal bond funds would also work.
Another strategy is making a Roth conversion. If your expect to be in a higher tax situation later on when you need these funds as compared to today, it may make sense to execute Roth conversions in level amounts prior to year end and in 2011 and 2012. Even if you expect to be taxed the same in the long term, you may want to opt for some Roth conversions due to their flexibility. Roth conversion amounts can be withdrawn without penalty after five years (even prior to age 59 ½), Roth’s can provide some tax diversification in your retirement income strategy and they aren’t subject to required minimum distributions. Partial or total conversions can be made, but the optimal decision depends on your unique situation.
With the above, every person’s tax situation is unique. So I would not solely rely on what I recommend above. Seek expertise on this matter with a financial planner and/or your tax accountant to make sure what if any moves are best for your situation.
In the big picture, our future tax environment will be very unpredictable. I feel that something will eventually have to give and given our historical situation, my guess we are heading towards a higher tax burden. But by being proactive and taking action now, this may provide more tax efficiency for your financial future.