3 ways to cope with year-end tax uncertainty

November 23, 2010

USA-TAXES/The end of the year is in sight. But with taxes still in flux, it’s easy to succumb to your own worst instincts and just block out all the noise: After all, how can you even think about your own year-end tax planning when you don’t know what the rules are, and may not know till after the end of the year?

“People can get paralyzed, and not take any action,” says Rich Kohan, principal of personal financial services at PricewaterhouseCoopers.

With December rapidly approaching, there’s very little time for Congress to act on the Bush tax cuts, which are slated to expire at year-end, increasing the risk that nothing will happen before that date. Democrats would like to see the tax cuts extended for couples who make less than $250,000 (or $200,000 for singles), while Republicans want them kept in place for everyone, including the richest Americans.

Extending the tax cuts would mean the difference between an average effective tax rate of 23.5% and 20.7% for the average American, according to the Tax Policy Center. For the top 1% of taxpayers, meanwhile, it would be the difference between 32.7% and 24.8%, according to TPC’s calculations.

House Speaker Nancy Pelosi, a Democrat, has said that she plans to schedule a vote on extending the middle-class tax breaks in early December, but House Republicans want to block that vote, and John Boehner, the House minority leader, is expected to become the speaker in January. In the Senate, Harry Reid, the majority leader, has also said he wants to schedule a vote on taxes.

With very few working days left before year-end, it’s tough to guess what might happen, and for individual taxpayers that uncertainty is just the problem.

The human brain simply isn’t so good at making decisions under uncertain conditions. Even when the rules are clear, taxes can bring out our deepest neuroses, as people sometimes go so far as to refuse to open letters from the Internal Revenue Service. Procrastination, superstition, denial—even in normal tax times, these emotions bubble to the surface. But with so much in flux, it’s easy to get paralyzed.

When it comes to taxes, however, paralysis is the worst possible move right now. After all, whether or not Congress acts before year-end, December 31st closes off the period during which individual taxpayers can take control of their tax situation for this year. In fact, it’s already getting late in the year for big moves like selling a business, or even doing a Roth conversion.

So how do you get beyond paralysis and take control?

First off, let’s state the obvious: For the vast majority of taxpayers, the debate in Washington leaves them with very little they can control. For wealthier taxpayers, of course, there are many tax-planning options. Three big ones are expenses, investments and gifts.

Expenses. It’s simple math: Deductions for expenses are worth more when taxes are higher. That’s why one of the simplest things you can do between now and year-end if you expect your taxes to be up is to defer some expenses till after January 1st. You may, for example, be able to defer payment of state income taxes or real estate taxes. You might also choose to make charitable contributions in early-2011, rather than late-2010.

Investments. If you don’t yet have capital losses stockpiled (as so many people do), it may be worth taking them now. Tax rules let you offset capital gains with capital losses (which is more valuable in the future if rates are higher) and then to deduct $3,000 against income each year (also more valuable in the future if rates are higher). Conversely, investors with long-term capital gains may also want to sell this year to lock in the 15% tax rate. In either case, remember: The investment decision should come first, and you’ll need to account for transaction costs.

Gifts. Even for those who don’t have enough assets to consider more complicated estate-planning strategies, giving away money while you’re alive is a smart move. The rules permit anyone to give away up to $13,000 per beneficiary tax-free this year. (That means a couple with three children could give a total of $78,000 tax-free.) But this year, there’s extra advantages to gifting above that level. That’s because the gift tax this year is at a low 35% rate, while the estate tax—when it comes back next year—is likely to be at either 45% (where it was in 2009, and where the Obama Administration would like it to be again) or 55% (if Congress doesn’t act).

Photo: People wait in line on tax deadline day at the main Post Office in New York April 15, 2009. REUTERS/Chip East

Comments

The IRS is nothing to play with. Please, please, please see a tax professional who is proficient in tax planning to make sure you are adhering to IRS guidelines. It is vital that all your i’s are dotted and all your t’s are crossed. If not, the IRS can disallow your deduction and you will end up paying more taxes than if you had not taken the deduction in the first place. http://small-business-tax-info.com

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