Stay a Step Ahead of the Tax Collector

A good mantra, for investing and the rest of your life, is "Focus on what you can control."

While most people are inclined to put taxes into the "out of my control" bucket, that doesn't have to be the case. (For proof, look no further than the army of tax advisors and attorneys geared toward helping the well-heeled shave their tax bills.)

Key to cutting your tax bill is staying current on tax-law changes. Although there aren't yet details on tax hikes likely to go into effect because of the federal stimulus plan, here's a summary of recent and impending tax-law changes. I'll also give you my thoughts on how you can act to either take advantage of these changes or minimize their effect on your bottom line. Some of these changes have an impact only on those in very high tax brackets, while others affect individuals of all income levels.

IRA Conversions
Starting this year, anyone will be able to convert an IRA, regardless of income limit. And those who convert in 2010 will be able to spread the conversion-related taxes over two years: 2011 and 2012. This article details the ins and outs of IRA conversions, as well as prime candidates for conversion.

Required Minimum Distributions
Those over 70 1/2 years old are again required to take minimum distributions from their traditional IRAs, 401(k)s, and some other retirement plans, after distributions were suspended for 2009 to allow retiree account balances to rebound. This article details the ins and outs of required minimum distributions, and IRS Publication 590 includes tables to help you calculate the appropriate distribution for you. Because the penalties for not taking distributions are onerous (a 50% tax on the amount you should have taken out but didn't), ask your mutual fund company or brokerage firm to sign you up for automatic distributions.

Dividend Tax
Through 2010, the dividend-tax rate remains at zero for taxpayers in the 10% and 15% tax brackets, and is 15% for all other taxpayers.

Long-Term Capital Gains Tax 
Through 2010, taxpayers in the 10% and 15% brackets will not owe capital gains tax on the sale of assets they've owned for a year or more. Long-term capital gains tax rates remain at 15% for all other taxpayers.

Estate Tax
The federal estate tax is repealed on a temporary basis in 2010 and then is set to jump up to 55% for estates of more than $1 million in 2011. However, the estate-tax landscape remains murky. Some tax pundits expect Congress to put in place a new estate tax soon, which could be retroactive to January. Given that the estate-tax system is bound to be in flux during the next few years, it pays to check with an estate-planning attorney to make sure your plan still makes sense.

Gift Tax
The annual gift-tax exclusion stays the same as it was in 2009: $13,000. That means you can gift $13,000 apiece to an unlimited number of people this year without having to worry about a gift tax or even fill out the gift-tax paperwork.

Say, for example, you and your spouse would like to help your daughter and her husband buy a new house. You could each gift $13,000 to both your daughter and son-in-law, for a total of $52,000.

Savers in 529 college-savings plans can actually gift $65,000 in a single year without triggering a gift tax, assuming they make no further contributions to the same individual's college plan in the subsequent four years. In that case, the IRS assumes that your contribution is spread over five years ($13,000 x 5 = $65,000). Couples can actually contribute $130,000 to one child's college-savings plan in 2009, assuming they make no further gifts from 2010 through 2013, without getting into gift-tax terrain.

Also, if you're gifting to pay educational or medical expenses, you can circumvent the gift-tax system altogether by making payments directly to the educational or medical institution.

401(k) Contribution Limits
The maximum 401(k) contribution remains the same for 2010: $16,500 for those under age 50 and $22,000 for savers over 50. (Contribution limits for 403(b) and 457 plan participants are the same.)

Note that the 401(k) limits apply to both Roth and traditional 401(k) contributions. However, because you're contributing aftertax dollars to the Roth 401(k), your effective contribution rate is much higher than it is for the traditional 401(k). This is one of several reasons I think the Roth 401(k) can be a very attractive option for higher-income savers looking to max out their tax-advantaged options.

IRA Contribution Limits
IRA contribution limits are also unchanged from 2009: $5,000 if you're under 50 and $6,000 for individuals over 50. These amounts apply whether you're contributing to a Roth IRA, a traditional deductible IRA, or a traditional nondeductible IRA.

The 2010 income ranges for Roth eligibility are also the same as in 2009. Individuals filing singly and making less than $120,000 who are covered by a company retirement plan will be able to make at least a partial Roth IRA contribution in 2010. (The amount you can contribute is "phased out," or reduced, for single filers who make between $105,000 and $120,000 a year.) Married couples filing jointly can make at least a partial contribution if they are covered by a company plan and earn less than $177,000 per year in 2010. (Contributions begin to phase out for joint filers earning between $167,000 and $177,000.) Individuals of any age can make a Roth IRA contribution, as long as they have "eligible compensation," such as wages, salaries, tips, and commissions.

Individuals earning less than $66,000 in 2010 who are covered by a company retirement plan can make at least a partially deductible contribution to a traditional IRA. (Contributions phase out, or are reduced, for individuals who make between $56,000 and $66,000.) Married couples filing jointly can make at least a partially deductible IRA contribution if they earn less than $109,000. (Contributions begin to phase out for couples who make between $89,000 and $109,000.)

However, despite the deductibility of traditional IRA contributions for some individuals, I think the Roth is the better bet for most people. That's because you'll enjoy tax-free withdrawals from a Roth IRA, whereas you'll owe ordinary income taxes on the traditional deductible IRA withdrawals. Also, the fact that Roth IRAs don't require mandatory withdrawals is an added benefit for individuals who don't need the money in retirement; that allows Roth investors to stretch out the tax-saving effects for a longer period of time than is possible for a traditional IRA.

In addition, you can still contribute to a Roth at any age, as long as you have eligible compensation, but traditional IRA contributions aren't permitted after age 70 1/2. Finally, should you need the money before retirement, a Roth enables you to put your mitts on your contributions at any time without taxes or penalty. Tapping your retirement accounts early isn't a great idea, but this is by far the best option if you're in a bind.

First-Time Home Buyer Tax Credit
The First-Time Home Buyer Tax Credit, originally set to expire last year, has been extended through the first part of the year. People who buy a principal residence between Jan. 1, 2009, and April 30, 2010, may be able to claim a tax credit that amounts to 10% of their purchase price, with an upper limit of $8,000. Should the taxpayer sell the home within three years or no longer use it as a principal residence, he or she will have to return the credit.

To claim the credit, buyers must not have owned a principal residence within the past three years. There are also income limitations to claiming the credit. For purchases made after Nov. 6, 2009, the credit begins phasing out for single filers who earn more than $125,000, and married couples filing jointly can't claim any portion of the credit if they earn more than $225,000. (Purchases made between Jan. 1, 2009, and Nov. 6, 2009, were eligible for the credit, but buyers were subject to more stringent income limitations.)

Move-Up/Repeat Home Buyer Tax Credit
Existing homeowners who purchase a principal residence between Nov. 6, 2009, and April 30, 2010, are eligible to claim a credit equal to 10% of the new home's purchase price, up to a limit of $6,500. If the newly purchased home costs more than $800,000, the homebuyers are not eligible for the credit. As with the first-time home buyer tax credit, this credit begins phasing out for single income-tax filers who earn more than $125,000 and married couples filing jointly who earn more than $225,000.

Credit for Home Energy-Efficiency Improvements 
Homeowners can receive a tax credit for 30% of the cost of certain efficiency-improving items, up to $1,500, for improvements made during the 2009 and 2010 tax year. The credit was previously only for 10% of eligible costs. Items such as energy-efficient windows, heating and cooling units, and insulation qualify. Click here for more details.  

Sales Tax
Those who itemize their deductions can no longer deduct their state sales tax paid rather than deducting their state and local income taxes.

See More in Our Tax Relief Center

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