Wednesday, December 15, 2010

Taxing Matters

It looks like Congress and the White House have agreed on a plan that will continue the current income tax rates, capital gains tax rate and dividends tax rate for two additional years (2011 and 2012). The framework agreed to also includes a patch for the Alternative Minimum Tax (AMT) that should (again) prevent its application to us middle-class taxpayers.

This is called “kicking the can down the road” which means we haven’t heard the last of these issues – like vampires, they will return from the dead at the next dawn – i.e., the 2012 election cycle. Undoubtedly, there will be some members of Congress who will rise to the level of hypocrisy we have come to know and love from our elected representatives on these issues. I tell ya, there is no position that any politician hasn’t taken that he or she won’t attempt to walk back when faced with losing their job and contemplating having to actually work for a living like the rest of us.

It is what it is, and it is my job to deal with the reality on the ground and bring you the best thinking and advice in advancing your goals.

The Alternative Minimum Tax (AMT)
Earlier in the year we were concerned that many middle class taxpayers would be subject to the Alternative Minimum Tax as the size of the previous years’ “patch” had been reduced for 2010. It looks like we’re going to escape this one, one more time.

Roth IRA Conversions
2010 is the first year that anyone can convert pre-tax retirement assets to post-tax retirement assets (Roth IRA) regardless of income level. Of course, such conversions require the payment of income taxes on converted assets at the taxpayer’s marginal rate. There has been some urgency on the part of the financial advice community as the income tax rates applicable to 2010 conversions were a known quantity, but the tax rates applicable to conversions after 2010 were not. With the agreement to continue the current rates for two more years, the urgency to beat the tax collector by converting pre-tax assets in 2010 has abated somewhat. That doesn’t mean that conversions in 2010 no longer make sense. I think many taxpayers will be best served with a series of annual conversions, timed and allocated in such a manner that the extra income is taxed within the taxpayer’s current marginal tax bracket. As they say, “individual situations can and will vary – consult your professional advisors before taking action”.

There is at least one remaining reason to effect a conversion in 2010: the “one-time only” ability to defer the taxation of the amount converted into the two tax years subsequent to 2010, namely, 2011 and 2012. Taxpayers converting assets in 2010 may elect to split the amount converted into two allocations: 50% to be added to their income for tax year 2011 and 50% to be added to their income for tax year 2012. With the (probable) continuation of the 2010 income tax rates and brackets, the taxes due on conversions in 2011 and 2012 are likely to be similar to conversions taxed in 2010 ASSUMING the taxpayer’s other income does not significantly increase. Those electing the deferral are taking the chance that their other income could be larger than they anticipate with current information, and thus pay a higher marginal rate on a 2010 conversion in future years. The tax rates are certain, the amount of taxable income is not, particularly if your income is given to fluctuation or in those situations where your employer finally gets around to recognizing your outstanding contribution and gives you that raise that you’ve been deserving for lo these many years.

For assets converted in 2010, it probably makes sense to tax the transaction in 2010, which is an available option.

Regardless, Roth conversions contain an escape clause, not unlike those contractual fine print items that allowed our noble bankers to escape punishment with their 7 and 8-figure bonuses intact. A Roth conversion can be reversed (“re-characterized” in IRS parlance) up until the filing date of the tax return for the year in question. For most of us, this is April 15, but the rule allows a reversal up to the filing date as extended, which means that reversals can be effected as late as mid-October (October 17, 2011 for 2010 returns). A reversal of the conversion puts the assets back in a pre-tax state as if the conversion had never taken place. So, if you do a conversion here in the remaining days of 2010, and then realize – before you file your 2010 return – that “things have changed” – you get a free do-over. This do-over is available every year in which a Roth conversion is effected. So for those doing a series of annual conversions, each separate conversion has a “free-look” period that expires on the filing date for the return for that tax year, including extensions. And you thought extensions were just for hair.

Roth Contributory IRAs
Aside from the Roth IRA Conversion issue, many taxpayers can make annual contributions to a Roth IRA. The allowance of such contributions is based on income. A chart is probably the best way to illustrate:

Oops - the chart didn't survive - contact me if you want the details or check IRS Pub590

Back Door Roth IRAs
If your income precludes you from making a contribution (see above) consider the Back Door Roth IRA. Anyone can fund a Traditional IRA regardless of income, but you probably will not be able to take a tax deduction for the contribution due to income limits or coverage by an employer plan such as a 401k, etc. There is no provision in the Roth conversion rules to prevent taxpayers from funding a Traditional IRA and then turning around the next day, week or month and converting the Traditional IRA to a Roth IRA. So it’s a two-step process, not unlike being coerced into a line dance at a cowboy-themed nightclub: 1) open a Traditional IRA and fund it (maximum $5,000 or $6,000), 2) open a Roth IRA Conversion account and convert the assets in the Traditional IRA into the Roth IRA. Depending on how the assets in the Traditional IRA have grown – or not - prior to the conversion, there will likely be little or no taxable income as the result of the conversion. A conversion even an Atheist can love.

Payroll Tax Holiday
The new agreement also includes a reduction in the EMPLOYEE contribution to Social Security (FICA) from the current 6.2% to 4.2% for one year - 2011. This step should have been taken the day after Mr. Obama’s Inauguration, but better late than never. FICA taxes are imposed on all earned income up to $106,800 with the maximum tax equaling $6,621.60 (the employer pays an equal amount). With this reduction, the maximum FICA tax will be $4,485.60, a savings of $2,136, or about 32%. I haven’t heard anything specific about the treatment for the Self-Employed, but presumably they will get the same reduction – that’s only fair. We’re all about being fair in America. Employers aren’t getting a break on their share, so expect to hear some breast-beating from the corporate and small business lobbies. Think about using this windfall to increase retirement plan contributions. Payroll taxes are made with after-tax dollars, so one could use this extra money for a Roth IRA contribution without increasing income taxes in 2011. If one were to use these funds to make a pre-tax retirement contribution, income taxes would be lower than otherwise.

I’m sure there will be more ideas that percolate up in the next few weeks and I’ll be sure and share my thoughts about them. As always, please contact me if anything here strikes your fancy [no statement made herein is to be construed as offering tax, legal, accounting or financial advice. Consult the appropriate professional for questions about your specific situation].

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