Now is a good time for some year-end tax planning. As always, there have been some changes to the tax laws, and it appears that just about everyone will be affected by at least one of the changes. I thought I’d write this newsletter before year-end and let you know of some of the tax law changes.

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YEAR-END TAX PLANNING FOR 2010 – Time is money.

I notice every year, that for many of my clients, I could have reduced their taxes by some pre-emptive year-end planning. Give me a call at 650-326-1099, if you have large capital gains this year or other extraordinary income, or if you are affected by any of the tax law changes that I mention in this newsletter. Most likely, we can decide over the phone if it’s worth your while to come in and talk face-to-face. Remember: A little of your time this year will save you big money next year.

If I were asked to name the most sweeping and wide-ranging change, is the one affecting the Roth conversion would be the one. It’s a great deal for many people, and I discuss it in some detail a little later in this newsletter.

If you are considering making either a Roth or an IRA contribution, the limit is $5,000 if you are under 50 years of age and $6,000 for 50 and older.

The 30 percent Energy Credit is still available until December 31, 2010. The credit is 30 percent of your costs up to $1,500 credit. In other words, you would have to spend $5,000 on the addition of insulation, windows, doors, water heaters, furnaces, or other energy-saving devices designated by the government. And here’s what to look out for: The credit applies to your principal residence and it is a life-time credit. That means that you cannot spend $5,000 on windows one year, and then spend $5,000 on more windows a year later. However, there is a separate 30 percent credit for adding solar panels to your principle residence and second home—and there is no upper limit! Moreover, this credit is for solar panels placed into service by 2017.

BEWARE OF CONGRESS BEARING GIFTS

For 2010, essentially, there is no estate tax. It sounds wonderful at first, but there are limits: The no-estate-tax benefit applies only if the value is under $1.3 million for a single beneficiary or $4.3 million for a surviving spouse. If the estate is valued over those amounts, then the executor has to track down the original purchase prices of stocks, bonds, homes, art work, and myriad other assets. Then the executor must allocate the value of the assets. So instead of a stepped-up basis from date-of-death on all assets, you might have a very low basis on which to pay income tax when the asset is sold. There is no more unlimited marital deduction for surviving spouses. This law was passed years ago under President Bush, and like so many laws passed during one Administration, there is a temptation for the current Administration to change it, tweak it or do away with it outright. There was talk that Congress might have addressed the estate tax issue and make the changes retroactive to January 1, 2010. But estate tax returns are due nine months from date of death . . . and it’s already November. Tick-toc . . . tick-toc . . . tick-toc . . . .

Like all Congressional actions, there seems to be good news and bad news for on the estate tax for tax year 2010, due April 15, 2011. The good: unlimited marital deduction for surviving spouses is returning. The bad: the estate exemption amount is $1 million. Any estate valued at $1 million or more must file an estate tax return even if no tax is due. I hope Congress increases the exemption amount to $3 or $4 million and unlimited deduction for surviving spouses.

Looking ahead, several people have asked me about the income tax rates and capital gains rates for 2011. At this point, the answer is, “I don’t know for sure” However, I would offer this guideline: As I write this, we have a “lame-duck Congress” and the “Bush Tax Cuts” are set to on December 31, so the tax rates revert to what they were under President Clinton. The highest tax rate will increase from 35 percent to 39.6 percent (for incomes over $200,000), highest dividend rate will increase from 15 percent to 39.6 percent (for incomes over $200,000), and capital gains tax rate will increase from 15 percent to 20 percent. That is set . . . unless Congress changes them. In November, we elected a Democratic Senate and a Republican House of Representatives, so it’s anybody’s guess right now. Scenarios range from an extension of all of the Bush-era tax cuts, to extending only some of the Bush-era tax cuts, letting them all expire. To that last possibility, add that if they all expire, Congress may re-enact all or some of them after the new Congress takes their seats in January. And just to keep it interesting, all of the foregoing scenarios hinge on the power of the presidential veto.

If the tax rates are left as they are, the federal deficit will be at least $600 billion a year for the next 10 years and the federal debt would climb to $15 trillion by the end of this decade. I think the current budget deficit is $1.3 trillion. Sooner or later there have to be some tax rate increases, and there have to be some budget cuts.

Again, I invite you to make an appointment to review your current and possible tax positions so that you can make decisions based on your unique situation in a fluctuating environment.

Many people, when they leave their employer, when they are laid off, or when they retire, rollover their existing pension plan into their IRA. It sounds like a good idea, if only for the simplicity of it all: with the IRA at one brokerage firm there are fewer letters, fewer brokerage statements, one distribution, a lot less to keep track of, and easier tracking.

That may be true. However, if you have “basis” in your IRA, the amount of your tax-free distribution just decreased significantly. “Basis” in an IRA is the amount of the non-deductible contributions a taxpayer has made over the years. Over many years, the basis adds up. Basis is important because once a taxpayer starts taking distributions, a pro-rated amount of the distributions is tax-free. The calculation is the ratio of the basis (the numerator “upstairs”) and the value of all IRAs as year-end value (denominator “downstairs”). Here’s an example:

Martha makes non-deductible contributions over the years. When she starts taking out distributions, her IRA basis is $100,000. Her value of her IRAs is $200,000. So, $100,000 / $200,000 = 50 percent. So, 50 percent of her distributions are tax-free up until she uses up her $100,000 basis.

Let’s say that Martha decides to rollover her $500,000 pension plan to her $200,000 IRA before she takes distributions. Her basis is still $100,000 but now the value is $700,000 ($200,000 IRA + $500,000 pension plan). The calculation now is $100,000 divided by her new total IRA value of $700,000. Now only 14.28 percent of the distributions are tax-free. It’s quite a difference.

If your IRA deductions have complied with the tax-free provisions of the IRS all along, then this point is moot – rollover your pensions as much as you like.

It’s important to remember that with Roths, any distributions (after five years of contribution or conversion and you’re over 59-1/2) are tax-free and you are not required to take distributions even if you’re over 70 years old.

 

The IRS, among other tax-levying agencies, has hired a cadre of auditors, so they are out in-force auditing. With the huge deficits that our country and state are facing, and no increase of tax rates, tax agencies are shaking the money tree by auditing more tax returns. You have probably have noticed it already.

Before last year, I had maybe five audits in the 16 years since 1993. In December 2009, I had five audits in one month! Just so you know, the three tax returns I prepared came out as a no-change audit. The two tax returns I didn’t prepare but where I represented the client before the IRS, I was able to reduce the penalties significantly.

The types of tax returns the IRS is auditing are mostly those of the self-employed. Here’s what the auditor will do: He or she will add all the deposits made to your bank accounts for the year and add up all the income reported on your tax return. There’s lot of reasons why not all deposits are considered income: transfers from other accounts, loans, cash advances, inheritances, gifts. But the auditor does not take this into consideration, and he or she decides to levy a tax on what they perceive as income.

A little foresight and pre-emptive action on your part can set the record straight in no time. Just to audit-proof yourself, photocopy any checks that are loan advances, cash advances, inheritances, gifts, etc. In fact, if you use an ATM and your bank offers this service, be sure to use the option to produce a photocopy of the check that you deposited. I’m not saying that you won’t get audited, but I am saying that a habit of keeping these records will go a long way toward a hassle-free audit should the IRS come knocking on your door.

Well, not everyone needs to keep tax returns indefinitely. However, here’s a very common situation: The IRS wants to review your 2009 tax return. On there is a capital loss and rental property with depreciation. For reasons of this discussion, let’s say that the capital loss is a carryover from 2000 and you’ve had rental property forever. The IRS can ask to see the tax return for the year in which the capital loss was generated—that’s right: your 2000 return! The IRS is looking for proof of the basis plus all the subsequent years (your tax returns from 2000 through 2009) to show how the loss was carried forward. The basis would be on the form 1099-B, which your brokerage house was required to file (in this case in the year 2000) to report your sale of stock. The brokerage house was also required to send you a copy of the Form 1099-B. Therefore, you would do well to keep your tax returns and any supporting documents. And you don’t even have to have anything as complicated as a ten-year-old loss.

It’s the same circumstance with depreciation: the calculation of the basis and how the depreciation was carried over into following years is documented for each return and should be retained. Or the IRS’ reasons for audit could be about something else entirely. Before you toss those old records, give me a call, and we’ll discuss what needs to be retained and what can be shredded.

I think this is about it for now. I will mail your organizer at the end of December or beginning of January.

This newsletter is intended to be anoverview.

CONTACT ME NOW FOR YOUR TAX APPOINTMENT

650-326-1099 or DAVID@DAVIDHATTEA.COM

If you have any questions, please feel free to contact me. I welcome all your questions.

Please call now to make your tax appointment. The appointment can always be changed, if necessary. The sooner you call, the more likely you will get the time you want.