For years, we accountants have advised clients to “defer income” and “accelerate expenses.” The thought behind this strategy is that it is better to pay tax next year than it is to pay it this year. In most years, under most circumstances, this approach makes perfect sense. But in an environment with rising (or potentially rising) tax rates, we might want to think about going against conventional tax knowledge and explore ways to accelerate income to take advantage of our current rate structure.
It is now mid-November and Congress has yet to finalize any extension of the 2001 and 2003 Bush tax cuts. We continue to hear reports that post-election many democrats are willing to temporarily extend the tax cuts for everyone.
You never want to assume that Congress will act and pass these tax cuts. We all assumed that the estate tax would never lapse as it did back in January. Therefore in an effort to provide timely tax planning, let’s assume that Congress fails to pass this legislation in the next six weeks. Under this assumption, there are various aspects of our current tax structure that will change substantially.
With that in mind, here are a few ideas to ponder as it relates to year-end tax planning, and the potential “acceleration of income” and “deferring of expenses.”
Lock In Those Long Term Capital Gains
Are you sitting on appreciated investment property that you are going to be liquidating in the near future? Selling in 2010 will let you take advantage of the 15% tax rate where waiting for next year could cost you 20%. A potential strategy would be to sell half of your holdings and lock in the 15% rate on a portion of the appreciation without accelerating all of the income.
Note: You only lock in the 15% rate if you have held the property for longer than one year.
Many taxpayers are currently receiving proceeds from installment sales. Each year, they report capital gain on their tax return equal to the gross profit percentage of the proceeds they receive. At any point in an installment sale, you can “elect out” of installment treatment and report the remaining gain of the transaction as if you received all the proceeds from the individual who purchased your asset. Under normal circumstances, there wouldn’t be much benefit to accelerate all of the income into the current year. However, with the long term capital gain rate at 15% for most taxpayers in 2010, and the potential that the rate will raise to 20% (or ever higher) in the near future, paying 15% now may save you some tax dollars over the life of the transaction.
Bonus or Section 179 Depreciation
Taxpayers can claim two types of “special” depreciation in 2010 that will allow for more current expense and less expense over the remaining useful life of the asset. Bonus depreciation allows you to expense half of the cost of the asset in the first year it is placed in service; while Section 179 allows you to expense the entire cost of the asset in the first year of its service (both types of depreciation have specific guidelines and limitations).
If tax rates were staying the same, it would certainly make sense to take the greater expense amount in the current year to minimize today’s taxes. However, every dollar of deduction you take today is only worth a 35 cent tax savings (2010’s highest marginal rate for individuals), while that same deduction could be worth 39.6 cents in 2011 (highest marginal rates pre-Bush tax cuts). If taxpayer didn’t have a big income year in 2010, it may make even more sense to forego bonus or Section 179 depreciation and allow the expensing of the asset to be equally spread into future tax years.
Executives may be sitting on unexercised stock options. Depending on the type of stock option, exercising triggers taxable compensation. If you are planning to exercise these options for financial reasons in the near future, the best tax answer may be to exercise them before year-end. That way, the compensation is recognized in 2010 and subject to potentially lower rates than it would be in 2011.
Roth IRA Conversion
Of all the items talked about in this article, Roth conversions, in my mind, are the most convoluted. The concept itself is simple. We take funds previously held in a traditional IRA and convert them to a Roth IRA. This means I pick up income on the conversion (generally the value of the account at conversion), but the funds then grow tax free (not deferred) into my retirement. I don’t pay tax on any future distributions, and I don’t have to take required minimum distributions when I reach age 70½.
The complication comes in when you consider all of the outside factors of whether you should convert. Do you have outside funds that you can use to pay the tax on conversion or will you take money from the IRA to pay the tax? What will your retirement income look like, and what projected tax rate will you be at in the future? What do you think inflation will be? What return could you have obtained with the cash used to pay taxes on the conversion if you didn’t convert?
The bottom line…sit down with your financial advisor and us before making any moves on Roth IRA conversions. It may be a good choice for some people, but it is certainly not for everyone.
The big disclaimer on everything we talked about is that Congress may well extend all of the Bush tax cuts. We will have to be patient over the next six weeks and see how everything plays out.
I have often heard my tax partner Kurt Trimarchi say, “don’t let the tax tail wag the dog.” First and foremost, make decisions because they are the right financial decision for your family or business. Yes, accelerating income may be the right thing to do for tax purposes, but if it will really hurt cash flow for your home or business, it may not be worth it. Many business owners want the cash in their pocket today so they can reinvest in their own business or pursue new opportunities in the marketplace. Whatever your situation is, talk with me or a member of our Private Client Services Group about what makes the most sense for you, your family, and your business.