Look, it’s that time of year again, when the IRS puts out its secular holiday tree festooned with shiny tax deductions.
We’ll look at some of those perennial ornaments, but this year is different: the Bush tax cuts are set to expire on December 31, 2010, and nobody knows yet whether Congress will extend them, let them lapse, or do something in-between. Everyone can agree on one thing, though. “The tax rate right now is probably the lowest you’re going to have,” says Justin Ransome, a partner at Grant Thornton LLP. That goes for both income and capital gains taxes.
If you’re a small business owner, an investor, or a philanthropic sort, this means you might want to do exactly the opposite of what you usually do this time of year. So let’s start our top ten list with the topsy-turvy items.
1. Harvest capital gains
The current long-term capital gains tax rate is 15%. “Currently it’s about the lowest rate in town,” says Charlene Fleming, an accountant with KE & Associates in Seattle. If Congress doesn’t act, that’s going up to 20% in 2011. If you have appreciated assets (like a stock or mutual fund that went up) in a taxable account (not a retirement account or 529 plan), take the opportunity to sell and repurchase those assets. You’ll lock in any gains up to this point at the 15% rate. Granted, that means you’ll pay more capital gains tax now than you may have anticipated. But think long-term: If the tax rate goes up in the future, you win. If it stays the same, all you’re out is a few bucks in transaction fees. (It’s not going down.)
This sounds a little nutty, so I’m going to say it again: sell the investments that have made you money, pay the tax, and—assuming you still like those investments—buy them back. “I’ve recommended this to a couple of people, too, and they look at me like I grew two heads,” says Fleming. Trust both of her heads: it’s a smart move.
2. Accelerate income, delay expenses
Typically, at the end of the year, you want to get in any deductible expenses before December 31 and delay income, to the extent possible, until the following year. Because taxes may go up, however, consider turning this strategy on its head, because deductions get more valuable as your tax rate increases. “Take income this year and delay expenses,” says Fleming. “It just seems like the prudent thing to do. Eventually taxes are going to have to go up.”
Now, back to the old reliables:
3. Take advantage of education tax benefits
The Lifetime Learning Credit is available to most taxpayers and covers a wide variety of education expenses. I took an online finance class this year: it’s deductible. The American Opportunity Credit (formerly the Hope Credit) is specifically for college undergraduate expenses. Furthermore, the credits now cover “course materials,” like books, supplies, and beer. Okay, not beer. Finally, don’t forget to deduct student loan interest.
4. Max out your retirement accounts — and consider a conversion
You can stuff extra money into your 401(k) and take the deduction until December 31. For IRAs, you have until April 15. However, given what I said about tax rates going up, you may want to take the deduction next year.
Now, about that conversion: I’m talking about converting traditional IRA accounts into a Roth IRA. (Why, what did you think?) Normally, when you convert a traditional IRA to a Roth IRA, you’d have to pay income tax on the full converted amount. But this year, the tax hit for Roth IRA conversions can be spread out over two years. And if you remember that today’s tax rates are ridiculously low by historical standards, and possibly the lowest they’ll ever be, any taxes you pay now will likely pale in comparison to the taxes you’ll end up paying in the future.
5. Spend your FSA balances
If you have money in a Flexible Spending Account for health care or day care, use it now or lose it. Also, as of January 1, over-the-counter medication is no longer eligible for FSA reimbursement, so buy it now. Now is also the time to submit your paperwork for next year’s FSA. Oh, and don’t forget that summer camp is often deductible.
6. Take the Home Energy Efficiency Improvement Tax Credit
This credit offers you up to $1,500 back for greening your primary residence. Water heaters, insulation, doors and windows, HVAC—it’s all good. But you only get until December 31, so start demolishing now.
7. Check for underwithholding
I know, I know, most people overwithhold so they can get a juicy refund (a.k.a. an interest-free loan to the government). But underwithholding can sock you with a penalty. This is especially common if you’re self-employed. It’s not too late to fill out a new W-4 or send in an extra 1040-ES payment to reduce or eliminate your penalty.
8. Make a 1099/W-2 checklist
This saves me a lot of tax worries every year. If you’re self-employed and get 1099-MISCs, or have money at a number of banks and brokerages, or worked several jobs this year, you need to collect a pile of paperwork before you can file the 1040. Make a list now and check it off in February as the paperwork arrives. No more of that “oh crap, I thought I was going to get my taxes done today but I’m short a 1099” feeling.
9. Contribute to a 529 Plan
There is no federal income tax deduction for 529 plan contributions, but some states do offer this perk. Here’s the master list. (The catch is, you have to contribute to your home state’s plan — so if you live in California but contribute to New York’s 529 plan, you cannot deduct any of those contributions on your California state tax return — or vise versa. But if you live in New York and contribute to New York’s 529 plan, you can deduct up to $10,000 of contributions a year for married couples, $5,000 if you’re single.) If you’ve moved or haven’t recently checked the list above, see if you could save money by switching plans.
That said, should 529 contributions really be driven by upfront tax benefits? To put it another way, have you checked how much college costs these days?
If you’re lucky to have enough assets to be eligible for the estate tax, remember that right now there is no estate tax. And if Congress doesn’t do anything about it until the end of the year, on January 1, 2011, estate tax will be back. Will Congress do anything? Maybe. The bottom line is, after the end of 2010, no one knows exactly who it is going to apply to or what the rate will be. Last year, people joked about hanging on a few more days until the tax expired. It turned out not to be a joke. I suspect this won’t be, either.