The federal government may impose $1 trillion in higher federal taxes over the next decade to reduce colossal budget deficits.
Although the details remain uncertain as Congress and the administration prepare to shape tax policy, it’s not too soon to map ways to adjust your financial strategies for the new tax outlook.
Here are answers to common questions about what likely lies ahead…
What will happen to income tax rates? The 33% income tax rate — today’s second-highest bracket — probably will go to 36% for 2011, and today’s tax rate of 35% — the highest bracket — probably will go to 39.6%, as President Barack Obama has proposed in his budget plan. Other income tax rates are likely to stay the same as they are now: 10%… 15%… 25%… and 28%. Because tax rates were scheduled to rise in 2011, when the Bush-era tax cuts expire, Congress and the White House can say that they actually are cutting taxes for the middle class while allowing taxes to rise only for the “wealthy.”
Who will be affected by the higher rates? The new 36% rate would likely apply to single filers with taxable income that is higher than about $190,000 — compared with $171,850, which is today’s minimum income level that puts you in the second-highest tax bracket.
That rate likely also would apply to married couples filing joint returns with taxable income of more than about $230,000, compared with today’s minimum income of $209,250. If your taxable income will be greater than $375,000 (on a single or joint return), you probably will see your tax bracket go from 35% to 39.6% in 2011.
What about taxes on capital gains and dividends? Under Obama’s budget proposal, taxpayers in the 36% and 39.6% income tax brackets would owe 20% tax on long-term capital gains and so-called “qualified” dividends starting in 2011. Congress might go a step further and tax qualified dividends at 36% and 39.6%, rather than at reduced rates, for taxpayers in those brackets. In recent years, those gains and dividends have been taxed at no higher than 15%. Moderate-income taxpayers would continue to be taxed at 15% and low-income taxpayers at 0%.
So if you expect to sell some investments before long to raise cash for such purposes as college bills or buying a house, selling by year-end 2010 would mean that you will owe 15% in capital gains tax rather than a possible 20% or more.
What about nonqualified dividends and interest income? So-called nonqualified dividends and interest income would become less attractive for taxpayers in the top two brackets, who would be paying higher taxes on these because they are taxed as ordinary income. You may want to cut back on stocks and funds paying high dividends if this happens.
If my tax rate might be higher in 2011, should I delay some of my itemized deductions — such as charitable contributions — until next year so that I can get more of a tax break then? That usually would be a shrewd move. The higher your tax rate, the more you save by itemizing deductions. A $1,000 charitable contribution, for example, would save you $360 in a 36% tax bracket, compared with $330 in a 33% tax bracket. However, under the administration’s tax proposals, itemized deductions such as charitable contributions would save you no more than 28% in taxes because a maximum deduction rate of 28 cents on the dollar would be imposed.
So what should I do? Consider making more of your charitable donations in 2010 rather than 2011 if you’re currently in the 33% or 35% tax bracket.
If my income puts me in the 36% or 39.6% tax bracket next year, what can I do with my investments to soften the blow? Consider putting some money that is in your taxable accounts into tax-exempt municipal bonds and tax-exempt money-market funds… indexed mutual funds… and/or so-called “tax-managed” mutual funds, exchange-traded funds (ETFs) and closed-end funds that hold municipal bonds, all of which reduce the tax bite. Also, take capital losses when you can by selling mutual fund shares and stocks that have lost value since you bought them. Those losses can help offset taxable capital gains. And make the most of tax-deferred retirement plans, such as 401(k)s and SEPs, by contributing as much as you can.
Are there other ways that higher tax rates will affect my retirement planning? They may increase the appeal of Roth IRAs, which don’t give you an initial tax break on the money that you invest but allow it to grow tax-free. That’s convenient now because anyone can convert all or part of a traditional IRA to a Roth IRA, although you will have to pay taxes now on the money you convert if you did not initially pay taxes on it. Before this year, such conversions were permitted only if your income was $100,000 or less.
What else can I do as the tax picture clears up later this year? If you expect your tax rate to go higher in coming years, reverse traditional year-end tax planning. Instead of deferring income from 2010 to 2011, which is the usual strategy (to delay tax liability), it may pay to try to accelerate income from 2011 into 2010. That’s because you might be better off paying tax for 2010 at 33% or 35% instead of paying tax at 36% or 39.6% for 2011.
How can I do that? If you expect an annual bonus, ask if it can be paid to you this year. If you’re self-employed or run a small business, you might want to send out invoices as soon as possible and press for payment in 2010.
Are there any changes planned for the Alternative Minimum Tax (AMT)? For several years, Congress has scrambled at the last minute to adjust upward the income thresholds that trigger the AMT so that it doesn’t fall upon millions of additional taxpayers. Obama wants the 2009 AMT exemption levels to become the baseline amounts that would automatically be adjusted for inflation every year starting in 2010. Those levels were $46,700 for single taxpayers and $70,950 for married couples filing jointly.
Is there any good news for taxpayers? Some people with relatively high income actually may see some tax relief. In 2010, for example, the 33% tax rate kicks in at taxable income of $171,850 for singles and $209,250 for couples filing jointly. As mentioned earlier, Obama’s proposal would start the 36% bracket at about $190,000 (singles) or $230,000 (joint) in taxable income. Therefore, some income that will be taxed at 33% this year (income between $209,250 and $230,000 for couples, for example) would be taxed at only 28% under the proposal for 2011.
Anything else? If your company provides you with a cell phone or a similar device, you may be in luck. Obama’s proposals essentially say that any personal use of a company-provided cell phone would be tax-free if you use it mainly for business. Under current law, you have to keep extensive records and pay tax on the value of nonbusiness use.
