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  • The Individual Investor's Guide to Personal Tax Planning for Tax Year 2010

    The Individual Investor's Guide To Personal Tax Planning For Tax Year 2010 Splash image

    Much of the new tax bill signed in December 2010 is more of the same. Most of the tax rates and deductions that were in existence in 2010 will continue to be so in 2011 with the passage of the Tax Relief/Job Creation Act of 2010.

    Faced with the combination of high unemployment, a slow economic recovery and the threat of higher across-the-board tax increases, Congress opted for the simplest solution—to extend the tax cuts. Though the decision keeps money in consumer’s pockets, and actually increases cash for workers, it comes at a cost. Estimates say the legislation will add $858 billion to the federal deficit, making it the most expensive economic stimulus the U.S. has ever put into place. This is what happens when politicians wait until the last minute to figure out a solution to a long-term problem.

    Regardless of what you think about the new tax legislation, you will still have to pay taxes. Nothing in the bill simplifies the process; hence, the need for our annual tax guide. We provide an overview of the tax rates and deductions likely to impact the majority of AAII members. Since there are many details, loopholes and pitfalls within the tax code, it is impossible for this guide to provide enough details to cover specific tax situations. Thus, if you have questions, please consult a tax professional. It is your tax return and the IRS will hold you responsible for any errors made on it.

    Tax Software, Books and Guides

    Congress’ delay in acting created problems for those who publish tax software, books and related guides. This is because of the logistics required to produce and distribute physical material and the very real deadline for having those products available to the public. Therefore, if you use any software program (e.g., TurboTax), book (e.g., “J.K. Lasser’s Your Income Tax 2011”) or related aid, check for updates. It is highly probable that updates, or a supplement, have been produced since the original product was placed on the market. TurboTax is good about providing updates to download, and J.K. Lasser will have a comprehensive e-supplement on its website. I am sure other providers will do the same.

    A good example of why this is important is the alternative minimum tax (AMT). The annual exemptions had yet to be indexed for inflation at the start of December, and there was still uncertainty about what the 2010 levels would be. The tax bill includes a “fix” that adjusts the 2010 exemptions to $47,450 for single and head-of-household filers, $72,450 for married filing jointly and $36,225 for married filing separately.
    Another example is the deduction for state sales taxes. Whether this would still be an option was not determined until the tax bill passed Congress. Thanks to the new law, you can deduct state and local sales taxes in lieu of state and local income taxes for the 2010 tax year.

    Even if neither of these two specific examples apply to you, there are enough details to the 2010 tax law that were not resolved until last month that you should make sure you are using updated information. Check with the provider of any software, book or guide for updates.

      2010 2011 2012
    Long-Term Capital Gains Rate      
    Tax Bracket Above 15% 15% 15% 15%
    Tax Bracket 15% or Below 0% 0% 0%
    Qualified Dividends Rate      
    Tax Bracket Above 15% 15% 15% 15%
    Tax Bracket 15% or Below 0% 0% 0%
    Marginal Income Tax Rates      
    Top Bracket 35% 35% 35%
    Fifth Bracket 33% 33% 33%
    Fourth Bracket 28% 28% 28%
    Third Bracket 25% 25% 25%
    Second Bracket 15% 15% 15%
    First Bracket 10% 10% 10%
    Child Tax Credit $1,000 $1,000 $1,000
    Marriage Penalty Relief      
    Standard Deduction (% of  S.D. for singles)  200% 200% 200%
    15% Tax Bracket (% of bracket for singles) 200% 200% 200%
    Repeal (%) of Personal  100% 100% 100%
    Exemptions Phase-outs       
    Repeal (%) of Limitation on 100% 100% 100%
    Itemized Deductions      
    AMT Exemption      
    Single $47,450 $48,450 na
    Married Filing Joint $72,450 $74,450 na
    Head of Household $47,450 $48,450 na
    Estate Tax      
    Exemption taxrepealed $5 million $5 million
    Maximum Rate 0% 35% 35%


    What’s New?

    The federal income tax rates will stay unchanged in 2011 and 2012. Had the new law not passed, tax rates would have risen for all income levels. Instead, they are going to remain at 10%, 15%, 28%, 33% and 35%.
    In addition, payroll taxes (for Social Security) will be reduced by 2% for 2011. This cut also applies to those who are self-employed. The reduction is limited to the first $106,800 in salary, capping the value of the cut at $2,136. Those who earn less than $106,800 will only keep an extra 2% of their salary. In other words, a worker earning $50,000 per year will receive an extra $1,000 this year. Taxpayers who are not employed will not be eligible to take advantage of this tax break.

    The payroll tax cut is temporary and is set to expire on December 31, 2011. Because it is a one-time break, anyone who does not absolutely need the money for living expenses, should automatically direct it to savings or use it to reduce debt. This is not what Congress had in mind when they included the break (legislators would like you to actually spend the extra cash), but it is the more prudent financial move.
    As previously stated, a “fix” to the AMT was passed. This adjustment applies to the 2010 tax year.

    The repeal of the phase-out for the personal exemption was extended through 2012. Prior to 2010, the personal exemption was reduced after adjusted gross income exceeded certain levels (e.g. $250,200 for married couples filing joint returns). This penalty was rescinded for 2010 and now will continue to be so through 2012.

    Families will continue to benefit from three tax breaks in 2011 and 2012. First, an adjustment for the so-called “marriage penalty” is included. This puts the standard deduction for married couples filing jointly at double the standard deduction for those filing single. At press time, the standard deduction amounts for 2011 had not been announced. (Tax authority CCH projects the standard deduction to be $11,600 for married filing jointly and $5,800 for those filing under single status.)

    The second tax break for families is the child tax credit. The larger $1,000 credit will be maintained in 2011 and 2012. The credit phased out for married couples filing jointly with modified adjusted gross income (MAGI) above $110,000 in 2010, and our understanding is that this phase-out will stay in place for 2011 and 2012. If the child tax credit exceeds the tax liability, the difference will be paid to the taxpayer.
    The third break is the reinstatement of the estate tax with larger exemptions, along with a change to the application of the 2010 law. These are discussed below.

    Capital gains and dividend taxes will stay at 2010 levels in 2011 and 2012. Both long-term capital gains and qualified dividends are taxed at 15% if incurred for securities held within a taxable account. (There is no capital gains tax or dividend taxes for securities held within a retirement account, such as an IRA. See Robert Carlson’s article, “Do’s and Don’ts of IRA Investing,” in the March 2010 AAII Journal for investments that can cause an unexpected tax problem.) Collectibles, which include gold coins and bars, will be taxed at a 28% rate. Short-term capital gains will be taxed as ordinary income. If you are in the 10% or 15% tax bracket, long-term capital gains and qualified dividends are not taxed.

    Estate Tax

    There are two primary aspects to the revised estate tax code. The first, which was constantly in the headlines throughout December, is the new, higher exemption. Starting in 2011, the first $5 million of an estate will be exempt from taxes. This a per spouse exemption and it is portable, meaning if one spouse passes away, the surviving spouse can claim the exemption, resulting in a total effective exemption of $10 million. This is why so few families will have to pay estate taxes under the new law.

    The second aspect is the reinstatement of the step-up basis for 2010, 2011 and 2012. Though heirs do not owe any estate tax on assets inherited in 2010, the tax code required that cost basis be used to determine the gain on the sale of those assets. In other words, the taxable gain was calculated based on the purchase price paid by the deceased and the proceeds received by the heir at the time of sale. With the passage of the new tax law, however, the default method is the new rule, which is a maximum tax rate of 35%, a $5 million exemption and the step-up basis. If the new rules are used, capital gains are calculated as the difference between the proceeds at the time the assets are sold and the value of the assets at the time of inheritance. Therefore, those who became heirs in 2010 will have to determine which method provides the most tax advantages.

    In 2011 and 2012, heirs will only be able to use the new rules, which include the step-up basis.

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    Brokers to Start Reporting Cost Basis

    As of the start of this year, brokers are required to report both the cost basis of and the proceeds from stocks sold by investors. This rule applies specifically to stocks purchased after January 1, 2011; it does not apply to stocks purchased on December 31, 2010, or earlier. Mutual funds will be covered by this new rule beginning on January 1, 2012, and options and bonds will be covered beginning on January 1, 2013.

    This is a change from what brokers have historically reported. Previously, only proceeds were listed on Form 1099-B, including the tax statements you have received (or soon will) for the 2010 tax year. As of January 1, 2011, brokers must now list the cost basis. In addition, brokers must also state whether the gain or loss was short-term or long-term. The rule applies to all brokers, including online and full-service brokers.

    The change is the response to a 2008 law passed by Congress. The law is intended to limit the loss in revenues caused by investors who underestimate their capital gains on tax returns.

    A default accounting methodology known as first-in, first-out (FIFO) will be used when the purchase of a stock involves more than one transaction. The FIFO method treats the first shares purchased (“first in”) as also being the first shares sold (“first out”). Depending on how the stock has performed, this treatment can result in a larger tax bill (the shares appreciated in value) or a bigger capital loss (the shares fell in value).

    You can, however, specify to your broker which shares are to be sold first. For instance, if you built a position in a stock over the course of three days (say, Monday, Tuesday and Wednesday), you can sell the shares you bought on Wednesday first. In order to do this, you must provide written instructions to your broker detailing your intentions by the time order is executed, not afterward.

    Dustin Stamper at Grant Thorton’s National Tax Office emphasized the importance of providing these instructions in writing. If you give your broker specific instructions and your broker reports a different methodology to the IRS, the only way you can dispute what is on Form 1099-B is to provide a dated copy of your instructions. Stamper said that investors will not be able to retroactively determine which shares were sold; they must provide written instructions at or before the time the shares are sold.

    Change in Capital Gains Reporting

    Effective January 1, 2011, brokers are required to report the capital gains for stocks sold by their clients. This is a change from 2010 and previous years, when brokers only reported the proceeds from the sale of the stock. See the special write-up in the box above for details on this new rule, which will cover mutual funds as of 2012 and options and bonds as of 2013.

    Useful Tax Numbers

    Here is a list of the tax rates, deductions, exemptions, credits and other related items that may apply to your 2010 taxes. These numbers are based on what has been published by the IRS as of the time of publication and assumptions based on the new tax law.

    Standard Deduction

    For 2010, the standard deduction is $11,400 for married couples filing a joint return, $5,700 for those who are single or those who are married, but filing separate returns, and $8,400 for heads of household.

    The IRS had yet to release the 2011 standard deductions at the time of publication. CCH projects the standard deduction to be $11,600 for married filing a joint return, $5,800 for singles and married individuals filing separate returns, and $8,500 for heads of household.

    Personal Exemptions

    The 2010 personal exemption is $3,650. The exemption can be claimed for yourself, your spouse (if filing a joint return) and any qualifying dependents. Unlike previous years, there is no phase-out for the personal exemption—regardless of your income level, you can claim the full amount.

    As stated above, the new legislation extended the repeal of the phase-out through 2012. The IRS had yet to release the 2011 personal exemption at the time of publication. CCH projects the personal exemption for 2011 to be $3,700.

    Individual Retirement Accounts and 401(k) Plans

    In 2010, the maximum annual contribution for IRAs remained at $5,000 ($6,000 for any individual who is age 50 or older); in 2011, these amounts remain the same.

    In 2010, the maximum annual contribution limit for 401(k)s is $16,500 ($22,000 if you are age 50 or over); in 2011, those amounts remain the same.

    In 2010, the maximum annual contribution for SIMPLE plans was $11,500 (those age 50 or over could make a maximum catch-up contribution of $5,500); in 2011, those amounts remain the same.

    Qualified Plan Contributions

    In 2010, the maximum annual contribution for qualified plans, including SEP and Keogh plans, was $49,000 or 25% of your compensation, whichever is less; in 2011, those amounts will remain the same.

    Estate and Gift Tax Limits

    As previously stated, there is no estate tax for 2010. For 2011, a $5 million exemption exists, and it is portable to the surviving spouse. See the previous section about the estate tax for information on calculating taxable gains from the sale of the inherited assets.

    The annual gift tax exclusion is $13,000 in 2010 and $26,000 for consenting couples. (You will need to file Form 709). These limits will remain unchanged in 2011.

    Required Minimum Distributions (RMDs)

    As stated in the December 2010 AAII Journal, individuals age 70½ and older were required to take a distribution from their retirement accounts by December 31, 2010. (This requirement was waived in 2009.) These accounts include 401(k) plans, 403(b) plans, 457(b) plans, traditional IRAs, SEP IRAs, SARSEP IRAs, SIMPLE IRAs and Roth 401(k) plans. Roth IRA plans are exempt while the owner is alive.

    You must also take a required minimum distribution (RMD) in 2011 if you are 70½ or older during this calendar year.

    According to the IRS, “Generally, a RMD is calculated for each account by dividing the prior December 31st balance of that IRA or retirement plan account by a life expectancy factor that IRS publishes in Tables in Publication 590, Individual Retirement Arrangements (IRAs).”

    Child Tax Credit

    In 2010, the child tax credit for dependent children younger than 17 is $1,000.

    In 2011, the child tax credit will remain at $1,000.

    Kiddie Tax

    In 2010, the “kiddie tax” applies to children up to age 18 and could apply to children up to age 23—depending on how much earned income they have and whether or not they are full-time students.

    Under the kiddie tax rules, children with investment income above a certain amount may have part or all of their investment income taxed at their parents’ income tax rate.

    For 2010, the kiddie tax rule applies if the child is 17 or under by the end of the year, and the child’s total investment income for the year was more than $1,900. It is projected this amount will remain the same for 2011.

    In addition, the kiddie tax can apply to older children, depending on how much earned income they have and whether or not they are full-time students:

    • Starting in the year that your child turns 18, the kiddie tax will apply if your child’s earned income (including salaries and wages, commissions, professional fees and tips) is less than half of the child’s overall support.
    • Starting in the year your child turns 19, the kiddie tax will apply if your child is a full-time student.
    • The kiddie tax will stop applying in the year your child turns 24.
    • The kiddie tax will also not apply if your child is married filing jointly.

    Charitable Donations

    Donations of clothing and other personal items must be in “good condition” or better in order to be deducted. In addition, charitable contributions of cash (regardless of the amount) to any qualified charity must be supported by a dated bank record (such as a cancelled check) or a dated receipt from the charity that must include the name of the charity and the date and amount of the contribution. Form 8283 must be filled out if your total deduction for all noncash contributions exceeds $500.

    Congress also extended through 2011 the provision allowing tax-free distributions from IRAs to qualified charities for individuals over age 70½. The maximum contribution limit remains at $100,000. The provision is set to expire on December 31, 2011.

    Medicare Part D

    Taxpayers who itemize deductions can deduct (as a medical expense) the premiums they pay for the Medicare Part D prescription drug insurance program. Premiums for Medicare Part B supplemental insurance are also deductible. Medical expenses must exceed 7.5% of adjusted gross income to qualify for deductions.

    Itemized Deduction Phase-Outs

    Previously, taxpayers with adjusted gross income above a certain amount lost part of the benefit from their itemized deductions. This phase-out was reduced in 2009 and fully repealed in 2010. In other words, in 2010, the full benefit of itemized deductions can be applied.

    Under the new tax legislation, the repeal of the phase out remains in force for 2011 as well.

    Planning Considerations: Married taxpayers filing jointly will need to calculate whether taking the increased standard deduction or itemizing deductions will generate the most tax savings overall. In doing so, make sure to consider whether state law restricts the ability to itemize to only those who itemize for federal purposes. The higher deductions may also require more couples to pay alternative minimum tax (AMT).

    Sales Tax Deduction

    As stated previously, the provision allowing taxpayers who itemize deductions the option of choosing between a deduction of sales taxes or income taxes when claiming a state and local tax deduction was extended into 2010 and 2011. This is a change included in the new tax legislation.

    For a complete tax guide to the buying and selling of your personal investments, go to our Personal Investments 2010 Tax Guide.

    Tax-Exempt Interest Reporting

    State and local governments are required to report interest paid on tax-exempt state and local bonds on Form 1099-INT, Interest Income. This amount must be shown on your tax return and is for information only.

    Health Savings Accounts

    You may be able to take a deduction if you contributed to a Health Savings Account (HSA). To qualify, you must be covered by a “high-deductible health plan.” More information can be found below.

    Health Savings Accounts

    You may be able to deduct contributions to a Health Savings Account (HSA). These tax-free savings accounts were established under the Medicare Act of 2003, and can be used to pay for medical expenses incurred by you, your spouse or your dependents. They are used in conjunction with high-deductible health plans, where your basic health insurance does not cover first-dollar medical expenses.

    HSAs may be established by anyone who is covered by an HSA-qualified “high-deductible health plan,” is not covered by any other health insurance and is not enrolled in Medicare. Qualified high-deductible health plans must have an annual deductible of at least $1,200 for self-coverage and $2,400 for family coverage in 2010; these minimum deductibles will remain the same in 2011.

    Tax-deductible contributions can be made to the health savings account for the full amount of the annual deductible each year, up to a maximum of $3,050 for self-coverage and $6,150 for families in 2010. Like the deductible requirements, these amounts will remain unchanged for 2011. If you are over age 55, you can also make a “catch-up” contribution to your account of up to $1,000 and still enjoy the same tax advantages.

    Individuals can also make a one-time transfer from their IRA to an HSA, subject to the contribution limits applicable for the year of the transfer.

    Contributions to HSAs can be made by you, your employer or both. You can fully deduct your own contributions to an HSA, even if you do not itemize, and contributions made by your employer are not included in your taxable income. The interest and investment earnings generated by the account are also not taxable while in the HSA.

    Amounts distributed from the HSA are not taxable as long as they are used to pay for qualified medical expenses. They can be used to:

    • Cover the health insurance deductible and any co-payments for medical services, prescriptions, or products;
    • Purchase over-the-counter drugs (a doctor’s prescription will be required to deduct over-the-counter medication starting in 2011) and long-term care insurance and expenses; and
    • Pay health insurance premiums or medical expenses during any period of unemployment.

    Amounts distributed that are not used to pay for qualified medical expenses will be taxable, plus a 10% penalty will be applied. The penalty increases to 20% in 2011.

    HSAs are similar to IRAs in that they are owned by individuals—you are not dependent on a particular employer to enjoy the advantages of an HSA. And if you change jobs, the HSA goes with you.

    What if you already have an existing medical savings account (MSA)? In that case, you can either retain it or roll the amount over into a new HSA.

    For more information on HSAs, read IRS Publication 969, available at www.irs.gov.

    Education Savings

    The 2009 stimulus bill expanded the Hope education credit into the American Opportunity education credit. The maximum credit is $2,500 per year for the first four years of post-secondary education for tuition and related expenses (including books). However, the credit phases out for higher income taxpayers. This credit was extended for both 2011 and 2012.

    You can make non-deductible contributions to qualified tuition plans, also known as section 529 plans. (However, the contributions may be deductible from your state income tax, depending on where you live.) These accounts, offered by states or their designees, are maintained solely for the qualified higher education expenses of a beneficiary. Distributions are tax-free, provided that the distributions are used to pay qualified expenses. Though the definition of “qualified education expense” has included computers, computer technology and Internet service, this is no longer the case in 2011.

    For both 2010 and 2011, the contribution limit to a Coverdell Education Savings Account was kept at $2,000 per beneficiary, as part of the new tax law. The contributions are not deductible, but they grow tax-free in the IRA. Coverdell accounts may be used to fund qualified elementary, secondary and higher education expenses. However, the amount that can be contributed is limited for higher-income taxpayers.

    Investment Strategies: 2011 and Beyond

    Given the nature of the changing tax rates in the past few years, and the likelihood that changes will be made in the near future, tax planning opportunities are difficult to assess.

    Listed below are traditional tax planning strategies that can help keep your tax bill down under various tax scenarios. It is important, however, to keep in mind that your goals and risk tolerance should drive your investment decisions, not just the income tax impact of an investment.

    Consider Roth IRA Conversion Opportunities

    As of 2010, you have the option of converting all or part of your traditional IRA into a Roth IRA, regardless of your adjusted gross income. Roth IRAs can provide certain advantages: The converted assets can be withdrawn tax-free at any time, future earnings are also tax-free (with some limitations), and Roth IRA owners are not required to take any minimum distributions in retirement. The downside, however, is that the conversion amount is subject to current taxation.

    While the benefits of a Roth IRA conversion could be considerable, taxpayers must carefully weigh the upfront tax costs against the long-term tax advantages. For more on this, see “Retirement Plans: Evaluating the New Roth IRA Conversion Opportunity,” by Christine Fahlund in the November 2009 AAII Journal and “New Rules for Converting to a Roth IRA” by William Reichenstein, Alicia Waltenberger and Douglas Rothermich in the January 2010 AAII Journal. You may also want to consult a tax advisor for the best strategy.

    Take Advantage of Lower Marginal Rates

    Deferring income that is taxed at higher ordinary tax rates makes sense. However, currently qualified dividends and long-term capital gains are taxed at the same rate—and the rates are at a rock bottom 0% for taxpayers in the 15% or below marginal tax brackets. The new tax law extended these rates until the end of 2012, at which time Congress will have to act to prevent them from resetting to a higher level.

    Sell Low-Basis Stock

    The current tax environment continues to present the opportunity to sell low-basis stock held for more than one year, because long-term capital gains rates may eventually be reset higher from the maximum rate of 15% (0% for the two lowest income brackets). Though tax considerations should never be the primary reason for selling a security, if you have large positions in either gifted or inherited stocks, or stocks received from a sale of a business, you should consider using the proceeds from selling the stock to diversify your portfolio. This is particularly the case if a large portion of your wealth is concentrated in just a few securities.

    What You Can Keep From Selling Your Home

    You may be able to exclude up to $250,000 of gain ($500,000 for married taxpayers filing jointly) when you sell your main home. The exclusion is allowed each time you sell your main home, but no more than once every two years.

    To exclude the gain, you must have owned the home and used it as your principal residence for at least two out of the five years before its sale. Periods of use include short absences (such as summer vacations), but not longer breaks (such as one-year sabbaticals). You also must not have excluded the gain on another home sale during the two years before the current sale.

    Married taxpayers filing a joint return can exclude gains if either qualifies for the year of the sale, but both spouses must meet the use test to claim the $500,000 maximum exclusion.

    If you do not meet the ownership and use tests, you may be allowed to exclude a reduced amount if the sale was due to health, a change in employment or certain unforeseen circumstances.

    A widow or widower can take up to two years after the death of a spouse to sell a home and claim the $500,000 exclusion, as long as the survivor has not remarried and the sale would otherwise meet the requirements.

    Be aware that under a change in tax laws that took effect in 2009, if you convert a second home into your main home, you may not be able to exclude all of your gain on the subsequent sale of that home even if you meet the ownership and use requirements. The portion of the gain that is no longer excludable is based on the ratio of the time after 2008 that it was a second home relative to the total time you owned it.

    Excluded gains are not reported on your federal tax report; unexcluded gains are reported on Schedule D, Capital Gains or Losses.

    For a complete description of the rules, see IRS Publication 523, Selling Your Home, available at www.irs.gov.

    Use Losses Carefully

    While tax considerations should not drive your investment decision, you can take advantage of losses in holdings in which you would prefer to either sell or reduce from an investment standpoint.

    Capital losses first reduce capital gains: long-term losses reduce long-term gains first, and short-term losses reduce short-term gains first. Any long-term losses left over reduce short-term gains and vice versa. If you still have losses remaining after offsetting capital gains, you can reduce your “ordinary” income by up to $3,000. Losses not used this year can be carried forward to future years until they are used up. For more information, see “Capital Pains: Rules for Capital Losses” by Julian Block in the September 2010 AAII Journal.

    When planning, make sure you don’t run afoul of the wash-sale rules. If you sell an investment at a loss and then acquire substantially identical securities during the 30-day period before or 30-day period after the sale, the loss will be disallowed.

    Consider the Impact of Taxes on Mutual Fund Investments

    Selecting tax-aware managers of mutual funds may be important to maximizing your aftertax rate of return in your taxable investment portfolio.

    You may choose when to sell shares of the fund and may, therefore, create long-term versus short-term capital gains. But you don’t control the investments within the fund. Should an equity manager fail to extend the holding period on a stock, it could cost you 20% of your gain (35% ordinary rate for short-term capital gains versus 15% long-term capital gains rate).

    Some mutual fund dividends will qualify for the 15% rate, while others will not. Dividends paid by stocks held by the fund and passed through to the shareholder will qualify for the dividend tax rate. However, capital distributions and bond interest will not. These payments are reported on Form 1099, which specifies the type of distribution.

    For more on mutual fund distributions, see the box below.

    Be Careful With Mutual Fund Distributions

    Investment returns generated by a mutual fund can take the form of dividends, interest and/or capital gains and losses. A mutual fund is required to distribute dividends, interest and net realized gains to you each year.

    Mutual fund distributions are taxable whether you take them in cash or reinvest them in fund shares, unless they are income dividends from tax-exempt municipal bond funds, or if they are within a tax-sheltered account such as an IRA and other retirement account (where they are tax- sheltered until withdrawn).

    The status of any capital gains or dividend distributed to you by a mutual fund depends on how long the fund owned the securities that produced the gain or dividend—not on how long you owned shares in the fund. The information you will need to determine how your distributions are taxed will be on your fund’s Form 1099–DIV.

    What about losses?

    A mutual fund’s capital losses are never distributed to shareholders, but are used to offset capital gains realized by the fund during the year. Any additional losses are carried forward by the fund to apply against gains realized in the future. The only losses you can claim are those you may have incurred when you redeemed your own shares of a fund.

    Because mutual fund distributions are taxed even if they are reinvested, it is important to remember that you should add reinvested income, dividends and capital gains (from both taxable and tax-free funds) to your original cost basis when it comes time to figure gains or losses on any mutual fund shares that are sold. If you do not, you will, in effect, be paying taxes twice on those distributions. (Beginning on January 1, 2012, mutual funds and brokers will be required to report the cost basis for mutual fund shares bought and sold after that date.)

    In addition, consider delaying an investment in a mutual fund if you are investing close to the fund’s ex-dividend date. When a distribution is made, it is subject to tax, even if you reinvest it in that fund (although the reinvested amount increases your tax basis in the fund).

    Mutual funds commonly make distributions toward the end of the year. Investors must be wary of this distribution date. Generally, you should not invest in a mutual fund shortly before its distribution date, because a portion of your investment will be immediately returned to you with an accompanying tax liability. Most mutual funds should be able to give you a good idea of when their year-end distributions will take place, so calling the fund company prior to investing can be a wise move.

    AAII’s “Individual Investor’s Guide to the Top Mutual Funds” provides a tax-cost ratio for all covered funds. Next month’s AAII Journal will include the 2011 top funds guide.

    Reconsider Taxable Versus Tax-Free Bonds

    Interest from tax-free municipal bonds is generally exempt from federal income taxes, unlike the interest from taxable bonds, which is taxed as income. Like any bond, credit quality matters as you want to ensure that the issuer will not default. Changing yields can also alter the aftertax yield advantage, making municipal bonds more or less attractive to taxable bonds.

    Additionally, private-activity bonds (a type of tax-free bond) could increase your exposure to the alternative minimum tax since their interest income is taxable for purposes of the alternative minimum tax. The 2009 stimulus bill waived this for bonds issued in 2009 and 2010, and 2009 and 2010 refundings of bonds issued after December 31, 2003, through January 1, 2009. The two-year exemption was not included in the new tax bill and has expired, meaning it does not extend into 2011. At press time, legislation to extend the exemption was being discussed.

    You should review your bond and money market accounts to make sure that you are earning the highest aftertax return. But don’t forget to consider the state tax implications of switching from tax-free to taxable bonds before making any final portfolio decisions.

    Consider Increasing Retirement Savings

    You may want to use any additional cash flows you receive this year to increase the amount invested in an IRA or 401(k) plan. This is particularly the case for cash received from the 2011 payroll tax cut, since the reduction should only be in effect for one year. The main advantage of retirement accounts—tax deferral—continues to make them a good investment vehicle.

    Review the Tax Implications of Taxable Vs. Tax-Deferred Accounts

    The spread between capital gains and ordinary income rates has important implications with respect to your asset allocation between taxable and tax-deferred (retirement) accounts. For example, from a tax perspective, holding individual stocks in tax-deferred accounts and bonds in taxable accounts could be expensive, because gains resulting from stocks held in tax-deferred plans such as IRAs or 401(k) plans will be taxed at ordinary rates when taken as a distribution. By reversing that structure, taxable bonds and other tax-inefficient assets will be shielded from tax in the deferred accounts, while equities will enjoy the reduced rates for dividends and capital gains in personal accounts. Tax-free municipal bonds should, of course, remain outside of retirement accounts. Individuals should also consider the cost of commissions and taxes, as well as current cash flow needs, before making any investment moves between taxable and tax-deferred accounts.

    Protect Social Security Benefits

    If you are receiving Social Security benefits, you may have to pay taxes on them if your “modified” adjusted gross income (primarily your taxable income plus any tax-exempt interest income plus half of your Social Security benefits) exceeds certain levels. To protect your benefits, watch the amount of interest you receive from municipal bonds, since this amount is included in your modified adjusted gross income when determining the Social Security benefit taxability. In addition, you may want to delay taxable distributions from a retirement plan or IRA.

    Income Level
    Percent of
    SS Benefits
    Below $25,000 Single & Head of Household 0%
    Below $32,000 Married Filing Jointly 0%
    $25,000 to $34,000 Single & Head of Household 50%
    $32,000 to $44,000 Married Filing Jointly 50%
    Above $34,000 Single & Head of Household 85%
    Above $44,000 Married Filing Jointly 85%


    It is important to remember that taxes are not the key to investment planning. And the temporary duration of the current tax law provisions should motivate individuals to reconsider existing strategies in the coming years. However, one thing is certain: There will be more tax changes coming, and everyone should consider how the changes directly affect their overall tax and investment strategies.

    Tax Planning Strategies

    All Taxpayers: Determine Where You Are at the End of the Year

    At the end of each year, you should take the time to assess your tax situation. Doing so will give you the opportunity to shift certain items around, should that be beneficial in terms of your tax liability. Taking a few initial steps now and using year-end planning strategies can result in significant tax savings.

    How can you effectively plan?

    Here are the basic steps you should take to help start your personal tax planning:

    • Estimate your income, deductions, credits and exemptions for 2010 and 2011 using the Tax Forecasting Worksheet (page 19);
    • Identify items that you can shift from 2011 into 2012 and beyond (or vice versa);
    • Determine your marginal tax rate—the rate at which your next dollar of income will be taxed—for 2011 and 2012;
    • Determine how much tax you owe and when you must pay it to avoid underpayment penalties;
    • Determine whether you are subject to the alternative minimum tax (AMT);
    • Consult with your tax professional, and then take the actions needed to make the best of your tax situation.

    To minimize your taxes, consider both short-term and long-term tax planning issues and strategies. Starting early will give you extra time to obtain additional information about items that concern you and to investigate additional ideas for tax savings or deferral. The Tax Forecasting Worksheet on page 19 will provide a starting point for evaluating the tax effects of various strategies.

    Avoiding Tax Underpayment Penalties

    Make sure you determine your 2011 tax liability as early as possible, as well as the due dates for paying those taxes (including the self-employment tax and the alternative minimum tax [AMT]), so that you avoid underpayment penalties.

    Federal tax law requires the payment of income taxes throughout the year as you earn your income. This obligation may be met through withholding, quarterly estimated tax payments, or both. If you do not meet this obligation, you may be assessed an underpayment penalty.

    If your total tax due minus the amount you had withheld is less than 10% of your total tax due, you will not be assessed an underpayment penalty. The disadvantage of overpaying throughout the year, though, is that you are in effect making an interest-free loan to the government. However, the underpayment penalty can be high, and it is calculated as interest on the underpaid balance until it is paid, or until the regular filing date for the final tax return, whichever is earlier.

    You can avoid underpayment tax penalties by adopting one of the safe harbor rules. The basic rule is to pay the required amount by the end of the year through withholding and quarterly estimated payments. The required amount will be one of the following, depending on your individual situation:

    • 90% of the current year’s tax liability;
    • 100% of the prior year’s tax liability (increases to 110% for taxpayers who had adjusted gross income in excess of $150,000 or $75,000 for those married filing separately for 2010 and 2011); or
    • 90% of the tax liability based on a quarterly annualization of current year-to-date income (See IRS Form 505 and IRS Publication 505 for worksheets).

    Penalties are based on any underpayment, which is the difference between the lowest amount required to be paid by each quarterly payment date and the amount actually paid by that date. The annual required amount, based on either of the first two alternatives, is paid in equal installments. In the case of the third method, which is based on annualized income, the amount due each quarter is based on actual income received for each installment period. The third method is typically more beneficial if you do not earn income evenly throughout the year (e.g., you operate a seasonal business) or had an unexpected increase in income, because it allows for lower required payments in the early quarters.

    Income tax payments made through withholding from your paycheck (or from your pension or other payments) are given special treatment. The IRS treats income tax that is withheld as having been paid equally throughout the year (unless you prefer to use actual payment dates). This lets you make up for underpaid amounts retroactively, because amounts withheld late in the year may be used to increase the amounts paid in earlier quarters.

    State and Local Rules: Be aware that many states have underpayment rules that vary from the federal requirements.

    Timing: Income & Deductions for Taxpayers Not Subject to AMT

    You have opportunities to reduce your taxes if you can control the timing of either your income or expenses. However, it is important to make sure you understand whether you may be subject to the alternative minimum tax (AMT) before adopting these strategies. (See the box below for more information.)

    AMT: An Unpleasant Surprise

    Are you subject to the alternative minimum tax? This tax comes as a surprise to many taxpayers. You may be subject to this tax, especially if any of the following criteria apply to your situation:

    • You have large itemized deductions for state and local taxes, including property and state income tax, or from state sales tax;
    • You have exercised incentive stock options;
    • You have significant deductions for accelerated depreciation;
    • You have large miscellaneous itemized deductions or a large deduction for unreimbursed employee business expenses;
    • You have tax-exempt income from private-activity bonds (new legislation at press time was being introduced to address this; its fate is unknown); or
    • You have a large capital gain.

    The alternative minimum tax is calculated by first determining the tentative minimum tax. The tentative minimum tax is 26% of the first $175,000 ($87,500 for married filing separately) of alternative minimum taxable income in excess of the exemption amount, plus 28% of any additional alternative minimum taxable income. However, for alternative minimum tax purposes, dividends and capital gains will be taxed under the same rules as those used for regular tax calculations. The alternative minimum tax is the excess of the tentative minimum tax above the regular tax calculated.

    Alternative minimum taxable income adds back certain preference items to regular taxable income—including state income taxes, real estate taxes and miscellaneous itemized deductions—and can cause the alternative minimum tax to be larger than the regular tax.

    In addition, although the tax rate on capital gains and dividend income is the same for both the regular tax and the alternative minimum tax, the disparity in rates between the alternative minimum tax and the regular tax may result in a higher effective rate on all income, including capital gains and dividends.

    The IRS offers the AMT Assistant, an electronic version of the AMT Worksheet in the 1040 Instructions. By filling in a few simple questions, you can determine whether or not you owe the alternative minimum tax. Go to the AMT Assistant at www.irs.gov (found in the Online Services section).


    Your income is generally taxed in the year of receipt, so having the ability to control when you receive it affords a strategic tax planning opportunity. Deferring income until a later year will, in most cases, delay the payment of tax. You cannot defer taxation by merely delaying receipt of the income if the funds are available to you and the time of payment is subject to your unrestricted discretion. Any decision to defer income must be weighed with the lost time-value of the money and other risks that could alter or forfeit your right to the income.

    The timing of bonuses, recognition of capital gains from the sale of stocks, and the exercise of non-qualified stock options are all events that can easily be delayed into a subsequent year. You should also consider the deferral of compensation through the use of various retirement plans and deferred-compensation arrangements. If you operate a business or collect rental income and report that income on the cash receipts and disbursements method, you have an opportunity to delay or accelerate the billing to your customers or tenants and determine the timing of the related income.


    You can reduce taxes by controlling the payment of deductible expenses. If paid by December 31, you may deduct certain expenses that are due the following year on your current year tax return. This strategy helps when you have a higher tax liability in the current year than you expect to have in the coming year. Again, you must balance this decision with the time-value of money and other inherent risks.

    For example, if you paid a deductible expense in December 2010 instead of April 2011, you reduced your 2010 tax instead of your 2011 tax, but you also lost the use of your money for three-and- one-half months. Generally, this will be to your advantage, unless you have an alternative use for the funds that will produce a very high return in that three-and-one-half-month period. You must decide whether the cash used to pay the expense early should be used for something more urgent or more valuable than the accelerated tax benefit.

    For those who will pay 2012 estimated taxes based on their 2011 tax liability, reducing your 2011 taxes has another advantage: Your 2012 estimated tax payments may be smaller.

    State Taxes

    If accelerating deductions makes sense for you and you choose to claim a deduction on your state and local income taxes, you may want to prepay the balance on your estimated state tax liability in December, rather than waiting until 2012. This secures that deduction on your 2011 tax return, even though the payment might not be required by the state until January 16, 2012, or April 16, 2012.

    Charitable Contributions

    If you are planning on making a gift to a charity in 2012, consider making the gift in 2011 to accelerate the tax benefit of the contribution. However, it is important to note that certain limitations exist with respect to deductions for charitable contributions.

    You should also consider the benefits of gifting appreciated stock to a charity. If you donate long-term appreciated stock directly to the charity, you get a deduction for the full fair market value of the stock; whereas, if you sell the stock first and donate cash, you only get a deduction for the aftertax cash donated. (If you have an unrealized loss in the stock, however, it might be more beneficial from a tax standpoint to sell the stock and then donate the cash proceeds. Doing so would give you deductions for both the capital loss and the charitable donation.)

    When making a gift to charity, you must have an appropriate record of the gift in order to properly support the deduction. In addition, cash contributions of any amount must be supported by a written record, either in the form of a bank record (for example, a cancelled check) or a written receipt from the charity. The record must include the name of the charity, the date, and the amount of the contribution.

    Prepaid Interest

    A cash basis taxpayer may not deduct prepaid interest before the tax year to which the interest relates. However, there is some flexibility to prepay year-end interest that is due early in the following year. For example, if a mortgage payment is due on January 10, a taxpayer can accelerate the deduction of the portion of the interest relating to the period up to January 1 by mailing the check in December.

    The most significant interest deductions currently available are for home mortgage interest and for investment interest expense to the extent of current-year investment income. Interest paid in relation to investments that earn a tax-free return is not deductible.

    Medical Expenses

    If the timing of certain medical and dental expenditures is flexible and your overall medical expenses are high in the current year, you may want to accelerate payment of these expenses. Because unreimbursed medical expenses are only deductible to the extent that they exceed 7.5% of adjusted gross income, it is best from a tax standpoint to incur expenses—such as replacement eyeglasses or contact lenses, elective surgery, dental work, and routine physical examinations—in a year in which you have already gone over (or the added expenses would take you over) the 7.5% threshold.

    Miscellaneous Itemized Deductions

    Miscellaneous itemized deductions are only deductible to the extent that they exceed 2% of adjusted gross income. This category is large but includes:

    • Tax preparation fees such as tax preparation software, tax publications and any fee paid for electronic filing; and
    • Investment fees, custodial fees, trust administration fees, and other expenses paid for managing your investments that produce taxable income.

    Accelerating miscellaneous itemized deductions only benefits taxpayers who accumulate expenses sufficient enough to exceed the 2% threshold. If possible, it may be advantageous to pay these types of expenses in one year if, because of the 2% floor, you would not receive a benefit of the deduction in each of the two consecutive years.

    Timing Caution for Taxpayers Subject to AMT

    The alternative minimum tax (AMT) was originally designed to ensure that everyone would pay his or her fair share of income taxes. In 1987, only 140,000 taxpayers were subject to the AMT. Since then, however, it has evolved into a separate tax regime that will affect millions of unsuspecting taxpayers at some time in the future.

    The wisdom of conventional tax planning advice to defer income and accelerate certain types of deductions may not hold true if an individual expects to be subject to the AMT. Accordingly, during the tax planning process, it is critical that you determine whether you are subject to the AMT in both the current year and the following year. This analysis is even more complicated because the AMT exemption level must be “fixed” on nearly an annual basis. (The new tax bill provided AMT exemptions for only 2010 and 2011; Congress will have to act on the 2012 exemptions to prevent a large number of taxpayers from being hit by the AMT.)

    If you are continuously subject to the AMT, avoid investing in private-activity (municipal) bonds. Income from these bonds is taxable for AMT purposes. (The 2009 stimulus bill did waive this for certain bonds issued in 2009 and 2010, but the provision has expired and will not apply in 2011. At press time, new legislation was introduced to extend the provision into 2011, but the bill’s fate is unknown.) Furthermore, you should be aware that unusual combinations of income and deductions might require AMT planning that runs contrary to conventional tax-planning advice.

    Although the exercise of an incentive stock option (ISO) does not give rise to regular taxable income for the employee, the difference between the exercise price and the market price of a stock must be recognized for AMT purposes for the year in which the option is exercised. Accordingly, the exercise of ISOs with a large bargain element often causes a tax liability under the AMT tax regime.

    The AMT arena is extremely complex, so generalizations are difficult. If you think you may be subject to the AMT, you should consult with a tax professional to determine how to minimize your exposure.

    Where's My Money? Tracking Your Refund 24/7

    If you are expecting a refund on your 2010 income tax, you can check on its status if it has been at least three to four weeks since the date you filed your return by mail, or 72 hours if you filed electronically. You will need to supply the following information: your Social Security number or IRS Individual Taxpayer Identification number, your filing status, and the exact whole-dollar refund amount as it is shown on your return.

    You can check the status of your refund in two ways:

    • On the Internet, go to www.irs.gov and click on “Individuals” and then “Check on Your Refund.”
    • By telephone (for automated information), call 800-829-4477.

    If you are unable to get information on your refund through either of these two automated services, you can call the IRS for assistance at 800-829-1040.

    The IRS website also allows you to start a trace for lost or missing refund checks, or to notify the IRS of an address change when refund checks go undelivered. Taxpayers can avoid undelivered refund checks by having refunds deposited directly into a personal checking or savings account. This option is available for both paper and electronically filed returns.

    Year-End Estate and Gift Tax Planning

    Year-end planning from an estate planning perspective typically involves ensuring that “annual exclusion” gifts are completed by the end of a calendar year.

    Under the federal gift tax system, each donor is permitted to make non-taxable gifts of a certain amount each year to any donee. These gifts are called “annual exclusion” gifts and do not count against the donor’s lifetime gifts exemption. The exemption was $1 million in 2010, but was raised to $5 million as of January 1, 2011. The annual gift exclusion level was $13,000 in 2010 and remains unchanged in 2011. To the extent not used, the annual exclusion evaporates at the end of each calendar year.

    Annual transfers that take advantage of this exclusion can both diminish the donor’s estate tax liability and improve the lives of the recipients. These gifts can take many forms (cash, stocks, real estate, partnership interests) and can be given outright through Uniform Transfers to Minors accounts, and even through a trust—provided it contains special provisions designed to allow the gift to qualify for the annual exclusion.

    A special note of thanks goes out to John W. Roth, a senior writer/analyst at tax authority CCH (www.cch.com) and Dustin Stamper at the National Tax Office of Grant Thornton LLP (www.GT.com) for answering detailed questions about the new tax legislation. In addition, “J.K. Lasser’s Your Income Tax 2011” (John Wiley & Sons, 2010) was extremely helpful in creating this year’s guide.


    David from TX posted over 5 years ago:

    What's the Estate Tax exemption for generation skipping transfers for 2011 and 2012 ?

    AAII from IL posted over 5 years ago:

    The generation-skipping transfer (GST) exemption amount is $5 million for 2011 and 2012, with a GST tax rate of 35%.

    Claude from GA posted over 5 years ago:

    From an IRS news release dated 12/23/10 and Revenue Procedure 2011-12, one learns that (1) the 2011 standard deduction for married couples filing a joint return will be $11,600; (2) the additional standard deduction for the blind and senior citizens will be $1150 for married individuals; (3) for married individuals filing a joint return the tax rate will be 10% for taxable income not over $17,000, then 15% up to $69,000 of taxable income, then 25% to $139,350, then 28% to $212,300, then 33% to $379,150, and 35% on the excess; and (4) the 2011 personal exemption will be $3700.

    Bruce from FL posted over 5 years ago:

    Are the maximum income limits still in place for 2011 for a couple to contribute to a Roth IRA? But not for conversions from a standard IRA into a Roth IRA? So is a two-step process required for higher income couples - first contribute to a non-deductible standard IRA; then immediately convert that to a Roth IRA?

    John from NC posted over 5 years ago:

    I can't seem to save off the entire article in a single PDF file, as I was able to do last year. It looks like I'll need to save off many separate files, including 2011 Tax Rates, etc.

    Roger from FL posted over 5 years ago:

    How about providing a downloadable spread sheet format for the Tax Forecasting Worksheet?

    K from IN posted over 5 years ago:

    Where is the link to the downloadable PDF file for the whole article?? I received no response from a message to the webmaster several days ago.

    Jean from IL posted over 5 years ago:

    For the link to the PDF, look under the second paragraph of the article on the left. There's a heading that says "Print This Article" and the second choice is "Download Printable PDF."

    Keat from IL posted over 5 years ago:

    This tax guidelines are so useful even for someone like me using Turbotax to prepare my income tax. They are written in concise easy to understand language, However, they are most helpful especially in tax planning for the following year. I highly recommend everyone to read this article.


    T.E.LAWRENCE from Hawaii posted over 5 years ago:

    Is there a tax bemifit contributing to grandchildren 529 education plans vice paying federal and or state taxes?

    Harry from CA posted over 5 years ago:

    short term capital gains are not mentioned. Is short term capital gains the same as long term capital gains?

    Alfred from TX posted over 5 years ago:

    I would like in detail on 401k distributions and the tax

    James from CA posted over 4 years ago:

    Are the maximum income limits still in place for 2011 for a couple to contribute to a Roth IRA? But not for conversions from a standard IRA into a Roth IRA? So is a two-step process required for higher income couples - first contribute to a non-deductible standard IRA; then immediately convert that to a Roth IRA?

    posted about 1 year ago by Bruce from Florida

    Bruce, yes. make the non-deductable contribution and switch it to a Roth. As long as there are no gains in that short period of time, you will not owe any tax. I did ours on online at Vanguard and it took about 10 minutes. Simply and my wife and I have another 10,000 growing tax free. Awesome. How this helps. Jim Hoffmann

    Charles from IL posted over 4 years ago:

    The IRS says, "Can you contribute to a Roth IRA for your spouse? You can contribute to a Roth IRA for your spouse provided the contributions satisfy the spousal IRA limit discussed in chapter 1 under How Much Can Be Contributed, you file jointly, and your modified AGI is less than $179,000." Read publication 590 for more information at http://www.irs.gov/publications/p590/index.html. -Charles Rotblut, AAII

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