A couple of notes .. One, Barron's is a must read for those that are investors ..
Second, the lower tax rates in 2011 and 2012 make converting a ROTH even a better idea as you can do it this year and split the tax over the next two years. Before, it was a question of paying tax in 2010 or split, now it seems a no brainer, pay the taxes in 11 and 12.
At Barrons.com the holiday season doesn't seem complete without a conversation with tax expert Bob Willens.
The 64-year-old CPA and president of Robert Willens LLC is a respected tax consultant for both wealthy individuals and corporations. And just as he did last year (see Electronic Q&A, "Girding for Higher Investor Taxes," Dec. 1, 2009), he has a few savvy suggestions for investors making tax-wise moves ahead of the year's end.
It's been a strange and disquieting year for tax planners. Until this week, it was uncertain if the Bush-era income tax cuts would get extended and little was known about the fate of taxes for capital gains, dividends and estates.
But on Monday, President Obama and Republican leaders cut a deal extending the current income tax rates, lowering estate taxes for the wealthy, patching the alternative minimum tax and extending unemployment benefits for the long-term jobless.
Now, all that's needed is for enough resistant Democrats to fall in line.
Bio Name: Robert Willens Age: 64
Title: President, Robert Willens LLC
Education: BS in business administration, American University; MBA in finance, St. John's University
Hobbies: Jogging, watching professional and college football. Willens has also been a professor at the Columbia Business School for the last 17 years.
Recently, Willens shared his thoughts on the likelihood of that happening, as well as a few prudent tax strategies – including a novel maneuver for bond investors. Here's an excerpt from our conversation.
Barrons.com:What is your impression of the recently inked deal between President Obama and Republican leaders?
Willens: It's very positive for investors. The tax package, if it's approved by Congress, extends the Bush-era income tax cuts for two years. That means the tax rate for capital gains and dividend income remains at the current 15% rate for all income levels rather than rising to a top rate of 20% for capital gains and 39.6% for dividends in 2011. This is terrific for investors, particularly those invested in stocks. It will increase their after-tax return. It will also, presumably help generate more investor interest in equities, which is bullish for the stock market.
Q:Democrats are not happy. But the clock is ticking on the Bush-era income tax cuts. They must be extended before the end of the year or the income tax rates revert back to old levels. Can Obama get this deal approved?
A: The chances are exceedingly high. The Republicans will be on board. Democrats, even liberal Democrats, realize this is better than reinstating higher tax rates next year. They are also getting the extension to unemployment benefits – a big issue for them. So the Democrats will hold their noses and vote "Yes." I think the Democrats are most incensed by the estate tax. Under the deal worked out by Obama and Republicans, a person who dies can leave up to $5 million to heirs free of estate taxes, and after that it's taxed at a top rate of 35%. That's a lower tax rate and a higher exemption than the Democrats wanted. I was surprised that the deal was so favorable. The estate tax has lapsed for 2010 and was set to spring next year to 55% with a $1 million exemption. I thought they would strike a deal for a 45% tax with a $3 million exemption. So to see a $5 billion exemption with 35% tax rate is shocking.
Q: The capital gains and dividend tax remains unchanged for two years. The alternative minimum tax received a fix, thus allowing 22 million middle-income families to avoid an additional tax. The estate tax has been reinstated. All things considered, not much is changing for the average investor.
A: You're right. And because we are no longer looking at a huge tax increase for investors in 2011, normal tax strategies remain appropriate for investors of all income levels.
One small but influential class of investors got a big break. The carried interest provision, which would affect mostly private-equity moguls and hedge funds, did not make it into Obama's compromise. Carried interest is now reported as capital gains and taxed at a top rate of 15%. Many people believe it should be taxed as ordinary income at a top rate of 35%. As it stands now, these investors get to keep their preferential tax rate. They have good reason to be happy. For every $1 dollar in carried interest they generate, they save 20 cents in taxes.
Q:What is the single smartest tax-related move an investor should make before the end of 2010?
A: Here's a strategy that we haven't seen in a few years, but is ideal for 2010 given how the bond market performed this year. If you have bonds that have appreciated and you've held them for at least a year, consider selling them and realize the long-term capital gains, which get taxed at 15%. Repurchase the same or a substantially identical bond. Because the wash-sale rule only applies to losses and not gains, you can repurchase the bond immediately after the sale. You will have to pay a premium over the bond's face amount. So when you file your tax return for the year during which you repurchased the bond, amortize that premium and offset the tax on the interest income that you would otherwise have to report on your taxes. In effect, you have converted interest income taxed at a top rate of 35% into capital gains taxed at 15%. Anytime you can do that is a good day's work
Q:What other strategies do you recommend? For instance, what is your thinking on deferring or accelerating income?
A: Because a tax hike is unlikely in 2011, the normal strategy is for investors to defer reporting income until no earlier than next year. They should also accelerate deductions. Because it is so late in the year, it's not easy to accelerate deductions. The income side of things is where investors have more flexibility right now. If investors face a big tax hike, they accelerate the recognition of income into the year when tax rates are still low. You need to be very sure that tax rates will rise and are unlikely to return to lower levels.
Q:What about realizing capital gains and losses?
A: As long as tax rates are not changing next year, I would realize losses. If you have already realized capital gains, then start looking at your portfolio for unrealized losses. If you sell those securities by Dec. 31, you can offset any capital gains and up to $3,000 of ordinary income. Remember to take into account the wash-sale rule, which prohibits deducting the loss if you buy the same holding 30 days before or after the sale. If an investor wants to stay exposed to a stock without running afoul of the wash-sale rule, they can sell the stock, realize the loss and at the same time sell an in-the-money put option. Anything else is pretty much off limits.
Q:What about Roth IRAs. Should investors convert their traditional IRAs before the end of 2010?
A: That was a strategy that made the most sense when income tax rates were expected to climb in 2011. I am not saying that investors should never convert a traditional IRA into a Roth. Remember, when you convert to a Roth IRA, you have to pay taxes on the balance. I would wait until 2011, at the soonest. That way, you don't have to report the income for another year.
Q:We haven't talked about the mortgage-interest deduction. The bipartisan deficit commission wants to restrict it. What do you see happening?
A: I see nothing coming up in the near future. The topic arises anytime a deficit commission gets appointed. The mortgage-interest deduction is unassailable and sacrosanct, and I don't see that changing.
I also don't expect to see any change in the charitable contribution deduction. People will cut back on charitable giving if the deduction is cut or eliminated, and that will hurt the funding available for charities. The government would have to make up the difference, so it would be a zero-sum gain.
Q:Do you have any recommendations for tax strategies in 2011?
A: I would make the same recommendations. The Bush tax cuts will be with us for at least the next two years. So in 2011, we face the same environment. I don't expect a lot to change in our discussions next year.
Q:Thanks for the advice.