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A Tax Plan for Uncertain Times


As the New Year approaches, it's more important than ever to monitor the debate over federal tax policy, be proactive in developing tax and investment strategies that are suited for today's changing tax environment, and work with professional advisors to ensure you don't pay more taxes than you should.

The fourth quarter of every year is traditionally the time to do a final review of your tax strategy in an effort to keep your tax liability in check. This year presents some unique challenges.

First, the tax cuts established by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) -- known collectively as “the Bush tax cuts” -- are set to expire at the end of the year. Second, it’s an election year, which means that members from all parties are weighing in on what has become a heated political debate. With only one month left in the year, no one knows for sure which, if any, of the current tax provisions may be extended and which may sunset.

During times of uncertainty, preparation is key. That means knowing as much as possible about the potential tax changes, and identifying options that will minimize their impact on your investments.

One of the most worrisome areas for taxpayers is the possibility of higher income tax rates. Today’s federal income-tax rates are 10%, 15%, 25%, 28%, 33% and 35%. In 2011, they may revert to 15%, 28%, 31%, 36% and 39.6%. Note that not only could the highest tax brackets rise, but the lowest rate of 10% may disappear altogether. Like income-tax rates, capital-gains rates are also set to expire at the end of 2010. If no congressional action is taken, the maximum rate will increase from 15% to 20% next year.

The tax treatment of qualifying dividends is another area up for debate. Although now taxed at lower long-term capital gains rates, qualifying dividends may be taxed at ordinary income levels next year. That would mean that taxpayers may face a double whammy -- not only could they see their ordinary income tax jump, but their dividend income could be taxed at those higher rates as well.

Perhaps the tax with the most complicated and uncertain future is the estate tax. There is currently no federal estate tax for 2010, although it reappears in 2011 with a $1 million exclusion amount (that is, up to $1 million of assets will be exempt from federal estate tax) and a top tax rate of 55%. By contrast, for 2009, estates received an exclusion of $3.5 million, and the top estate tax rate was 45%.

With no crystal ball, it’s impossible to predict the direction the government will take. To help navigate through this ambiguous tax-planning season, however, focus on a few key strategies as you manage your investments:

Selling Investments for Long-term Capital Gains. Now may be a good time to sell investments with embedded gains that you have owned for an extended period of time, if it makes sense within the context of your overall investment strategy. Should the capital gains rate increase from 15% to 20% for higher-income taxpayers, you’ll pay fewer taxes now than if you wait to sell them in 2011.

Reallocating Investments with Interest and Dividends. As they say in the real-estate industry: location, location, location. Look for opportunities to practice asset location -- that is strategically placing high-income, tax inefficient products in your tax-deferred accounts, such as your IRAs, whenever possible.

Harvesting Losses. Tax-loss harvesting is a strategy even more beneficial now, and in the next few years, with the likelihood of rising capital-gains taxes. Losses can be used to offset capital gains or, if you have no capital gains, you can use up to $3,000 to offset ordinary income. In addition, any losses that are not used in the current tax year can be carried forward into subsequent years to be applied against future gains.

Considering a Roth Conversion. Beginning in 2010, individuals may convert part or all of their traditional IRAs and certain other qualified plans to Roth IRAs, regardless of their income. Unlike with traditional IRAs, funds in a Roth IRA are not subject to required minimum distributions (RMDs) at age 70 1/2 and also are generally not taxed upon distribution. Given the possibility of rising tax rates, a Roth conversion may be a prudent strategy to discuss with your tax advisor before the end of the year.

Monitoring the Estate-Tax Debate. With so many questions surrounding the future of the estate tax, now is an opportune time to review your current estate plan to ensure that it allows for flexibility, no matter what the exemption limits may end up being. Assuming an exemption exists, you may want to consider developing a bypass or credit shelter trust and/or adding disclaimer provisions to build even more flexibility into your plan. Discuss these strategies further with your estate attorney.

As 2010 comes to a close and the beginning of the New Year approaches, continue to monitor the ongoing discussions in Washington over the federal tax policy until its much anticipated resolution. More importantly, be proactive in developing tax and investment strategies that are best suited for today’s changing tax environment and working with professional advisors whenever appropriate.

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Victor J. Dzau, MD, gives expert advice
Victor J. Dzau, MD, gives expert advice