Karl W. Blovet & Associates

Most people have filed their 2011 Income Tax Returns by now; therefore planning for 2012 should start immediately. Here are eight things the IRS suggests that you should do.

Adjust your withholding. Don’t provide the IRS with an interest free loan. If you had a large overpayment, now is a good time to review your withholding and make adjustments. The reduction in withholding improves your cash flow for the entire year. If you had a substantial underpayment, make adjustments so that interest and penalties are not assessed.

Store your returns and supporting documents in a safe place. If you receive an IRS Notice, or are examined, you will need to access the information quickly. You also need the information to prepare the 2012 income tax returns.

Organize you record keeping. Establish a central location where everyone in your household can place tax-related records all year long.

Review your payroll earnings statement. Make sure the proper withholdings are occurring and that your retirement plan contributions, medical insurance premiums, and flexible spending account contributions are as desired.

Shop for a tax professional early in the year. If you desire to use a professional to plan, strategize, and make financial planning decisions throughout the year, then search now. Choose a professional wisely. You are ultimately responsible for the accuracy of your returns.

Prepare to itemize deductions. If your expenses typically fall just below the amount to make itemizing advantageous, planning to bundle deductions into 2012 may be beneficial.

Strategize tuition payments. The American Opportunity Tax Credit will expire after 2012; therefore it may be advantageous to pay 2013 tuition in 2012.

Keep up with tax law changes. Meet with your tax professional during the year to discuss changes in the law and to discuss changes in your personal circumstances.

Tax planning for year-end 2011 should use both traditional year-end strategies as well as those that react to situations unique to this year. Particularly important at year-end 2011 is the impact of certain tax benefits scheduled to end with 2011; a look ahead at possible significant changes in the tax laws starting in 2013; and attention to new opportunities and pitfalls created during the past year through court cases and IRS rulings.

Income/deduction shifting

The traditional year-end strategy of income shifting applies to year-end 2011 but with an extra twist. Under traditional strategy, you time your income and deductions so that your taxable income is about even for 2011 and 2012 so your tax bracket does not spike in either 2011 or 2012. If you anticipate a higher tax bracket for 2012, you may want to accelerate income into 2011 and defer deductions into 2012. If you anticipate a leaner 2012, income might be delayed through deferred compensation arrangements, postponing year-end bonuses, maximizing deductible retirement contributions, and delaying year-end billings.

The twist for year-end 2011 is the uncertain future for tax rates after 2012. We believe that higher-income taxpayers will be asked to pay more, either through higher tax rates or more limited deductions. That may suggest a strategy in which income is not deferred but is recognized now at lower tax rates still available in 2011 and 2012.

Roth conversions

If you converted an individual retirement account (IRA) to a Roth IRA in 2010, you were given an option: recognize all income in 2010 or defer that income, half into 2011 and half into 2012. If you elected to defer that income into 2011 and 2012, do not forget to figure that income into your year-end planning for 2011.

If you initiated a Roth conversion earlier in 2011 and that Roth account has declined in value since then, you should consider a “Roth reconversion.” Reconverting your Roth IRA back to a regular IRA before year-end will allow you to avoid paying income tax on an account balance at its higher value.

Finally, if you have not yet made a Roth conversion, doing so at year-end 2011 might be an opportunity worth serious consideration. Variables include your present income tax bracket, how close you are to retirement, and your access to other funds both to pay the conversion tax and to delay distributions from your Roth account later.

Alternative Minimum Tax (AMT)

Because the AMT was not indexed for inflation, and for other reasons, the AMT today encroaches on many moderate-income taxpayers, especially two-income married couples. With most of your income and deductions for 2011 more predictable as year-end approaches, now is a good time to compute whether you will be subject to the AMT for 2011 or 2012.

Capital gains and losses

Time the recognition of capital gains and losses at year-end to minimize your net capital gains tax and maximize deductible capital losses. Many investors have excess capital losses from recent stock market declines that they may now “carry over” to offset capital gains that would otherwise be taxable.

Also of concern is whether the maximum tax rate for capital gains will rise from 15 percent to 20 percent or higher after year-end 2012 because of the scheduled expiration of the Bush-era tax cuts. Since long-term capital gains are only available on stocks and other capital assets held for more than one year, a capital asset must be bought on or before December 30, 2011 in order to be sold in 2012 and guarantee qualifying under the lower capital gains rates.

Finally, if you would like capital gains taxes at a zero percent rate, consider investing in “Section 1202” small business stock before year end. The 2010 Tax Relief Act allows the exclusion of 100 percent of the gain from the sale or exchange of qualified small business stock acquired by an individual after September 27, 2010, and before January 1, 2012, and held for more than five years. The window of opportunity to invest in stock that will yield 100 percent tax-free gain closes on December 31, 2011.

Payroll taxes

Wage earners and self-employed individuals will experience a tax increase in 2012 unless Congress extends the current employee-side payroll tax cut. For calendar year 2011, the employee-share of OASDI taxes is reduced from 6.2 percent to 4.2 percent up to the Social Security wage base of $106,800 (self-employed individuals receive a comparable benefit). President Obama has proposed to extend and enhance the payroll tax cut. The fate of the payroll tax cut will likely not be decided by Congress until late 2011.

Life changes

Marriage, divorce, the birth of a child, death, a change in job, or loss of a job, and retirement are just some of the life events that trigger a special urgency for year-end tax planning. After December 31, 2011, it will be too late to alter most of your bottom-line tax liability for 2011.

Medical expenses

Effective January 1, 2011, the Patient Protection and Affordable Care Act (PPACA) provides that over-the-counter medications and drugs can no longer be reimbursed from a health flexible spending arrangement (health FSA) unless a prescription is obtained. The rule also applies to health reimbursement arrangements (HRAs), health savings accounts (HSAs), and Archer medical savings accounts (Archer MSAs), an important consideration for employees who are required to make a decision prior to year-end 2011 on how much to fund their accounts in 2012.

Tax extenders

A number of tax extenders are scheduled to expire after December 31, 2011. They include:

  • the state and local sales tax deduction,
  • the higher education tuition deduction, and
  • the teacher’s classroom expense deduction.

Seniors age 70 1/2 and older should also consider making a charitable contribution directly from their IRAs up to $100,000 and paying no tax on the distribution. This tax break, especially advantageous to those who do not itemize deductions, is scheduled to end for distributions made in tax years beginning after December 31, 2011.

Casualty losses

Taxpayers in many states experienced natural disasters in 2011. A casualty loss can result from the damage, destruction or loss to your property from any sudden, unexpected or unusual event, such as a hurricane, tornado, earthquake, wildfire, or flood. Casualty losses are generally deductible in the year the casualty occurred, less ten percent of your adjusted gross income and a $100 per casualty deductible.

However, if you have a casualty loss from a federally declared disaster, you can elect to treat the loss as having occurred in the year immediately preceding the tax year in which the disaster happened, and you can deduct the loss on your return or amended return for that preceding tax year. The election gives taxpayers the opportunity to maximize their tax savings in the year in which the savings will be greatest.

Energy tax incentives

If you are considering replacing your roof, HVAC system, or windows and doors, doing so using energy-efficient materials before January 1, 2012 may generate tax savings. Through the end of 2011, a number of residential energy-efficiency improvements qualify for a tax credit. These include qualified windows and doors, insulation products, HVAC systems, and roofing. The “lifetime”credit amount for 2011, however, is $500 and no more than $200 of the credit amount can be attributed to exterior windows and skylights.

Gift/estate tax

The current estate tax through 2012 is set at a maximum 35 percent rate and a $5 million exemption amount. We are of the opinion that after 2012 Congress will lower the exclusion to $3.5 million and raise the top rate to 45 percent. In light of this possibility, lifetime gift-giving, ideally on an annual basis, should continue to form part of a master estate plan. The annual gift tax exclusion per donee on which no gift tax is due is $13,000 for 2011 (and, again, for 2012), with $26,000 allowed to each donee by married couples. Making a gift at year-end 2011 to take advantage of this annual, per-donee exclusion should be considered by anyone with even modest wealth.

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (“Act”). In addition, in early 2011, Illinois legislation was passed increasing the individual and corporate income tax rates. The new federal and state legislation will have a dramatic impact on how you prepare your 2010 and 2011 income tax returns. Listed below is a brief summary of portions of the legislation.

Individuals

The reduced Individual income tax rates (10, 15, 25, 28, 33, and 35 percent) have been extended through 2012.

Personal income tax in Illinois has been raised to 5%, effective January 1st of this year.  This increase is up from 3%, and will remain in effect until 2015, when the Illinois individual income tax is scheduled to decrease to 3.75% and remain at that rate through the year 2024, when it is scheduled to decrease to 3.25%.  These Illinois rates apply to individuals, estates, and trusts.

Capital Gains Tax Rates and Dividend Tax Rates remain unchanged.  Individuals in the 10% and 15% tax brackets will have a zero percent capital gains and qualified dividend tax rate, while other individuals with long term capital gains and qualified dividends will be taxed at a maximum 15% tax rate.  These rates will remain in effect through December 31, 2012.

Alternative Minimum Tax (“AMT”) exemptions are temporarily increased (patch) for 2010 and 2011.  For 2010, the individual exemption amount has been increased from $46,700 to $47,450, and the married filing jointly exemption has been increased from $70,950 to $72,450.  For 2011, the individual exemption amount is $48,450 and for married individuals filing jointly the exemption amount is $74,450.  These higher exemption amounts are designed to prevent some middle income earners from being subject to the AMT.

Social Security Tax Rates will be temporarily reduced by 2%.  For 2011, only the employee portion of social security taxes will be 4.2%, instead of the previous 6.2% rate.  This is paid in on the first $106,800.00 of compensation.  The employer portion of social security tax remains at 6.2%.  According to the IRS, this reduction will not affect an employee’s future Social Security benefits.

Tax Credits under the Act include enhancements to the child tax credit, earned income credit, adoption tax credit, and dependent care credit.  These credits will continue through 2012.  The credit for individuals who make energy efficient home improvements has been extended through 2011.

Individual Tax Deductions have been extended for 2010 and 2011.  Some of these include deductions for student loan interest, classroom expenses for teachers, and a state and local sales tax deduction.

Charitable Contributions and IRA Distributions: Taxpayers age 70 ½ or older can take a tax free distribution up to $100,000, when made from an IRA and paid directly to a qualified charitable organization.  This incentive continues through 2011.

Making Work Pay: The “Making Work Pay” credit, which was part of the 2009 Recovery Act, expired on December 31, 2010 and was not renewed.  The credit was worth $400 to taxpayers making $75,000 or less ($800 to married couples earning under $150,000).

Businesses

Self-Employment Tax is reduced from 12.4% to 10.4% in 2011.  Self-employed individuals will pay 10.4% on the net self-employment income up to $106,800.

Illinois State Corporate Income Taxes have been increased from 4.8% to 7%.  This increase will remain in effect until 2015, when the Illinois corporate tax rate will go back to 4.8%.

Bonus depreciation has been extended and doubled from 50 percent to 100 percent for qualified property placed in service before January 1, 2012.

Sec. 179 expensing has been extended through December 31, 2012.

Estate Tax

The federal estate tax has been reinstated through December 31, 2012. The maximum rate is 35 percent with $5 million exclusion amount. The legislation allows “portability” between spouses of the estate tax exclusion amount. For years beginning January 1, 2013, the exclusion amount and rate are scheduled to be $1 million and 55 percent respectively.

The Illinois estate tax has been reinstated, with an exclusion amount of $2 million, and a graduated rate scale ranging from 7.2 percent to 16 percent.

This year in particular, year end tax planning is full of uncertainties. This makes it even more difficult than previous years. If you believe that tax rates will not rise in 2011, including the 15% top rate on qualified dividends and long term capital gains, here is what most taxpayers should consider doing:

Accelerate deductions from 2011 to 2010 and defer income into early 2011 (do not jeopardize collection of the income), unless you expect to be at a higher marginal tax rate in 2011.

If you qualify to itemize deductions shift state and local income taxes into 2010. Pay your estimated tax payment s due in January, 2011 in December, 2010. This is not a strategy if you expect to be subject to the dreaded “alternative minimum tax” in 2010. Accelerate charitable contributions into 2010. If possible, make the donations using appreciated investments held more than one year. Do not donate investments that have declined in value. Pay your January, 2011 mortgage payment in December of 2010.

If you plan to do a Roth IRA conversion, converting in 2010 allows you to spread the resulting tax over 2011 and 2012. If you wait until 2011 to convert, the two year spread is not available.

Harvest capital losses, matching losses with capital gains to produce a net loss of $3,000. If you have a capital loss carry forward (from 2009 and earlier years), harvest capital gains if it fits your overall investment strategy in order to take advantage of the tax benefit.

You probably feel good that you filed your tax returns on or before April 15 and that you can forget about taxes for another year. Not so fast. Remember the struggles involved with the preparation of 2009 returns, took a look at them again, and determine how better record keeping and planning throughout the year could have assisted you during preparation time.

Tax planning begins with good organization. Valuable deductions are lost as a result of poor record keeping. Also, effective tax planning is a year-round undertaking that works best if started early.

Keep good records.

Maintaining good records for your investments is imperative. Most people still have losses as a result of the prolonged bear market and subsequent recovery that began in March of 2009. Keeping track of your cost basis will enable you to readily determine your capital losses or determine the amount of gains for those so fortunate.

With regard to year-round tax planning, start by determining your short and long term goals and objectives. Quantify your goals and objectives so that you can determine what it will take to get there based upon your time line. Almost everyone wants to save for a comfortable retirement, save for a down payment for that first house, or save for their children’s college education.

Take advantage of every opportunity that exists to put money into a tax favored program. Do it as early in the year as possible. Use your employer’s 401(k) plan, start an IRA, or add to an existing IRA. Consider a Roth IRA conversion. 

Tax favored education accounts allow you to contribute after tax dollars currently for subsequent tax free withdrawals for qualified education expenses. Education Saving Accounts allow you to contribute up to $2,000 per year, per child, under age 18 to cover costs of pre college education expenses as well as college expenses. State 529 plans allow you to contribute to the plan for qualified college expenses. Contributions are subject to gift tax. The $13,000 annual exclusion ($26,000 per married couple) can be used for this purpose.

Making Work Pay Credit: This provision allows a credit against income tax up to $400 for individuals whose modified adjusted gross income does not exceed $75,000 and $800 for married couples whose modified adjusted gross income does not exceed $150,000. It applies retroactively to January 1, 2009 and will be repeated in 2010. Taxpayers may take this credit through a reduction in payroll withholding or when filing their returns for the year.

$250 Economic Recovery Payment: This provision allows a one-time payment of $250, for 2009 only, to taxpayers on fixed incomes (primarily Social Security recipients).

First Time Home Buyer Tax Credit: The credit is increased to $8,000 for purchases made after December 31, 2008 and before December 1, 2009. It also eliminates any required repayment to the IRS. The credit is phased out for taxpayers with income in excess of $75,000 for individuals and $150,000 for married couples.

New Car Deduction: For the purchase of a new car in 2009, taxpayers are allowed a deduction for state and local sales taxes and excise taxes. Taxpayers do not need to itemize deductions to take advantage of this benefit. The deduction is phased out for individuals with income in excess of $125,000 and married couples with income in excess of $250,000.

Alternative Minimum Tax: This provision raises exemption amounts above the 2008 levels. The patch was designed to insulate approximately 26 million middle-income taxpayers from the AMT in 2009.

Unemployment Compensation: The provision excludes up to $2,400 of unemployment compensation from the recipient’s gross income for 2009.

Transit Benefit: The new law increases the current $120 per month income exclusion amount for transit passes to $230 per month.

COBRA Benefits: The provision allows individuals who are involuntarily separated from employment between September 1, 2008 and January 1, 2010 to elect to pay 35% of his/her COBRA coverage and have it treated as paying 100%.

Cashing out when changing employers: This act will cost you ordinary income taxes on your savings, as well as a 10% penalty. This should be an act of last resort only.

Doing nothing when changing employers: There are many reasons people leave their savings with former employers. Some fear of making a mistake, fear the amount of paper work involved, and some people are satisfied with the performance of their investments in their former plan. In general, by creating a new account and doing a direct transfer of your savings, you will have better investment options, you can consolidate your retirement savings accounts (easing your administrative burden), and better control the related expenses.

Not updating beneficiary designations: Because the inheritance rules regarding IRAs are so complex, it is imperative to make sure that your not creating a disaster for your loved ones by ignoring beneficiary designations.

Forgetting to invest the savings transferred: The last step is to choose the appropriate asset allocation after you have created the new account and transferred the savings. According to the Vanguard Group, many people forget to actually invest the savings once its been transferred. Instead, it sits in low-yielding money market accounts.

US Large Cap Stocks: Large US companies generate a significant portion (41% of revenues for the S & P 500 in 2005) of their revenue abroad. When the dollar is weak, international sales denominated in foreign currency translate into more revenue in dollars.

Foreign Stocks: US investors with a reasonable allocation to international stocks should get help as well. When the dollar declines in value, the value of international stocks goes up in dollar terms.

Foreign Bonds: Having a small portion of your allocation invested in bonds denominated in foreign currencies could provide a boost as well.

The key to compensating for the weak dollar is to maintain a globally well-diversified allocation. We recommend using no-load, low expense ratio index funds, or ETFs for those seeking broad international exposure.

Every year thousands of taxpayers overpay their income taxes because they use the standard deduction when itemizing deductions would be more advantageous. The causes are bad record keeping and simply not knowing or understanding the law. What follows is a basic review of what expenses qualify:

Taxes: State and local income taxes, real estate taxes, and personal property taxes are all deductible. Federal taxes, social security tax, and sales tax are not deductible.

Medical Expenses: You can deduct unreimbursed expenses for you, your spouse, and your dependents to the extent they exceed 7.5% of your adjusted gross income (AGI). This includes expenses for doctors, dentists, hospital care, prescriptions, nursing services, and medical aids. Also included are, insurance premiums, long term care premiums (within limits), and transportation and lodging.

Interest Expense: You can deduct interest paid on your primary residence and one second home. Also included are, first and second mortgages up to $1 million and home equity loans up to $100,000. Points are generally deductible and points incurred to refinance are amortized over the term of the loan. Interest paid on money used to acquire investments are deductible within certain limits.

Contributions: Donations to qualified organizations are deductible to the extent you receive no benefit in return. The organizations include churches, schools, libraries, and qualified charities. You can make donations in cash, check, or credit card. You can also deduct the fair market value of property other than cash. You must keep detailed records for donations of property other than cash, moreover you need a receipt for cash donations of $250 or more. All organizations must be located within the USA.

Casualty and Theft Losses: Losses from a fire, theft, or disaster are deductible within certain limits.

Miscellaneous Deductions: Included are certain unreimbursed employee expenses, investment expenses, gambling losses, and tax planning and tax preparation fees. Most of these expenses are subject to a 2% AGI floor.

To benefit the most, an awareness of the deductions that apply to you and good records are very important. If you have questions, please contact us.

In General: Defer income and accelerate deductions, harvest tax losses, maximize retirement plan contributions, avoid tax underpayments through withholding and estimated payments, and consider your exposure to the alternative minimum tax.

Car Donations: If you itemize your deductions you can donate a car (see previously featured article) to a qualified charity and deduct the fair market value of the car. Beginning in 2005, if you donate a car valued at more than $500 and the charity sells the car, you may only claim a deduction for the amount the charity receives, not the amount that you determine to be the fair market value.

Sales Tax Deduction: As a result of new tax legislation for 2004 and 2005, if you itemize your deductions, you can deduct the greater of either your state and local income taxes or your state and local sales taxes, but not both. This change will primarily benefit people in states with no state and local income taxes. Although, this change may even be advantageous for people who live in a low tax state or for people who have purchased big ticket items.

Year-End Donations: If you are planning a year-end donation to your favorite charity, consider giving shares of publicly traded stock or mutual fund shares that have substantially increased in value over the years. Provided you have owned the shares more than one year on the date of the donation, you can deduct the fair market value and not have to recognize capital gain on the increase in value on your Form 1040. Also, if you are considering donating cash but will not have the money until next year, charge your gift to a credit card this year. As a result, your donation is deductible this year even though you do not pay your credit card debt until next year.