Expiring tax cuts make reducing next year's tax bill more difficult

This is the time when taxpayers start thinking about strategies to reduce next year's tax bill. But such planning is exceptionally tricky this year.

Many tax cuts created in 2001 and 2003 are set to expire after Dec. 31, from historically low income tax rates to the temporary repeal of the federal estate tax.

Legislators talk about extending tax breaks but can't agree on who should get them. President Barack Obama and many Democrats want to maintain tax cuts for all but the wealthiest. Republicans have dug in their heels, saying the rich deserve tax relief, too.

Any action has been pushed off until after the November election. Even then, there's no guarantee that Congress will end the stalemate before the year is up. All this makes year-end tax planning a guessing game.

"It's unbelievably difficult. In my 35 years of doing this, I have never seen a situation where we have no clue," says Barbara Weltman, a tax lawyer and author of "J.K. Lasser's 1001 Deductions & Tax Breaks."

Some experts say that no one wants to raise taxes on families earning less than $250,000, and that middle-class families can count on the status quo. But can they? A year ago it was unthinkable that Congress would allow the estate tax to disappear. It did, and the estates of several billionaires who died this year, including New York Yankees owner George Steinbrenner, have escaped taxation.

And there's another problem looming. Usually by mid-November, the IRS publishes tables on the amount of taxes to be withheld from workers' paychecks in the next year, giving employers enough time to adjust their payroll software, says Mark Luscombe, principal tax analyst with CCH, an Illinois provider of tax information. "I don't know how long they feel they can hold off," he says.

The IRS could end up publishing tables based on higher tax rates, reducing withholdings later if Congress lowered taxes, Luscombe says. That, at least initially, would shrink workers' paychecks.

Treasury Department spokeswoman Sandra Salstrom said in an e-mail that tax legislation was expected by year-end and that the agency would remain flexible on releasing new tables.

That said, time is running out to make moves to save on taxes later. Here are suggestions based on how things stand now:

Do the opposite Normally, most taxpayers want to postpone income into the next year to delay taxes, while taking advantage of all the deductions possible before the year runs out.

But if income tax rates are headed up next year, you want to reverse this strategy, says Dennis Suckstorf, a senior financial planner with Financial Advantage in Columbia.

Self-employed individuals, for example, can time invoices so they're paid by Dec. 31 while taxes are still low, Suckstorf says. Deductions will be more valuable taken next year if rates go up, he says.

This strategy will work for many, but high-income taxpayers should calculate the best time to take deductions, adds Melissa Labant, tax manager for the American Institute of Certified Public Accountants.

That's because itemized deductions for this year only aren't phased out for high earners. So a wealthy person making a $100,000 charitable contribution this year can deduct the full amount, Labant says. If the donation is made next year, the deduction could be as little as $20,000 with the return of the phase-out, she says.

Take gains now Currently, the capital gains tax rate on securities owned for at least one year is zero for those in the bottom two tax brackets and 15 percent for everyone else. The top rate is set to return to 20 percent next year. 

Investors with appreciated securities should consider selling them now to take advantage of lower rates.

The zero tax rate, for example, applies to singles with taxable income of up to $34,000 and joint filers with twice that amount of income, says Bob D. Scharin, senior tax analyst with Thomson Reuters. A married couple with $60,000 in taxable income this year can see $8,000 in gains that won't be taxed, he says.

Reconsider dividends This income is now taxed like capital gains. Next year, dividends will again be taxed as ordinary income, potentially at a rate as high as 39.6 percent.

You can't control when you get dividends. But investors with dividend-paying stocks might want to shift to growth equities that pay little or no dividends, Luscombe says.

Fund retirement accounts Fully contribute to 401(k)s and similar retirement accounts at work, if you don't do so now. Contributions lower your taxable income.

Convert to a Roth  Regardless of income, you can convert a traditional IRA or 401(k) into a Roth IRA. You'll pay income taxes on converted amounts that haven't been taxed yet, but future Roth withdrawals will be tax-free.

If you expect to be in a higher tax bracket in the future, converting makes sense.

This year only, anyone switching to a Roth can opt to spread the tax bite from the conversion over their 2011 and 2012 tax returns. This leniency sounded great when Congress passed it a few years ago. Not so now. By waiting to pay, you will be taxed at whatever the rates are in 2011 and 2012. Given that rates likely are headed higher, investors should pay the tax bill on their 2010 return, Suckstorf says.

You don't have to decide until April 18, which is next year's tax deadline.

Use energy credits You have until Dec. 31 to get a credit for green improvements to a primary home, such as adding insulation and energy-efficient windows, doors, furnaces and water heaters. The credit can't exceed $1,500 for this year and last year combined.

If you used up the credit and still need to make improvements, wait until 2011, Scharin says. If legislators renew this credit, they could expand it and you could get an additional break, he says.

Shift education accounts The contribution limit to a Coverdell Education Savings Account is scheduled to plunge next year, and there will be more restrictions on how you can use the money. Families should consider rolling over Coverdell balances into a 529 college savings plan, whose tax-friendly provisions were made permanent in 2006, CCH advises. Investors in 529s don't have to pay taxes on earnings if the money is used for college.

Rockville financial planner Clark Kendall recommends 529 plans for their flexibility. For example, money in the account isn't part of your estate, so those funds won't be a factor if the estate tax returns, he says.


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