Rescuing your dwindling paycheck from the tax-man has become an important part of formulating an investment strategy, even if you are a rich politician.
Regardless what you were promised in 2008, your taxes will go up once the “Bush” tax cuts are allowed to expire. A recent article in Investor’s Business Daily outlined how those making far less than that magical $250,000 per year will see their taxes increase. Families making $50,000 per year will pay as much as an extra $835 per year.
Since tax rates will be rising regardless of your income, you can take steps to prepare. Here are a few strategies to consider in anticipation of the coming tax hike:
Before you panic, use a buy-and-hold investment approach
With an investment that increases in value by 6% each year, it will increase a little over 26% in four years, excluding any dividends or interest payments. So, although capital gain and other tax rates will increase next year, you may also want to consider holding investments with growth rates exceeding the increase in the tax rate. Buy-and-hold (excluding annual rebalancing of your portfolio) is one key factor in How A Second Grader Beats Wall Street.
Sell appreciated assets
Current long-term capital gains tax rates generally peak at 15%, but the rate is scheduled to increase to 20% after 2010. To avoid paying tax at the higher rate, consider selling those assets it makes sense to take advantage of today’s lower rates.
Take investment profits while rates are lower
Single investors with a maximum taxable income of $34,000 (including any capital gains or qualified dividends), and married couples with a maximum taxable income of $68,000, don’t pay taxes on qualified dividends received or long-term capital gains recognized in 2008, 2009, and 2010. Taxable income is what remains after deductions and personal exemptions are claimed. After 2010, the lowest capital gains rates will be 8% and 10%, a tax increase for all income levels.
Collect all possible income in 2010
With tax rates scheduled to rise next year, it makes sense to collect as much income as possible this year.
- If you’re self-employed, bill all your clients promptly. This could get a little dicey in December because your clients may want to pay in January to off-set their income. Consider offering a discount equal to the amount of extra tax you’d pay on that income.
- If you have any nonqualified stock options, exercise them in 2010. The difference between the stock’s exercise price and its fair market value is considered ordinary income and is included in your W-2.
- Ask your employer if you can receive your January bonus in December. Again, the company may prefer to pay it in January to offset its income.
Move investments to tax-free options
Certain types of investments provide tax-free income, tax-free growth, or aren’t taxed at all.
Municipal bonds and municipal bond funds can provide tax-free income
It can be tricky to calculate the real yield for a tax-free municipal bond because of the tax you don’t have to pay. Just remember that interest on certain municipal bonds is subject to the Alternative Minimum Tax.
Education savings plans also have tax advantages
Certain qualified tuition plans (QTPs), or section 529 plans, and Coverdell Education Savings Accounts (ESAs) allow you to save funds for your children’s future education expenses. Although the contributions you make aren’t tax deductible on your federal return, the earnings grow tax free and distributions to pay for qualified education expenses are tax-free as well. QTP contributions may be eligible for state tax deductions or credits. Unfortunately, the recent health care bill passed by Congress cut the amount you can set aside in your Coverdell account by 75%.
A Roth IRA grows income tax free
Roth IRA contributions aren’t tax-deductible, but you’ll pay no income tax on qualifying withdrawals. Generally, withdrawals are qualified if you’ve had the Roth at least 5 years and you are at least 59½ years old. A Roth IRA has many parameters and limitations, so be sure you consult an accountant or tax professional.
Life insurance proceeds are not subject to income tax
Life insurance can be a great way to pass wealth to your heirs without the worry about income taxes. In fact, if a life insurance policy is held until the insured’s death, the proceeds aren’t taxable. If the policy was owned by a life insurance trust, it may be free from estate taxes (again, check with a tax professional).
Get some advice
These strategies can be complex, with many potential features and pitfalls. Your financial advisor can explain your choices and help you determine which ones are most appropriate for you.
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