What you need to know about the Tax Relief Act of 2010

[March 02, 2011]  (ARA) - It was hard to miss the news about the 2010 Tax Relief Act that Congress passed and President Obama signed into law at the end of last year. What many Americans probably found easy to miss, however, is how the act will affect them as they prepare to file their 2010 tax returns this April 15.

The 2010 Tax Relief Act, in part, continued the lower tax rates created during the presidency of George W. Bush, and removed some near-term planning uncertainty. Consider these immediate action steps that may help you to better position yourself from a financial and retirement planning perspective:

Use Social Security tax rate reduction to increase retirement savings.
For 2011 the individual Social Security tax rate has been lowered from 6.2 percent to 4.2 percent. For an individual making $75,000, this 2 percent reduction could mean $1,500 more in his paycheck over the course of the year. In terms of planning, consider using this found money by contributing more to your 401(k) plan or funding a Roth or traditional IRA.

Use IRA distributions to make charitable contributions.
Prior tax law permitted individuals age 70 1/2 or older to use up to $100,000 per year of IRA distributions to make charitable contributions and avoid paying income tax on that amount. The 2010 Tax Relief Act reinstated it for 2010 and extended the provision through 2011.

Consider selling certain capital assets over the next two years.
The 2010 Tax Relief Act maintains the top capital gains tax rate of 15 percent as well as the special qualified dividends tax rate of 15 percent. As you consider your investment options over the next two years and whether you want to sell any assets, you should consider how these lower tax rates could benefit you.

Consider deferring tax liability on 2010 Roth IRA conversions to 2011/2012.
Earlier changes in tax law eliminated income limits on conversions from a traditional IRA to a Roth IRA and provided for a special one-time opportunity for 2010 conversions. You can opt to pay the taxes on the conversion entirely on your 2010 return, or defer them and pay half in 2011 and the other half in 2012. Prior to the 2010 Tax Relief Act it seemed like paying the tax in 2011 and 2012 at higher rates would be a bad choice. With the continuation of lower tax rates for 2011 and 2012 most taxpayers should now choose to defer this tax liability.

A trap for the unwary here is not planning to pay the conversion tax liability in 2011 and 2012. To avoid this trap you should estimate how much your tax liability will be for both years and then make sure you either adjust your withholding from your employer or make estimated payments so that you have the liability covered when you file your 2011 and 2012 tax returns.

Revisit estate planning.
Thanks to the 2010 Tax Relief Act the federal estate tax exemption is now $5 million. This means most people won't have to worry about estate planning to minimize or avoid federal estate taxes, though there are many other reasons besides taxes to do estate planning. Also, this provision is only effective for two years and could change after 2012. Estate and inheritance tax rules for a state may be different and generate tax issues at a lower amount than the $5 million federal exemption.

Plan for possible higher rates.
Traditional tax planning would have you defer a tax liability in order to keep more money in your pocket, earning interest, longer. However, since the 2010 Tax Relief Act only provides for continued lower rates for two years and rates could go up after that, it could make sense to trigger the income tax on an asset sooner and pay tax now. One way to do this is to convert non-Roth assets, which could be in your 401(k) or traditional IRA, into Roth assets. The creation of Roth assets allows you to hedge against increasing future tax rates and have after-tax assets to manage your tax position once in retirement.

Of course, you and your tax and financial advisers are in the best position to determine which of these strategies make sense for your personal circumstances. Be sure to consult with your tax and legal advisers regarding your personal circumstances. Keep in mind that that 2010 Tax Relief Act continues the recent history of an unsettled and uncertain tax environment, and the best way to defend against such uncertainty is to keep your focus on your financial and retirement plan goals and stay in action.

Archived columns