The end of the year is typically a time when we go on a tax deduction rampage, donating to charity and upping retirement plan contributions. But, for those whose income may put them in range for expiring Bush tax cuts, it might be wise to hold off on taking all those deductions this year. It’s tough to try to plan in these uncertain times, but you can only do your best.
Bush Tax Cuts
The so-called Bush tax cuts are expected to expire at the end of this year, so next year, some people could find themselves paying more. There are a number of ideas floating around about what should happen, from making the tax cuts permanent for everyone to letting them expire for everyone. What is likely to happen is something in between. Two of the plans with a decent amount of traction right now are:
- Let the tax cuts expire for couples making more than $250,000 and singles making more than $200,000.
- Temporarily extend the tax cuts for everyone.
While no one knows for sure what will end up happening with taxes, many feel that it is highly unlikely that everyone will end up with higher taxes starting next year. However, there is a reasonable chance that some people will be socked with increased taxes, and if you think that your taxes could go up next year, now is probably not the time to take a bunch of deductions.
Save Those Deductions for Next Year
If you are sure that you are going to be among those who see higher taxes next year, you might want to save your deductions. If possible, consider paying your property taxes after the first of the year. Also, save your charitable donations for after January 1, 2011. The same is true of tax-deductible retirement plan contributions. Keep all of that money you had planned to use for deduction getting this year, and wait until the new year. That way, you can lower next year’s taxable income by that much more. This works best if you have a regular plan for deductible contributions. This way, you make next year’s contributions according to plan, but they are augmented by the contributions you would normally make at the end of this year.
Of course, this plan is a risk, because your taxes may not go up. If your taxes don’t end up higher next year, it means that you probably pay more for this year than you had to, but next year’s tax bill will still be lower.
Planning for the End of This Year
There are still some things you can do to reduce your tax liability for 2010, of course. Some things, like the energy tax credits, will probably not be available next year. Additionally, if the long-term capital gains tax increases, you are better off selling your winners before December 31 and paying the lower rate. (Remember that you can offset some of your gains with losses from investments that have dropped in value.)
It is tough for everything to be so uncertain right now. However, Congress is likely to act on the issue of the Bush tax cuts by the end of the year (at least one would hope so). This means that you can set some of your contributions aside — perhaps in a high yield account — and wait for the outcome. Then, once you have a better idea of what is likely to happen to your tax rate, you can make a more informed decision.
David’s Note: Though the tax deduction benefits of making donations and selling stocks are real motivators in practice, I encourage you not to worry about the timing due solely to tax reasons. You should donate because you want to, and when you can. Delaying donations just means delaying your contribution to a worthy cause, which is not your intention I’m sure. On the investment front, all I can say is that markets are volatile. If you want to sell now and wait another month or two instead, the values of your holdings will be much different. Sell because you should, not because you believe it’s the right time for tax reasons.
And retirement contributions, of course, is a savings vehicle. You can almost never save too much, so save as much as you can, and forget about what will happen with next year’s rates because you will want to max your contributions as much as possible AGAIN next year.
On the other hand, here are the possible scenarios of waiting and some thoughts from a purely tax benefit standpoint.
- If your tax rates are going up next year, then your deductions will have a bigger benefit in 2011. So, if you wait to take all your deductions next year, you get a guaranteed return of interest for the time your money is in your hands (for a safe yield, that’s less than 2% a year and more like 1%) plus the difference of the tax rates. Furthermore, it’s possible that in certain scenarios, you can take a standard deduction in 2010 and an itemized deduction next year if you essentially shift all your deductions into 2011. If you can do this, it will probably net you the biggest benefit. Therefore, it makes sense to wait.
- If the tax rates stays the same, then waiting just means getting the deduction one year later. But again, you are actually keeping your contribution with you, so you might actually win by waiting even if tax rates stay the same. Whether you can pull off the deduction shifting strategy is tax rate independent, so it applies in this scenario too. Again, wait.
So basically, it pays to wait, whether tax rates changes or not. But then again, it NEVER made sense to do ANYTHING just for tax reasons. Making a donation just because you can get a tax write-off is the same reasoning as buying clothes because it’s 85% off. You are forgetting the fact that you are actually paying 15% for that item. Sure, in very limited cases, paying 15% will make sense, like when all your other shirts have holes in them and you need to go on an interview, but in general, it does not make sense.
Additionally, after accounting for all the factors, the difference of taking the deduction this year and next may not even be all that much, especially if you factor in that the outcome is uncertain.
In my honest opinion, there are lower hanging fruits to tackle in your financial life than worrying about this. And if you’ve done absolutely everything you can to shore up your finances, spend more time celebrating the holidays!